Recession probability in 2023: Odds are higher than Wall Street expects

A sense of fear is spreading in the financial market. The fear and greed index has moved to the fear zone of 38 while the S&P 500 and Nasdaq 100 indices have retreated by over 8% from the YTD high. 

Also, the US dollar index (DXY) has jumped to the highest point in over six months. The iShares 20+ Year Treasury Bond (TLT) ETF has slipped to the lowest level since October last year. 

Fed believes in a soft landing

The talk of a recession in the US has been a bit weak in the past few months. For one, the most recent data showed that the American economy rose by 2.1% in the second quarter after growing by 2.6% in Q1. And the Atlanta FedNow data estimates that the economy will expand by 4.9% in Q3.

Therefore, analysts believe that the odds of a recession have retreated in the past few months. In their recent report, analysts at Goldman Sachs reduced their estimate of the country’s falling to a recession to 20%. 

The Federal Reserve believes that it can engineer a soft landing, where it lowers inflation without causing a recession. In a statement on Monday, Chicago Fed’s Austan Goolsbee noted that the economy could avoid a recession even as interest rates remains at the highest level in more than two decades.

He cited the fact that the unemployment rate remains at historic lows while inflation has come down in the past few months.

Recession risks are elevated

I believe that recession risks are at an elevated level. For one, the yield curve has inverted to the lowest level since the Great Depression. Historically, the yield curve has been one of the best predictors of recessions. 

Further, recessions tend to come in a period of high interest rates. The Fed has hiked rates to 5.25% in 2008. They were at 6.5% before the dot com bubble and 20% during the 1980s economic crash.

The impact of high interest rates are now starting to sink in. Recent data shows that delinquencies on credit card loans have jumped to the highest point since 2012, as shown below. Delinquency rates on all consumer loans has also jumped to the highest level since 2020.

Further, bankruptcies have continued rising in the past few months and the trend will continue for a while as interest rates remains at an elevated level. 

Year-to-date default rates in the US and Europe are already above 2008 levels.

Interestingly, this is barely getting any attention.

We are on track to see more defaults in the US and Europe than all years back 2009, other than 2020.

Default rates have nearly tripled since 2022… pic.twitter.com/vzIFL4bSXe

— The Kobeissi Letter (@KobeissiLetter) September 23, 2023

Worse, inflation is not falling as fast as the Federal Reserve expected. The most recent data showed that the headline consumer price index (CPI) rose from 3.2% in July to 3.7% in August. This trend will go on as crude oil price continues rallying. As we wrote here, analysts at JP Morgan expect Brent to hit $150.

There are other inflationary factors. For example, vehicle prices are set to keep rising because of the ongoing UAW strike in the US. Climate change will also be inflationary, as evidenced by the rising orange juice and olive oil prices. It has also contributed to the traffic jam at the Panama Canal.

Unfortunately, the Fed has no tools to lower the key drivers of inflation. It cannot force OPEC+ to boost production. Also, the Fed cannot solve the crisis at the Panama Canal. 

Turning to stocks, valuations are still at a high level. I recently wrote about Nvidia, a $1 trillion company that has a PE ratio of over 200. Other companies like Tesla and Apple seem overvalued. As a result, as we saw in 2,000, the S&P 500 index has jumped because of only a handful of companies. 

Therefore, I believe that the probability of a recession happening in either 2023 or early 2024 are higher than expected. I place the odd at over 50%.