Is There a Recession on the Horizon?
The tariff wars are beginning, layoffs of government workers have started, and the domestic political scene remains very contentious. Is a recession imminent? Quite directly, a recession is not on our radar screen.
The most negative data recently reported for the economy is the Atlanta Fed GDP Now estimate of minus 2.4% for Q1, only slightly better than a minus 2.8% estimate on March 3. All of the weakness arose from trade, which by itself depressed GDP by 3.6%. That’s understandable, but wrong. GDP is a measure of domestic goods and service production. Exports add to GDP, since they are produced here, even though those goods are consumed overseas, while imports enter the GDP calculation with a negative sign, since they are produced overseas and displace domestic production. So, a rise in imports reduces measured GDP very sharply. Since everyone knew tariffs were coming, businesses had a strong incentive to ship goods into the U.S. before the tariffs went into effect. Imports surged in January and when the data becomes available, we expect another elevated level of imports to be reported for February. (March will see a sizable decline in imports.)
Does one month (or two) make a large difference? The way we measure GDP, it sure does. GDP is reported at annual rates. So, a large jump in one month is multiplied by 12 to get the annual rate and the increase for two months, both likely to show a large rise in imports, will be multiplied by 6. The increase in imports for one month is close to $40 billion. That’s why the Atlanta Fed calculated that trade depressed their GDP estimate by 3.6% by itself. Excluding trade, GDP was a positive 0.8%. But the weak forecast for Q1 GDP also reflects the inconvenient timing of new data. Trade data becomes available only with a relatively long lag. The latest number is for January and we won’t get the February trade report for another few weeks. But there’s far more to the story.
What happens to all those goods coming into the country? While firms brought them in to avoid tariffs, it is highly unlikely consumers would have bought them so quickly. So, much of that incremental supply landed in inventory. And inventories enter GDP with a positive sign. More inventory implies more production of GDP. Conceptually, there could be a nearly perfect offset between higher imports (creating a negative impact on GDP) and higher inventories (creating an offsetting positive effect). Unfortunately, inventories are one of the few economic reports that is released even later than trade, so the Atlanta Fed only knows that imports are higher and that carries through in their calculation to produce a weak GDP estimate and they don’t yet have the likely corresponding surge in inventories for January, which will be released March 17. Even worse, the quality of the early inventory reports is notoriously poor. The Bureau of Economic Analysis will have to engage in some heroic judgments about how much of the import surge landed in inventories. Understanding the data and how these estimates are put together, I think it is virtually impossible that Q1 GDP will show a negative number. With the limited data now at hand, I’d ballpark the Q1 GDP report around 2%, plus or minus at least half a percentage point.
Weak trade data are just one of the pieces of information investors must cope with. It seems like there’s a report of government worker firings, tariffs imposed and then deferred, and other tumultuous reports almost daily. Markets do not like uncertainty and we surely have an abundance of that, so stocks have retreated. But aside from that misleadingly negative trade report, the rest of the data suggest that the economy remains on a solid trajectory. Despite government layoffs, more than 150,000 net new hires were reported for February. Initial unemployment claims rose two weeks ago and immediately reversed last week. Nothing troubling to see there. The firing of government workers will be spread out over time, DOGE may find it difficult to decrease government headcount as much as they wish for legal reasons and because the work those workers produce may well be needed, so the total worker decline will not be large enough to reduce total employment sufficiently to hurt the economy. At the same time, the government is dropping regulatory limits on all kinds of activities, opening the door to more investment, although that takes time to rev up.
Nonetheless, the market is engaging in some wishful thinking. Bonds have repriced to anticipate as many as three 0.25 percent interest rate cuts by the Fed this year. This is a repeat of last year, when the market expected seven cuts, which did not happen. That’s unlikely barring a recession, which we do not expect. Slower growth, however, is very likely and it is safe to assume the market will extrapolate that excessively. The change in border policy will reduce the domestic workforce, possibly sharply if the government sends home large numbers of immigrants. Oddly, there’s no evidence of that in the recent data. To the contrary, if the employment reports are to be believed, the Hispanic workforce rose in January and February, as did the non-native workforce. I doubt these gains will last. Instead, the immigrant count may decline slightly, placing downward pressure on the unemployment rate and upward pressure on wages.
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