The Recession that Is Long In Coming
A version of this article was originally published at cullenhilkene.com.
We have been experiencing one of the most significant slow-motion arrivals of a recession in recent history. Market pundits have been predicting a recession ever since the Federal Reserve (Fed) began its rate-hiking cycle in March 2022 or even earlier, when the initial hiking cycle was signaled in late 2021. Since then, the Fed has repeatedly raised rates, now reaching around 5%. The rate of the hiking cycle has been as rapid as any in history, a deliberate move to combat inflation.
As of this writing, inflation seems to be abating, though it is too early to declare a full recovery. Most signs point to the Fed pausing in its next meeting. This pause creates a complex decision for the Fed, as the impact of rate hikes has famously long and variable lags. Typically, it takes 12 to 18 months for a rate hike to be fully felt. Thus, we have only begun to feel the impacts of the earliest hikes, a mere 125 basis points, with the majority of the rate hiking cycle's impact is yet to come. Most data suggests that a recession is imminent.
If a recession is indeed on the horizon, why has it not arrived already? One reason is the resilience of the American consumer. Is this a simple case of American consumers loving to spend money? Perhaps. However, this resilience can probably be better attributed to the amount and nature of the wealth created for Americans over the last few years:
The market capitalization of the American stock market increased by$7 trillion since bottoming during the pandemic. The market dropped dramatically in response to the pandemic, but a combination of fiscal stimulus and lax monetary policy created a significant amount of wealth for stock market participants. Although only about 10% of the population actively participates in the stock market, 64% of the population invests through their 401k plans. As a consequence, the wealth effect was felt quite broadly across the population.
Real estate is owned by more than 65% of Americans, and real estate valuations have skyrocketed over the past few years. The pandemic created a unique environment where many wealthy individuals sought residences away from urban centers, resulting in higher asset prices in secondary and tertiary markets and resort areas. Overall, real estate values increased to $43 trillion over the last three years, with $20 trillion of value created between 2020 and 2022. That means that the nearly 2/3 of Americans who call themselves homeowners saw an effective doubling of their real estate wealth. When considering that many of these Americans operated with significant leverage on their homes - 20% is a common downpayment - we're looking at tremendous gains on that expansion of equity. When considering that many Americans locked in low interest rates via initial mortgage or refinance, it stands to reason that lots of Americans feel confident in their financial positions.
In addition to the wealth generated by the stock market and real estate, Americans received $5 trillion in stimulus from the Trump administration and $2 trillion from the Biden administration. This had a number of knock-on effects. First, while asking many people to stay home rather than report for work, it freed up many blue collar workers to explore alternative avenues for employment. In addition, the departure of many of these workers to other professions - or their unwillingness to come back to work en masse - gave them a degree of leverage when the economy reopened. Business owners sought to meet the surging demand of the reopening economy, and would pay what it took to get workers back on the front lines of service. This scarcity of such workers led to significant wage increases. Middle-income individuals have seen their incomes rise more than they have historically, and for the first time in years, they have experienced real gains relative to broader inflation.
When taking all these factors into account, there is a long leash for the economy - and inflation - to keep running. For simple math, $30T of stock and real estate appreciation divided by 300M Americans means some $100k per American in asset appreciation cushion. Add that to significant wage increases for the bottom third and many consumers still have money to spend.
If that sounds like a lot of wealth to spend on things, it is. For comparison, the S&P 500 shows $11 billion in aggregate annual revenue. It seems that there is an excess of capital available to continue purchasing goods and services, particularly from the most valuable companies in the world. Despite the troubling signals and the Fed's efforts to cool inflation, the cash reserves available to consumers suggest that spending on services is unlikely to decline significantly in the short term.
In summary, the sheer amount of wealth created on the heels of the pandemic was breathtaking. And the unique circumstances we now see in the market make it unlikely that the created wealth will disappear. Few homeowners are looking to sell, given the unfavorable interest rate environment. Stocks have bounced since the October lows, as inflation has slowed. Even if the market tanks, the wealth created in the real estate market seems to provide ample "wealth effect" fuel to keep purchases happening. There is a reasonable expectation that the market can continue to move upward, despite the Fed's efforts to tame it.
