Following a particularly challenging year in the markets, attention is now on what 2023 may bring. Financial strategists have offered their predictions for the year, and a common and persistent theme is concern over an upcoming recession. 

In a past article, we defined a recession as a significant and widespread decline in economic activity that generally involves at least two consecutive quarters of negative economic growth. The article also distinguished between a recession and a bear market—the latter describing the market, rather than the economy.

In this article we’ll take a look at the current state of the economy and provide some thoughts on whether or not an upcoming recession is an inevitability and discuss the potential outcomes should we find ourselves in one.

What got us here?

The current environment is largely the result of persistently high inflation. No single occurrence was responsible for rising inflation, rather, it has been brought on by a variety of factors including pandemic-related supply chain disruptions and stimulus measures as well as geopolitical conflict and rising commodity prices. Together, these elements, along with others, contributed to a greater demand for goods and services than available supply—driving prices higher.

This past year, in an effort to lower inflation, central banks leaned heavily on their primary tool and increased interest rates significantly. Simply put, increasing interest rates—or the cost of borrowing—should result in higher interest charges on debt leading to a higher overall cost of major purchases for consumers and business as well as less disposable income. These factors should lower demand for goods and services, cooling prices in the process. 

Such restrictive policies are clearly not supportive of economic growth and are deliberately intended to slow down the economy. This raises the concern that in their effort to lower inflation, central banks may cool off the economy too much and trigger a recession.

Where are we now?

At present, there are many indicators that suggest that the economy remains in fairly good shape despite others showing early signs of cooling. Inflation also remains high, but appears to have peaked and has been gradually decreasing over the past several months. Ideally, inflation would continue to meaningfully decline while economic activity softens without a significant slowdown in the economy or a large increase in unemployment. There is no historical precedent for such a ‘soft landing’ but at the same time, there is also no historical precedent for an environment stemming from the crossroads of a global pandemic, massive stimulus measures, supply chain disruptions, and geopolitical conflict.

The alternative to this optimistic outcome would be a recession or a ‘hard landing.’ This is the expected outcome by most economists and investment professionals. Central banks such as the US Federal Reserve have been clear that they see triggering economic contraction as the likely solution to bring inflation down to their target. Historically, high inflation has typically needed a recession and a rise in unemployment in order to resolve, which supports this potential outcome.

Where are we going?

So if central banks, economists, and investment professionals believe we’re headed for a recession and history supports this notion, does that make it a certainty? Perhaps, but that doesn’t guarantee that we’ll be faced with a prolonged period of economic hardship nor does it mean that a recession is imminent. Recessions are not equal, and any potential upcoming recession doesn’t necessarily need to be deep and long-lasting nor does it need to be an economic catastrophe like the global financial crisis of 2007 to 2009. 

The cooling of the economy that we’re witnessing—and largely expecting to continue—is not due to the exposure of cracks in the financial system nor is it due to blatant excesses and risk taking on the part of consumers and businesses. Such factors would largely increase the likelihood of a deeper and painful recession. Instead, slower growth and potential contraction is being intentionally manufactured by central banks such as the US Federal Reserve and the Bank of Canada. It seems sensible that a recession that was deliberately initiated could be milder in nature than one inadvertently triggered.

A mild recession would still be expected to lead to higher unemployment, which would unquestionably be hard on those affected, but large and widespread layoffs are not inevitable. At present, the labour market continues to be a bright spot with the US unemployment rate (as seen in the earlier chart) dropping back down to 50-year lows. Other data points such as below-average layoffs, and above-average job openings and quits speak to the relative strength of the job market. That said, there are signs that the economy is losing momentum, with quit and hiring rates falling and wage growth starting to slow.

Moving forward, there may be a limit to how much weakness we see in the job market as there are structural factors at play that support a strong job market. As many baby boomers reach retirement age, they leave behind a gap in the workforce, which has been difficult to fill, particularly as the pandemic slowed immigration. This reality along with current labour market strength may limit a large increase in the unemployment rate and moderate the severity of any upcoming recession.

Additionally, any weakness in the economy would provide central banks with the opportunity to revisit their monetary policy and make room for a pause and eventual easing of rates—especially if inflation continues to decrease significantly. That said, central banks would not likely slash rates and provide excessive stimulus at the onset of a mild recession as this may undo any deliberate progress made towards lowering inflation. 

By their nature, recessions are the result of decreased economic activity or spending, so they’d likely be accompanied with a meaningful reduction in inflation. This is not to say that a recession is a net positive for everyone, but lower inflation would certainly be welcomed. 

Final thoughts

Over the past several weeks, the case for a soft landing—though still unlikely—no longer seems impossible. Still, the more likely scenario remains a mild recession, but based on the circumstances, including the current strength of the economy, such a recession may end up being on the softer and shorter end of the spectrum and also may not even materialize this year.

Looking at macroeconomic factors and trying to forecast what’s next for the global economy is extremely challenging at the best of times. The current environment is even more confusing with economic indicators sending conflicting messages. Complicating matters further is the notion that even if we were able to determine the direction of the economy, we’d still not necessarily be able to determine the direction of the markets. Historically, stocks have tended to act as a leading indicator declining in advance of an economic contraction, and rallying before economic recovery.

Despite uncertainty surrounding what may come for both the economy and the market, we may take solace in the fact that should a recession materialize, it would likely be one of the most anticipated recessions of all time. Given that a recession of some degree is largely expected, presumably markets have priced in this possibility. This doesn’t mean that stocks won’t decline further from here as expectations for the future can change. It also doesn’t mean that stocks must decline simply because expectations come to fruition. The market is forward-looking and historically, has had an uncanny ability to bottom while other data such as economic activity, earnings and employment continue to deteriorate. So even if the economy continues to slow—which it likely will—there will come a point where the market has already moved past it.