Just What Will Break First?
Tighter policy will eventually tame prices, but it’s still hard to see a U.S. recession anytime soon.
Seasoned sailors know a chain is only as strong as its weakest link, and weary parents will confirm they are only as content as their least-happy child. The risks of recession lie in the most fragile parts of the economy, and that is where we should all be looking as Jerome Powell and his Fed colleagues stress their determination to bring inflation under control.
But where to look? The Fed may have a poor track record of taming inflation without triggering a recession and some argue that Powell & Co. have already lost control. The key drivers of current price pressures, however, remain on the supply side, and all central banking textbooks stress the importance of not overreacting. Months from now, the main shock from Russian sanctions will have passed and global commodities prices should stabilize at higher levels. China’s COVID lockdowns may continue to cause havoc, but the pandemic has not hampered production elsewhere in Asia.
As long as these shocks don’t embed themselves into U.S. wage and price expectations, the places where recessions often start look remarkably resilient.
First, there’s a lot of attention on the rising pressures on consumers, the bulwark of America’s economy if not the world’s. Home prices soared nearly 19% last year, gasoline averaged $4.33 per gallon in March, and grocery baskets are running 9% more expensive this year with little apparent relief in sight.
But rarely has the average American consumer been better positioned to withstand these shocks. Savings rates may be edging down, but cash balances remain higher than pre-pandemic levels for all but the poorest households. In spite of headlines about the global order falling apart, consumer confidence actually notched higher in March. With 11.3 million potential jobs available, it may be some time before most Americans actually tighten their belts.
Banks are frequent suspects as triggers of the next recession when rates rise. Overextended lenders typically face rising defaults and must cut lending to meet regulatory requirements. Last week’s bank earnings reports showed sharp declines since last year, but capital ratios are still comfortably high and provide both scope and incentive to keep lending.
“Shadow banks” are often cited as a systemic vulnerability because there is less transparency, but this category includes vast pools of pension and endowment money that are deployed as loans and without any specific capitalization requirements. When the pandemic struck, many of these investors actually increased their allocations as prices adjusted, and they would likely do the same now in any significant downdraft.
Next on the list of potential weak links are companies themselves, which are beginning to show some of the stress of the current environment amid rising prices and narrowing margins. Spreads on less creditworthy firms reflect market concerns, with CCC-rated debt widening 125 basis points so far this year, compared to roughly half that for high yield debt overall.
While investors brace for mixed earnings results in the first quarter and worse when the next reporting season fully reflects the Russian commodity shocks, corporate America still looks remarkably strong. Savvy high yield managers will be on alert for the weakest firms that will flounder, but interest coverage ratios remain low, debt maturity profiles look manageable, and default rates are still lower than they have been in 20 years.
A fourth vulnerability may come from the Fed itself as it attempts to shrink its $8.5 trillion balance sheet even as it raises rates. With few precedents to guide the proper pace of “quantitative tightening,” markets are nervous that rates could spike much higher as the Fed not only stops buying government and mortgage-backed bonds, but may even start selling them. Anything unprecedented, of course, carries risks, but the simplest solution may just be to slow or halt the process.
Finally, there are plenty of global risks that the Fed’s inflation taming will aggravate. The most evident problem today may be a U.S. dollar that has strengthened some 7% since last year, hurting American exporters and squeezing any foreigner who owes money in U.S. currency. But that rate differential will not continue to rise forever, especially as the European Central Bank and others stake out their own plans to fight inflation with tighter policy.
Hawkish Fed signals should send investors back to reviewing the most fragile names in their portfolios. Powell’s tough talk should send economists back to hunt for vulnerabilities in the U.S. economy as the costs of workers, goods, and money all start to rise. But before sounding the recession alarm to abandon ship, a quick inspection of the anchor chain’s weakest links suggest it’s not at risk of breaking soon.