Get Ready For A Hard Landing: Why A Recession May Be All But Unavoidable Now

Just two months ago, there were growing whispers in the market that the Federal Reserve (the Fed) might achieve something truly rare: the so-called soft landing. That is, raising interest rates just enough to cool the country’s overheated inflation, but without pushing the whole thing into a recession. The chances now appear to have all but vanished, so this seems like a good time to consider what kind of landing we might be headed for, and how you might brace your portfolio accordingly...

What’s the difference between a hard, soft, and no landing?

When the economy runs too hot, it can lead to an increase in inflation. To combat that, the Fed typically raises interest rates, which generally will slow down economic activity and stabilize prices. The Fed’s goal is a soft landing: that dream scenario where the economy slows enough to tamp down inflation, but remains strong enough to avoid a recession. But, with every rate-hiking cycle, there’s also the risk of a hard landing, where the Fed raises rates so aggressively that it tips the economy into recession. And there’s also the risk of a no-landing scenario, where economic growth doesn’t slow and inflation remains high. That’s arguably not in the cards today, considering we’re seeing evidence of both growth and inflation coming down.

So what’s so hard about a soft landing?

While the Fed has attempted to engineer soft landings in the past, its record in actually achieving this goal has been mixed, at best. This chart shows each of the Fed’s hiking cycles since the 1970s (solid red line), the US inflation rate (dotted green line), and recessions (shaded gray areas). In most instances, aggressive interest rate increases were followed – at some point – by a recession. The only real example of a successful soft landing engineered by the Fed was in the mid-1990s, when the central bank raised interest rates from 3% to 6% while avoiding a recession.

Aggressive rate hikes to tame inflation have often resulted in recessions. Source: Reuters.

As the debate today centers on whether the Fed's current round of interest rate hikes will shove the economy into a recession, it’s important to view this rate-hiking cycle in the appropriate historical context. This next chart provides a stark visual representation of the Fed’s hiking cycles during the past 50 years: the one we’re in is the second most aggressive. Had the chart covered the entirety of the Fed’s 110-year history, this cycle would be the second-most aggressive over that time too.

The Fed’s current rate-hiking cycle is its second-most aggressive. Source: BlackRock.

The takeaway from all of this is that apart from one rate-hiking cycle in the 1980s, every other round of interest rate hikes has been less aggressive than the current one, and most of them sparked a recession. So if history is any guide, the likelihood of the Fed successfully engineering a soft landing is low. What’s more, those odds have probably taken a turn for the worse after the recent mini-banking crisis.

What’s the turmoil in the banking sector got to do with a hard landing?

The short answer: it’s accelerating the withdrawal of credit, which is the lifeblood of the economy. Consumers and businesses can barely function without it. Tight lending and credit standards cause consumer spending and business investment to plunge, which derails economic growth. When credit is too loose, however, it results in the opposite problem, causing the economy to overheat, inflating bubbles, and more (you just have to think back to the lead-up to the 2008-09 global financial crisis).

This is all captured really well in the chart below. The blue line plots the results of a quarterly survey (called the senior loan officer opinion survey, or “SLOOS”) conducted by the Fed to gather information on bank lending practices. Specifically, that line shows the net share of surveyed banks reporting that they’ve tightened their lending standards. When the line goes up, it means that banks are becoming more cautious. And when that happens, bank lending over the next few quarters ends up declining (a logical outcome). This is captured by the red line, which shows actual bank lending four quarters in the future. This is plotted on an inverted axis – that is, when the red line goes up, it means that bank lending fell in the future. And the gray shaded areas, like in the earlier chart, indicate recessions.

The relationship between banks’ reported lending practices and actual lending four quarters later. Source: Goldman Sachs.

So when the SLOOS survey indicates that banks are becoming more cautious in their lending practices, it often precedes a decrease in actual lending in the future, a kind of harbinger of a recession (notice how the red line shoots higher during all the shaded gray areas).

The latest SLOOS survey captured by the blue line is for the final quarter of 2022, which showed a significant increase in the number of banks tightening their loan standards. Put differently, the lending environment was deteriorating even before last quarter’s turmoil in the banking sector. The latest episode of stress, then, will only intensify things: worsening credit conditions as banks tighten their lending standards in a bid to strengthen their balance sheets – in the end increasing the odds of a recession.

What does this all mean for you?

Markets arguably are underestimating the risk of a hard landing, so it might be worth exercising caution with your investment portfolio. That is, reduce your risk exposure, and make sure your portfolio is well-diversified and doesn’t contain leverage. You might want to lower your exposure to stocks and/or tilt it toward quality companies in defensive sectors, like consumer staples, utilities, and healthcare. When it comes to fixed income, it might be best to swap out riskier, high-yield corporate bonds for investment-grade ones while loading up on safe, long-term government bonds, which are arguably the best hedge against a recession. Consider holding some gold and cutting your exposure to other commodities, especially industrial metals and energy.

Finally, and this is maybe the most sensible thing you can do: consider holding some cash, potentially doing so via money market funds, which are currently offering yields above 4%. I discuss the key roles cash can play in a portfolio – and dig into those funds – here.