When Will The Recession Hit?

When Will The Recession Hit?
Stéphane Renevier, CFA

over 1 year ago5 mins

  • Piper Sandler’s chief investment strategist Michael Kantrowitz came up with an interesting framework to help time when we should expect the broader economy to slow down

  • His roadmap shows that Housing is the first to fall to higher rates, followed by Orders, Profits, and finally Employment (hence why it’s called the HOPE Cycle).

  • Looking at what those indicators tell us, we’re likely in the “O” phase currently, and might have six to 12 months before the rest of the economy slows.

Piper Sandler’s chief investment strategist Michael Kantrowitz came up with an interesting framework to help time when we should expect the broader economy to slow down

His roadmap shows that Housing is the first to fall to higher rates, followed by Orders, Profits, and finally Employment (hence why it’s called the HOPE Cycle).

Looking at what those indicators tell us, we’re likely in the “O” phase currently, and might have six to 12 months before the rest of the economy slows.

Most economists agree a recession is inevitable – that it’s not a question of if, but when. And on that question, the HOPE Cycle, created by Piper Sandler’s chief investment strategist Michael Kantrowitz, can offer some insight. It shows how higher interest rate impacts ripple across four key parts of the economy – Housing, Orders, Profits, and Employment (or HOPE). So let’s take a look at the cycle and see what it’s telling us now…

Source: @MichaelKantro
Source: @MichaelKantro

Housing: it’s the first to slow

The first sector to react to higher interest rates is the housing market, and it tends to react in a big way. Residential real-estate is the largest asset class in the world, after all, and is directly linked to other important sectors of the economy – consumer retailers, for example, and banks.

Here, higher interest rates translate to higher mortgage rates, which add to the cost of buying a home and reduce demand. And when mortgage rates rise quite far, quite fast, as they have recently – the rate on a US 30-year fixed mortgage loan just topped 6%, from 2.5% a few months ago – the impact is almost immediate. Would-be buyers get forced out of the market; while sellers find they have to wait longer to find a buyer and may have to compromise on price.

So what does the data tell us? The NAHB housing market index, which takes the pulse of the single-family housing market by surveying people about things like housing affordability, how many prospective buyers toured new homes, and expected sales, peaked back in 2021, and recently fell for a sixth-straight month. New housing starts and building permits, a gauge of new-home construction, have also slowed. And since these indicators show the peak happened a few months ago, we’re probably already past stage 1.

Orders: new orders from firms and consumers taper off next

When firms expect consumers to soon cut their spending, they adjust their production as soon as they can. And right now, there are plenty of reasons why consumers are about to tighten their belts: steeper housing costs and higher prices for food, gasoline, and services are squeezing household budgets and making it more likely they’ll lower their spending.

What does the data tell us? The ISM Manufacturing New Orders, which surveys over 400 firms about new orders, inventories, order backlogs, and production plans, has been steadily falling since last year. And with both consumer and business confidence falling off a cliff, it’s unlikely we’ll see a quick turnaround. That being said, new orders for consumer goods have remained strong and manufacturing sales have seen only a small dip.

This suggests that we may be somewhere close to the middle of that second stage. If that’s true, we likely have less than a year before the broader economy starts to slow down (T=0 in the chart above).

Profits: eventually, companies take a hit

If it seems like companies’ profits have remained remarkably resilient, that’s because, as the framework shows, the impact of higher rates on earnings isn’t immediate. It takes hold only after consumers tighten the purse strings.

And in the short term, companies are often able to keep their profits up by cutting costs, passing some other costs on to their consumers, or delaying spending. But eventually, a slowdown in consumer spending and an increase in both financing and production expenses start to bite, and companies’ earnings decline. At this point, companies will have to significantly tighten their belts, firing workers and abandoning expansion plans. This has huge repercussions on the rest of the economy and is the reason why a reduction in profits tends to be quickly followed by a slowdown in the rest of the economy.

What does the data tell us? Capital goods (goods used to produce other goods), industrial production, and average weekly overtime hours (AWH) of production and nonsupervisory employees in the manufacturing sector are still expanding, albeit at a slower rate. This suggests that we haven’t yet reached the stage when profits shrink, but that we’re getting closer. And when we do get there, it’ll most likely be less than a year before the rest of the economy follows into the slowdown.

Employment: the final slowdown

Employment is the last to react to higher interest rates, and starts slowing only after the broader economy. It’s only when firms are downsizing aggressively, when consumers have cut their spending, and when house prices have been down from their highs for a few months that unemployment increases, wages and benefits slow, and inflation decreases.

What does the data tell us? Payrolls and personal income are strong, and core CPI is high. And while many point to those factors as evidence of economic resilience, that overlooks the current economic conditions. Put differently, higher interest rates are already weakening the economy, but it just isn’t showing yet on those lagging economic indicators.

So when will the recession hit?

The HOPE Cycle’s roadmap and the data suggest we’re well into the slowdown, in the “Orders” phase. And that tends to precede a more general slowdown in the economy by six to 12 months. It doesn’t necessarily predict that we will enter a recession – it’s a roadmap, not an exact recipe, after all – but it certainly shows that the slowdown in growth might happen earlier than what some economists expect.

So watch for signs of a slowdown in companies’ profits for the second half of this year, as it may indicate that the framework is playing out, and that the economy is indeed likely to fall into a recession sometime next year.

As for what you should do with your portfolio, I’d argue that a defensive stance is still warranted, at least until a slowdown in companies’ profits becomes clearer in the data. In the meantime, make sure you’re holding high-quality companies in defensive industries. I shared a few ideas here.

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