September 25, 2023


General Inside You

The Curse of the Strong U.S. Economy

The Curse of the Strong U.S. Economy

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.

Firms are also still going strong, with profitability at record highs. They undoubtedly face headwinds. Margins across the S&P 500 are falling from exceptionally high levels and driven by fast wage growth required to attract and retain workers in a tight labor market. But consistently strong sales growth, even if nominal, more than compensates for margin contraction for now, resulting in near-record profits. Against this backdrop of profits and strong labor demand, firms are reluctant to turn to layoffs quickly, thus keeping the labor market and spending strong, which in turn reinforces firms’ sales and profits.

The Curse of Strength

This would all be good news if it didn’t stoke the fire of inflation, which has proved too strong, too broad, and too fast moving. Though headline inflation has fallen the last two months, as widely predicted, those declines were disappointingly small, and we’ve seen inflation metastasize to ever more categories.

Since there is little the Federal Reserve can do about high energy prices, for example, it must work all the harder where it does have influence to bring price growth back to acceptable levels. The primary target is the very tight labor market that’s driving wage inflation. The Fed would like to see labor markets with enough slack that wage growth moderates to a level consistent with their 2% target. But looking at the booming services economy, with wages running at over 6%, we’re a long way off.

All this has persuaded the Fed to sketch a “rate path” (sequence of hikes) to high levels and keeping monetary policy “tight” until at least the end of 2025. After a summer of doubting the Fed’s resolve, markets have largely resigned to that outcome, pricing a similarly aggressive rate path for the next few years as what the Fed has announced.

This situation is unique in the modern era, as the Fed and markets would not normally view the economy’s strength as a problem. It is the cyclical overshoot in demand, outstripping the capacity of the supply side, that has delivered problematically high inflation.

Recession — If That’s What It Takes

In reality, it’s unknowable — for the Fed and for markets — how high and how fast interest rates should rise, and for how long they should stay at high levels. Less monetary headwind would be required if inflation falls more convincingly, but the opposite situation could also materialize. Faced with lags between raising rates and slowing the economy, the Fed is not only confined to a rear-view mirror — it is also driving in the dark.

In fighting inflation, the Fed is now much more accepting of the risk of causing a recession, simply because the risks to the economy are far more consequential than in 2021.

What’s at stake is a structural unmooring of long-run inflation expectations, something that could end the 40-year regime of structurally anchored inflation. This would be far worse than a downturn, even a deep one, and lead to a re-ordering of the business environment that has thrived on stable inflation. High valuations, low interest rates, and long cycles are just some of the benefits of an anchored inflation regime we take for granted.

To protect those long-term expectations — still anchored today — the Fed has been exceptionally clear: They will keep policy rates at “tight” levels — even if inflation is moderating, even if growth is anemic, and even if unemployment is rising. This is a calculated risk based on the belief that taking the foot off the brake too soon is risking a far more damaging blow to inflation expectations than the damage incurred by letting the economy slip into a recession.

That recession is increasingly likely in 2023, though the strength suggests it’s not imminent. Meanwhile, the hopes of a “soft landing” are fading as that strength forces higher rates that strangle the economy.

What remains distinct about today’s recession risk is the absence of convincing systemic threats, akin to the banking crisis of 2008. Risks of financial accidents are rising as years of very low rates are being reversed. But those are less likely to cripple banks and disrupt lending, a hallmark of financial recession and systemic damage. All this points to chances of a milder downturn than what is often assumed when 2008 is used as a mental model.

What Executives Should Do

When recession looms, the reaction from executives is often to retreat behind the moat, pull up the drawbridge by cutting orders, production, investment, and the workforce, all with an aim to fortify the balance sheet with liquidity to ride out the storm.

But this alone would be a wasted opportunity to improve competitive position at a time when rivals will be distracted. Increased competitive spread and volatility are hallmarks of all major periods of instability and crisis in the last 50 years. Firms with strong foundations should look through the economic storm to see what advantages may be obtainable — particularly if others are retreating or wavering.

Hunkering down is especially likely to be a strategic error in industries that will face tight capacity — either on the production or labor side — after the recession. They should use the recession to build and hire selectively to be in a strong position to capture incremental share on the other side.

In other words, it remains imperative to build resilience, which we define as the outperformance through a downturn relative to peers and relative to the economy broadly. Building such dynamic advantage starts before the downturn hits (anticipating and preparing); buffering the immediate shock; navigating the downturn as it unfolds (seizing opportunities to capture share); and capitalizing on advantages after the recession is over (capacity, growth trajectory and fit with new market circumstances).

It’s easy for companies to feel a false sense of confidence about resilience, after the ups and downs of Covid. But the true test of resilience is not mere survival and restoration of previous performance levels but rather a building a systematic approach which can be deployed repeatedly to obtain competitive advantage in turbulent periods. From this perspective, companies would be well advised to seize the opportunity to review their recent experience of Covid to ask: What was our resilience relative to competitors, what lessons can be obtained from the last crisis, and have we constructed a crisis playbook and capability?