In recent months, the financial market discourse has been increasingly dominated by the prospect of a “soft landing,” a scenario where the economy slows down without nosediving into a recession. This narrative is getting louder while discussions around a potential recession seem to be receding in 2023. However, it’s worth noting that this isn’t the first instance of such an uptick in “soft landing” discussions. Similar narratives surged in 2000 and 2006, both instances followed by a recession. This correlation begs the question: Is this a coincidence or a cautionary tale?
Market Behavior Reflecting the “Soft Landing” Sentiment
The notion of a ‘soft landing’ isn’t confined to just discussions; it is significantly influencing market behavior. The impressive rally of the S&P 500 over the past 6 months, primarily driven by robust earnings expectations, attests to this market sentiment. Analysts are predicting significant S&P 500 earnings growth and an economy that skillfully evades a potential recession. But there’s a red flag that cannot be ignored: the yield curve inversion.
The Yield Curve Inversion: A Precursor to a Recession?
A yield curve inversion is a phenomenon where the Federal Reserve has hiked short-term rates too aggressively relative to long-term growth expectations. This inversion is often a common precursor to a recession. This happens because banks borrow at short-term rates and lend at longer-term rates. If short-term rates exceed long-term ones, lending slows down, consequently tightening credit and potentially triggering a recession. Historically, the yield curve has been a reliable GDP predictor. When the curve has inverted, GDP contractions have typically followed within 15 months, as evidenced in the 1970s, 1990s, and 2000s. Notably, we are already 12 months into the current inversion.
“Soft Landing” Advocates and the Corporate Debt Conundrum
Despite this historical pattern, investors are growing impatient, with many regarding a recession as very unlikely. This optimism is fueled by low interest payments for businesses and robust nominal GDP growth. Advocates of a ‘soft landing’ argue that businesses are shielded from rate hikes as they’ve locked in their debt at low rates. As a result, corporate interest payments have stayed flat since 2021 and are below pre-pandemic levels.
However, this period of low interest payments may not be sustainable. The overall volume of corporate debt, coupled with rising corporate bond yields, is a good predictor of the interest paid by corporations. Corporations, laden with debt and facing high rates, are on the brink of significant increases in interest payments. When they hit their debt maturity wall and start refinancing, they’ll have to do so at higher rates.
Past recessions have often been preceded by spikes in corporate interest payments, as seen in 1990, 2000, and 2006. This cycle, however, hasn’t yet seen such a surge.
A Historical Perspective: High GDP Growth Doesn’t Ward Off a Recession
Another pillar of the ‘soft landing’ argument is the robust nominal GDP growth. The year-on-year change in GDP is over 5%, surpassing anything witnessed post-financial crisis. This has led to a belief among market participants that a recession is unlikely in such an environment.
However, history tells us otherwise. Recessions have occurred even with nominal GDP growth above 5%, as witnessed in 1970, 1975, and 1980. In each of these cases, equities endured significant downturns. This historical pattern serves as a reminder that high GDP growth doesn’t necessarily ward off a recession.
While the narrative of a ‘soft landing’ is gaining consensus, businesses are nearing their debt maturity wall. Added to that, history has shown that recessions can occur even amidst high GDP growth. Therefore, despite the prevalent optimism, an air of caution is warranted. As every seasoned market observer knows, the financial landscape can quickly shift, and understanding these underlying dynamics is crucial for navigating potential future turbulence.