Why The 2023 Recession Never Happened | Neil Dutta

The consensus 'excess savings' narrative is misleading because savings rates need not rise to pre-pandemic levels given that household balance sheets (home equity, stock values) have improved substantially, reducing precautionary saving needs.

“there's a view I mean and you know it feels like the the excess savings story is another one that kind of I mean every it feels like every six months for the last few years it's all people have drawn down their excess savings and they don't have any other way to to spend money I mean it's sort of there's no right saving rate number one I mean part of the issue is that if you if you go back to the period following the financial crisis it was um it was a period where we had a lengthy balance sheet repair and the savings rate was going up steadily from like three or 4 per to eight or % by 2019 there's no reason for the savings rate to have to get up that high if you look at where household balance sheets are right people have a lot more equity in their homes uh their debt burdens are a lot lower because a lot of them are termed out on their mortgages so there's no reason for the savings rate to actually go up that high”

In fall 2022, nearly every mainstream economist was bearish on the economy and forecasting an imminent, potentially deep recession; Bloomberg's economics probability calculator showed 99% chance of recession.

“in the fall of 2022 nearly every mainstream Economist was very bearish on the economy most of them were forecasting an imminent recession that could be a very deep recession I think the Bloomberg economics probability calculator had it at a 99% chance which which really is stunning”

Historically whoever wins the White House brings Congress along with them, so control of Senate and House depends on presidential outcome, which affects legislative scope for stimulus.

“because historically I mean at least in recent elections whoever wins the White House brings the other brings Congress along with them so if it's if it's Trump then it's probable that the Republicans control the Senate and and the uh and the house and if it's if it's Biden you know what does that mean for the Senate and the house”

From early 1980s to 2008, as asset values rose relative to income, savings rates fell—a relationship that reversed in the 2010s during balance sheet repair, but may be reasserting now that household balance sheets have healed.

“this is basically what happened you know from the early 1980s all the way to 2007 2008 right as asset values went up savings rate came down and that relationship was sort of upended in the 2010s following the financial crisis for the reasons we mentioned right balance sheet repair and so forth but it could well be that those prior historical r relationships are now reasserting yourself”

Mainstream narrative of consumers borrowing to maintain lifestyles is a morality tale but misses the data; revolving credit relative to disposable income peaked around 2007, not recently, and has been relatively stable, suggesting consumer borrowing is aligned with income growth, not crisis-level excess.

“there is a a narrative that oh my God you said it's a morality Tale But us consumers are borrowing like crazy to maintain their Lifestyles but you know I've looked at some aggregate data of like consumer debts relative to income or disposable income however you know GDP however what you want to divide it by and I think it peaked in in in 2000 like I think there was a you know giant people getting more indebted from the 70s to 2000 but I think it's been relatively stable right now”

The neutral rate (the rate where policy is neither restrictive nor stimulative) is probably higher than the Fed believes it to be (Fed thinks ~2.5%); this implies the Fed can keep rates higher without crushing the economy, reducing recession risk from extended tightening.

“I also think neutral rates are probably somewhat higher you know right this is right like what is the break even for you know where the economy slows down versus speeds up and you know and I think that number is probably higher than the fed the FED believes it's not you know they think it's two and a half percent I have some skepticism around that”

The equity market is actually a better leading indicator of Fed policy shifts this cycle; the stock market has correctly predicted 5 of the last 5 Fed pivots, whereas bond market has been abysmal; equity prices communicate economic information to most Americans better than bond yields do.

“the stock market gets ding for you know predicting nine of the last five recessions I mean the famous Samuelson quote but it's probably predicted five of predicted five of the last five fed pivots so how dumb is the stock market in that sense I mean that is the primary transmission mechanism for how most of America processes economic information beyond their job right I mean it's you know what are you hearing I mean no one's you know the 6:30 Nightly News I mean Lester Holt isn't telling you what what the 10 years's trading at he's telling you what the stock prices went up”

The bond market is not omniscient; it has a history of pricing tightening cycles too soon and calling the cycle over before it actually ends; in 2023 markets priced 4 cuts and Fed hiked more instead, showing bond market error is possible.

“Bond Traders I mean there's always and another thing that I hate is that everyone always likes to dunk on Equity Market investors and it's sort of the bond Market's the smart one the stock market's the dumb one but let's think let's talk a little bit about that I mean the bond markets have a habit of pricing and tightening Cycles too soon once the tightening cycle starts the bond markets have a habit of thinking that the cycle over way before it actually ends right”

In early 2023, the mere expectation that the Fed would pause (rather than continue hiking) sparked a huge rally in fixed income, translating to lower mortgage rates that caused the housing market to rebound sharply, revealing strong underlying housing demand.

“by early 2023 just the expectation that the FED would pause sparked a huge rally in in fixed income and that obviously translated to lower mortgage rates and the housing market took off so I thought that was pretty revealing right if you're able to drive a lot of incremental activity into housing with a very modest decline in rates what does that tell you about the underlying demand in housing it's pretty strong”

The ISM manufacturing index has been below 50 throughout 2023, but year-over-year manufacturing production was up slightly (December 2023 vs December 2022), suggesting the ISM overstates weakness by measuring month-to-month momentum rather than absolute production levels.

“the ism was basically below 50 all year in 202 23 if you look at year-over-year manufacturing production it was up a little bit December of 23 against December of 22”

The pandemic created a Dynamic where people were confined and could not consume services, so they bought goods instead, creating a manufacturing boom. As the pandemic faded, consumption rotated from goods to services, naturally causing manufacturing to look worse—but this is normalization, not recession.

“we had a pandemic Dynamic where people were shut in that supercharged the manufacturing sector because people couldn't do they couldn't do things but they could buy stuff and so stuff is produced it's manufactured and that basically lit a fire in the manufacturing SE sector and so you had a big boom in in in in goods and then as the pandemic was kind of fading you saw rotation from Goods to services and obviously that's going to make manufacturing look a lot worse than otherwise would right and so is that necessarily recession or is it just a normalization of the economy”

Consumers are spending money on goods while inventories are being drawn down significantly; this gap is unsustainable and must be filled by firms restocking inventories, which will support manufacturing later.

“if we're talking about manufacturing let's look at what's happening with consumer spending I mean we know that consumers are spending money and we know that inventories are being drawn down quite I mean that's that's pretty clear I mean even if you look at the Atlanta feds tracking estimate for the fourth qu it looks like inventories are going to be cutting GDP growth by another 50 to 60 basis points in the four quarter so you know that's not sustainable I mean if you have consumers spending on Goods climbing and inventory is continuing to come down and and at some point firms will need to replenish their inventories and once they do that that is going to support the manufacturing sector”

Fed statements in mid-2022 indicated the Fed believed a recession was required to quell inflation, which made recession forecasts sensible at that time, but holding onto recession calls beyond mid-2022 made less sense as conditions evolved.

“recession risk was elevated in in 2022 particularly in June and a lot of that had to do with the FED right jack because the FED basically told us that they thought a recession was required to quell inflation so I think having a recession call in the middle of 2022 made sense but as the year went on I think holding on to the call made less sense”

The Fed did not actually need to hike rates to break the housing market in early 2022; by talking about rate hikes, the Fed talked the housing market into collapse without actually raising rates much initially.

“the FED did break the housing market without actually hiking right I mean they basically talk the housing market into Oblivion in early 2022”

The decision to make a soft-landing call despite consensus being 99% bearish makes sense only if you weigh probabilities wisely and choose your battles with consensus carefully—picking fights constantly for attention is not the same as providing solid research for investment decisions.

“I learned from my mentor you know Ethan Harris who was formerly the head of Economics at Bank of America Merl Lynch is that this business is about weighing probabilities and then choosing your battles with the consensus wisely so I don't like to always pick fights with the consensus I mean I think that's good to like get a lot of attention at like ctail party but I don't think that that's necessarily the best way to go when you're when you're in the business which is providing you know research solutions for people to use in their investment process”

The primary reason for optimism in late 2022 was recognition that labor markets were fine—unemployment was low, employment growth was solid, nominal incomes were rising, and simultaneously the Russian invasion of Ukraine shock was wearing off, causing prices (especially energy) to come down.

“what led my optimism primarily was just recognizing that the labor markets were fine right unemployment was low we were generating relatively solid employment growth so nominal incomes were rising and at the same time the shock of the Russian invasion of Ukraine was wearing off right so as a result prices were coming down particularly Energy prices”

The 2024 US election presents a significant risk: Any new government (Trump or Biden) will likely introduce fiscal stimulus as its first act (following historical pattern of recent administrations), which could trigger a bond market reaction if viewed as inflationary; this could create market instability even without recession.

“I think the election is something to think about Jack I mean so one of the things I think about is the the mood the bond Market's in obviously we're coming off a period of very very elevated inflation and it's getting better now there's no doubt about that but I guess the question is what does the composition of the new government look like next year because no new government comes in and Promises to do less for the people right I mean President Obama had the American Recovery and reinvestment act you had tax cutting jobs act under President Trump you had the American Rescue plan under President Biden”

Government stimulus was a significant driver of real income growth and economic support; this fiscal tailwind is likely to fade in 2024, necessitating Fed rate cuts to provide yield curve steepening to offset the fiscal withdrawal.

“obviously the government spending money was a big was a big driver of this as well we did have a very strong fiscal impulse that's probably going to fade somewhat this year but that's one of the reasons why we think the FED is probably going to end up cutting rates a few times to you know provide some steepening of the yield curve to offset a little bit of that fiscal”

Industrial stocks have outperformed the S&P 500 over the past 12 months despite ISM being below 50, demonstrating that ISM is not a reliable equity market predictor and consensus reliance on it for recession forecasting was misplaced.

“I mean so you know my own view is that if we're talking about manufacturing let's look at what's happening with consumer spending I mean we know that consumers are spending money and we know that inventories are being drawn down quite I mean that's that's pretty clear I mean even if you look at the Atlanta feds tracking estimate for the fourth qu it looks like inventories are going to be cutting GDP growth by another 50 to 60 basis points in the four quarter so you know that's not sustainable I mean if you have consumers spending on Goods climbing and inventory is continuing to come down and and at some point firms will need to replenish their inventories and once they do that that is going to support the manufacturing sector”

Rapid Fed tightening in 2022 hurt the economy at the margins of the financial system (private equity, corporate credit, M&A) and slowed housing, but many households were insulated because they were locked into 30-year mortgages at 3.25%, limiting tightening transmission.

“obviously people have termed out on their mortgages and so you know the the effective rate that people are paying is not going up as much as the FED funds rate but the FED did kill off a lot of activity you know at the margins of the financial system I mean you know P private Equity you know as an example you know areas in the corporate credit markets you know so the you know m&a I mean there there was a lot of things that did that did slow down obviously they slowed the housing market down quite a bit”

Credit delinquencies are rising but from exceptionally low 2021 levels; subprime borrowers who improved have migrated into prime category, leaving worse credits in subprime, so higher delinquency rates are compositional not systemic.

“there's no doubt about that but it's also important to remember that a lot of those sub I mean you're you're left with a A you know some of those sub like subprime borrowers have gravitated to Prime and so the people that you're left with in the subprime categories are net worse right they're they're worse credits and so that's what makes the delinquencies look somewhat higher”

Bond market pricing in 2021 (10-year at 1.5% when nominal GDP growth was 10%) was incorrect; if bond market were tracking nominal GDP growth correctly, yields should have been higher; this shows bond market was 'abysmal' at capturing growth dynamics.

“in 2021 the 10 year was at like one and a half percent and nomal so the bond market is the truth forecasting nominal GDP which was you know at 10% so yeah”

Manufacturing work week has declined over the last 11-12 months primarily because of inventory shedding, and this is unlikely to persist as inventory replenishment occurs, which should support manufacturing work week and broader labor income.

“and keep in mind that a lot of the reason why the work week has declined over the last year is because it goes back to something that we said talked about earlier which is this inventory shedding in the manufacturing sector so if you look at the manufacturing Work Week Jack it's it's come down quite a bit over the last 11 12 months and that is unlikely to persist because you you'll likely see some inventory restocking this year and once that happens I mean you probably see the manufacturing Work Week extend which should again support the lab the labor markets more generally and labor income”

Real incomes are the most notable positive indicator, combined with strong housing market recovery (new home sales picking up, representing signed contracts that drive future construction and household spending).

“I certainly think the continued pickup in real incomes is the most notable indicator obviously the housing market as well right so new home sales were picking up particularly early this year and again new home sales represent signed contracts right so a contract is signed then builders start to make the house and then people move in and they fill it with things”

Labor market momentum (change in payrolls) has slowed, but the level of activity (unemployment rate) remains strong; the flatline in aggregate hours (employment × work week) despite 2-2.5% growth suggests hours must eventually grow to match economy, creating job growth or work week extension.

“there's two ways of looking at economic data right the first is momentum so a momentum indicator would be something like the change in payrolls and then there's looking at the level of activity right and so a level of activity indicator would be something like the unemployment rate right so in relation to the recent past that's momentum and in that sense the labor market slowing but the level of activity in the labor market remains pretty good because the unemployment rate remains very low”

New home sales are forward-looking indicators because they represent signed contracts before construction begins; new home sales strength in 2023 should have signaled to consensus economists that housing market weakness would not produce major construction employment declines, undermining the bearish call.

“new home sales represent signed contracts right so a contract is signed then builders start to make the house and then people move in and they fill it with things right and so and remember that a Lynch pin for the bearish call on the economy was what that we'd have a big drop in construction employment because of the housing market detonating in 2022 didn't happen”

Credit indicators beyond the yield curve—specifically the excess bond premium (proxy for credit risk in corporate markets)—may be better recession indicators than the yield curve, and looking at overall slope of financial conditions across multiple indicators (not just one) is important.

“I mean also it's Al also to keep in mind like what's going on with corporate credit I mean there's been a lot of research out of the FED that talks about you know things like the EXS Bond uh premium right I mean this is basically appr proxy for credit for risk in the corporate credit Market and you know they've talked about how that might be a better recession indicator than say the yield curve so you know I just think it's important to look at the overall slope of financial GRS not just one thing here and there”

Upper income quintiles have excess savings while lower income quintiles do not, but falling gas prices and moderating grocery prices help lower income quintiles significantly and support demand.

“well well maybe the upper income quintiles are you know they have a lot of excess savings but the lower income quintiles they don't okay but at the same time let's talk about that I mean gas prices are down a lot it's highly probable I mean if you look at agricultural Commodities that grocery store prices will probably start to moderate sometime this year also who do you think that helps right”

If the Fed keeps rates at 5.5% forever without cutting, inflation expectations are declining so tightening conditions would result, slowing growth below potential and pushing unemployment higher—maintaining current rates indefinitely would become problematic.

“if the FED keeps interest rates where they are forever I mean at what point will that start to cont cause a contraction in economic activity I mean I think it would probably happen relatively soon I mean if the FED doesn't cut I mean remember a lot of what we're seeing in the markets is is premised on the expectation that the FED will end up cutting several times this year so if they don't end up doing that that represents a tightening of financial conditions which would imply some slowing in the economy um and considering we're at you know running at about two two and a half percent I mean you could easily see you know an economy growing below potential which could then push the unemployment rate higher”

From 2002-2008, bank credit relative to GDP was rising steadily every year, but since the financial crisis, banks haven't been the incremental driver—credit growth has just tracked nominal GDP without growing much faster.

“if you go and you look at you know Bank credit growth relative to the economy from 2002 to 208 I mean it was Rising steadily every single year but since you know since the financial crisis I mean Banks haven't been you know the incremental driver of things I mean it's basically track nominal GDP it hasn't grown much faster so it's hard to say that it's been the Lynch pin for the economy frankly in recent years right”

Making payroll revisions the lynchpin of your forward economic call is 'a bit ridiculous'—the underlying story hasn't changed and market reaction supports this view.

“you know I think the label markets are fine I mean I wouldn't say that they're Gang Busters but they don't have to be either so but generally speaking I think the idea that you're going to like make revisions like a Lynch pin for your forward call I think is a bit ridiculous”

Dutta's interest in what happens in early 2025 with new government and its fiscal plans, and how bond market investors will fund or refuse to fund those plans—this will be key factor in economic outlook.

“so what what kind of things will be talking about in early 2025 and what will bond market investors be willing to fund so it sounds like if the you know new government gets elected and there's a lot of fiscal stimulus they they want to sort of prime the pump when when they first get in office I mean sounds like that will be a continual boost to the economy but so your worry is not about recession but just that you know mixup in the long end of the bond market yeah I mean I think it'll it would create a more destabilizing situation in the fixed income markets as a result that's possible”