Touch and go - recession, soft landing or second wind?

The narrative in markets over the last year has been simple: will the US achieve the mythical ‘soft landing’ or will higher rates push the US economy into recession? A ‘soft landing’ is now the consensus view and is fully priced into markets. Is this truly the end of the debate?

We think not.

Our view is that markets are entering a new stage, where risks are more symmetric rather than skewed to the downside, with the changing skew being driven by conflicting signals from US data. We see signs of an emerging upside risk, that of a ‘second wind’ to economic growth, spurred by recent strong non-farm payrolls and GDP reports. But at the same time, softening hiring intentions data and subdued business surveys still suggest that a recession cannot be ruled out. These scenarios have very different implications and a nimble approach will be key to navigating markets over the coming months.

The narrative in markets has shifted away from ‘recession risk’ but our view is that investors risk becoming complacent. A soft landing may now be the most likely scenario, but recession risks are still very elevated. Historically, during most cycles, the economy often appears to be headed for a 'soft landing' just before going into recession.

One critical signpost of a recession – a significant rise in the unemployment rate – remains absent.  However, it is not unusual for the unemployment rate to take some time to show a definitive rise at the beginning of a recession. 

Our analysis shows that in US recessions, the first 0.5 percentage point (ppt) rise from the low in the unemployment rate can take an extended period (on average eight months), while the rise beyond that occurs much faster (on average three months for the next 0.5ppt).   

The reason is that businesses initially tend to respond to softer conditions via reducing hiring and reducing hours worked. In other words, they hoard labour. It is only as economic weakness persists that employers cut jobs.

Our analysis shows this pattern is consistent across a number of developed economies. When the unemployment rate rises a mild-to-moderate amount, most of the adjustment in the labour market is via a reduction in average hours worked, rather than employment. It is only during severe downturns in the labour market that broad-based job losses occur.