A US Recession? Don't Count on It Yet
By: Oscar Muñoz, Jan Groen
January 26, 2023 - 3 minutes 30 seconds
The eye-popping and unexpected decline to below 50 in the ISM Services index earlier this month brought again to the fore discussions about the state of the US economy and corresponding mounting recession risks. While the December plunge to contraction territory would suggest increasing risks of a downturn in US output more broadly, we are of the view that the move lower is overdone. It is likely more noise than signal (for now at least).
The index's sharp drop in December was partly likely overdue given the expectation of below-trend growth ahead. This was also reflected in the index's widening gap vs the S&P Global's equivalent PMI and other regional surveys that had been pointing to a more subdued outlook for activity. Furthermore, the ISM Services survey has proven to be quite volatile recently, so it is a stretch to assign meaningful credence to one-month moves in the data.
Looking at the details of the report, the plunge in the headline from a solid 56.5 in November to recession-like territory at 49.6 in December was driven by significant double-digit retreats in both the business activity (output) and new orders components. The latter in particular was the most eye-catching given it registered the largest one-month decline in the history of the series (if we exclude the post-Covid April 2020 plunge). The historic monthly decline in new orders could potentially indicate a softening in demand (and perhaps worsening sentiment) for the services sector ahead. However, our view is that the outsized drop likely reflected a catch-up lower after overshooting in recent months, rather than signaling a sudden retrenchment in activity. In that context, we would expect a rebound in some of these components in the January report.
The details of the ISM Services survey also suggest a recession is still a distance away. The less volatile 3-month moving averages of key survey components including new orders, business activity, and employment still indicate the bar remains high. Indeed, a more reliable recession signal has historically coincided with sharper, and more prolonged declines into contraction territory simultaneously across those three components. As of now we are yet to see such an across-the-board decline in the survey, and this is likely to translate to below-trend growth rather than an outright contraction in the near term.
The index's sharp drop in December was partly likely overdue given the expectation of below-trend growth ahead. This was also reflected in the index's widening gap vs the S&P Global's equivalent PMI and other regional surveys that had been pointing to a more subdued outlook for activity. Furthermore, the ISM Services survey has proven to be quite volatile recently, so it is a stretch to assign meaningful credence to one-month moves in the data.
Looking at the details of the report, the plunge in the headline from a solid 56.5 in November to recession-like territory at 49.6 in December was driven by significant double-digit retreats in both the business activity (output) and new orders components. The latter in particular was the most eye-catching given it registered the largest one-month decline in the history of the series (if we exclude the post-Covid April 2020 plunge). The historic monthly decline in new orders could potentially indicate a softening in demand (and perhaps worsening sentiment) for the services sector ahead. However, our view is that the outsized drop likely reflected a catch-up lower after overshooting in recent months, rather than signaling a sudden retrenchment in activity. In that context, we would expect a rebound in some of these components in the January report.
The details of the ISM Services survey also suggest a recession is still a distance away. The less volatile 3-month moving averages of key survey components including new orders, business activity, and employment still indicate the bar remains high. Indeed, a more reliable recession signal has historically coincided with sharper, and more prolonged declines into contraction territory simultaneously across those three components. As of now we are yet to see such an across-the-board decline in the survey, and this is likely to translate to below-trend growth rather than an outright contraction in the near term.
The Labor Market Begs to Differ
A sudden souring of services activity also does not square with the current overly tight dynamics of the labor market, and what that entails regarding the outlook for consumer spending. The latest data showed a fresh decline to a 50-year low in the unemployment rate and still subdued jobless claims, which hardly spell trouble ahead for the consumer. Indeed, consumer spending has remained more than solid in recent months, particularly for services, as the consumer continues to benefit from falling energy prices and broadly healthy balance sheets. Q4 GDP growth is currently tracking a q/q AR pace that is closer to 4% than to 3%, which would mean an acceleration following Q3's 3.2% rebound in output.
Apart from supporting real incomes, falling gasoline prices have also aided consumer sentiment in recent months. Indeed, our preferred confidence-based recession signal is far from suggesting the consumer is overly concerned about the economic outlook. In other words, the US consumer remains fundamentally sound and supportive of an expansion in outlays in the months ahead.
All told, while output and consumer (services) spending might slow down in the quarters ahead (indeed, that would be consistent with our forecast for recession in 23H2), the current state of the economy offers no reason to be overly concerned despite the opposite case being made by both the ISM and PMI surveys. In fact, a strong labor market and a firm economic outlook provide additional room for the Fed to continue tightening its monetary policy stance.
We remain of the view that the Committee will repeat its December 50bp rate increase at its February meeting, as Fed officials continue to overweight concerns about the inflation outlook over those for full employment. We expect the FOMC to reach a terminal rate at 5.25%-5.50% by its May FOMC meeting.
Apart from supporting real incomes, falling gasoline prices have also aided consumer sentiment in recent months. Indeed, our preferred confidence-based recession signal is far from suggesting the consumer is overly concerned about the economic outlook. In other words, the US consumer remains fundamentally sound and supportive of an expansion in outlays in the months ahead.
All told, while output and consumer (services) spending might slow down in the quarters ahead (indeed, that would be consistent with our forecast for recession in 23H2), the current state of the economy offers no reason to be overly concerned despite the opposite case being made by both the ISM and PMI surveys. In fact, a strong labor market and a firm economic outlook provide additional room for the Fed to continue tightening its monetary policy stance.
We remain of the view that the Committee will repeat its December 50bp rate increase at its February meeting, as Fed officials continue to overweight concerns about the inflation outlook over those for full employment. We expect the FOMC to reach a terminal rate at 5.25%-5.50% by its May FOMC meeting.
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Vice President and U.S. Macro Strategist, TD Securities
Vice President and U.S. Macro Strategist, TD Securities
Vice President and U.S. Macro Strategist, TD Securities
Chief U.S. Macro Strategist, TD Securities
Chief U.S. Macro Strategist, TD Securities
Chief U.S. Macro Strategist, TD Securities