We’ve been on the record since last year stating that we did not see a recession brewing in the economy. In fact, last June, we wrote that the market may rebound strongly if a recession does not show up. 14 months and no recession later, the global stock market has rebounded by more than 12%. While we still don’t expect a recession, we argue that the odds of one occurring are higher today than they were at this time last year. Ironically, however, markets seem less concerned about a recession today than they did one year ago.
Conditions have gotten “tighter”
One year ago, the common argument for a recession went like this: rising interest rates will tighten credit in the economy. That will lead to reduced borrowing and less consumption. This was expected to hurt growth and cause a recession. Just one problem: that hasn’t happened. In fact, growth, as measured by GDP, was actually stronger during the second quarter than it was in the first. And based on the Federal Reserve’s GDP Now tracker, growth is accelerating even more now during the third quarter.
The latest estimate has third quarter GDP tracking at 4.1%, up from 2.4% during the second quarter (it was 2% in the first quarter). While this is good news today, we’d like to point out that the conditions that were expected to cause a slowdown aren’t just still in place—they’ve gotten worse.
Mainly, interest rates have risen across the board. In other words, borrowing conditions have gotten even “tighter” than they were last year. The Fed’s interest rate, mortgage rates, and real rates in the market, are all much higher than they were one year ago:
Why this hasn’t been a problem
So how come rising interest rates hasn’t been the burden on economic growth that it was expected to be? Well, we can’t be exactly sure, but we have one main theory. That is that most homeowners have mortgage rates that are well below current rates. According to Redfin, 62% of homeowners have a fixed rate mortgage under 4%, and nearly 80% of homeowners have a rate below 5%.
At the same time, these homeowners have kept their jobs, they’ve seen their wages increase, inflation fall, and their home values have held steady. That’s a good combination for feeling pretty good about yourself. So perhaps it’s no surprise that consumer sentiment recently hit a two year high. Strong consumer attitudes have led to continued consumer spending, which is the lifeblood of the US economy.
How things could change
While most homeowners have been insulated from rising interest rates, new home buyers are not. Per the same Redfin report cited above, the share of homeowners with mortgage rates under 5% is starting to decline slightly.
As the percent of homeowners with rates above 5% starts to climb, mortgage payments will become a greater liability on the overall consumer’s purchasing power. So far, that’s not happening because people aren’t moving. But, long-term, that’s a problem. The economy needs people to move. Banks rely on the financing of mortgage loans to generate revenue and so do numerous trade jobs: think construction, HVAC, electricians, etc.
Existing home sales have been on a steep decline, but if they pick back up, we enter a bit of an economic catch-22:
A pick up in home sales, at current mortgage rates, would mean more consumers are dealing with higher financing costs. In order to deal with these higher costs, they may cut back on discretionary spending elsewhere.
How the slow down can be avoided
One of the key assumptions that the stock market has made is that inflation is now under control. The market currently expects one, five, and ten year inflation rates of 2.58%, 2.43%, and 2.36%. Such levels are in line with the benign inflation we saw during the 2010s. If the market is correct with its forecast, then that would mean the Federal Reserve has likely lowered interest rates from their current level of 5.33%.
Sure enough, the market expects the Federal Funds rate to lower to 4% by the end of 2024, and 3.50% by the end of 2025. If that were to happen then mortgage rates would certainly be lower than they are today. In that case, the housing market, (and the consumer, in general), would likely experience the soft landing the market is currently pricing in. (See: What is a soft landing?)
Last year, the market expected rising interest rates to have caused a recession by now. That didn’t happen, and growth is actually accelerating. But the conditions that were expected to cause a slow down haven’t gone away, they’ve actually become more pronounced. At the moment, the market has made some assumptions about the path for inflation and interest rates. Those assumptions have helped the stock market rally. The real test begins now and over the next year, as we start to learn if the market’s assumptions are correct.
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