The U.S. economy, though clearly facing a growing risk of recession, continues to exhibit remarkable strengths, particularly in the labor market, as illustrated by continued job creation and another drop in the unemployment rate in the September 2022 jobs report.
Yet, right now that strength is a curse more than a blessing. With every sign of strength, it will get harder to rein in persistent and broad-based inflation without the Fed raising rates to levels that make a recession inevitable. And the risk is not linear: Though inflation is high today, expectations of long-term inflation are still modest. For nearly 40 years, we’ve lived in an era of structurally anchored inflation, where inflation doesn’t move much within the business cycle. If expectations unanchor, the cost would be far higher than a downturn — it would be an era of higher volatility and a less favorable business environment.
The current constellation of macroeconomic signals is unique, with many signs of strength coexisting with weaknesses. That limits the usefulness of models and predictions, and it forces executives to closely analyze cyclical momentum — and to think through the next downturn and the risks and opportunities it holds.
Signs of Strength in the U.S. Economy
With GDP contracting in the first half of the year and a cratering stock market, it may seem surprising to describe the U.S. economy as “strong.” While the haze of macroeconomic data is exceptionally contradictory, the evidence of a strong economy is difficult to ignore.
First, consider the labor market. An unequivocal sign of recession is when firms collectively shrink their workforce and unemployment rises sharply. Today, unemployment is near a half-century low.
Second, while the stock market is in bear market territory (>20% drawdown), a closer look reveals similarly conflicting signals. Equity prices are down because valuations of stocks have been crushed. The reality of higher interest rates pushes down today’s value of future cashflows, leading to lower equity prices. However, S&P 500 earnings are still positive and, at present, expectations for growth remain. Headwinds are real, but so is the strength.
The current reality of the U.S. economy is that highly profitable firms are employing a record number of workers and paying them rising wages. A sudden stop to this picture is less plausible, although not impossible (remember the exogenous shock of Covid and the pandemic freeze), although a slowing in job creation is inevitable. The questions are how fast and to what extent the economy loses its strength and why.
The Sources of Strength
The booming labor market translates into wages and spending, which is a good place to start gauging the strength of the real economy. Total consumer spending is in a tug of war between declining goods consumption and a booming service economy. Following an enormous overshoot in the consumption of durable goods (think lockdowns and stimulus checks) the hangover is now palpable, with real spending on goods falling, if still above pre-Covid levels. But the service economy is twice as big and consumers are still catching up on holidays, restaurant meals, and the like — high inflation notwithstanding. On aggregate, total consumption proves resilient and continues to grow for now.
Besides a booming labor market, exceptionally strong household balance sheets help keep spending high. Households’ net worth is far higher than pre-Covid for every single income quintile, providing some buffer to the headwinds of inflation and dour consumer sentiment. Cash balances, in particular, stand out. Aside from the bottom income quintile, most Americans have significantly more cash than before Covid. The middle quintile (40th–60th percentile) is estimated to have held approximately $100 billion in cash at the end of 2019. That figure now is north of $530 billion. Inflation is eating into the purchasing power of that cash, but clearly it represents a measure of insulation for spending.