Recession is far from a worst-case scenario

The two most popular conversations in financial media, Fed policy and inflation, usually lead to the same question: Is the U.S. economy headed for a recession or not?

All this talk about "soft landings," whether or not the Fed can "thread the needle," and any other tired clichés you may have heard in recent months are focused on that singular outcome.

There won't be an official answer, of course, until late July when second-quarter GDP numbers are released. So, let's instead confront some honest truths.

First, we might be in a recession already and just not know it yet. The economy contracted by 1.5% in the first quarter compared to a year earlier. If the same is true for Q2 (April thru June), we will look back on the first half of 2022 as a recession.

That's important because, once we attach the recession label, the climb back toward positive growth is further along than it may seem. There have been 12 economic recessions since World War II. Those lasted an average of 11 months. If the coming recession has a similar duration, we will be halfway through it by the time it becomes official.

Second, financial markets are suggesting a near-term recession is the most likely outcome. We don't need to waste time worrying about what happens if we avoid a recession (spoiler: stocks will go up), but it's important to acknowledge that a good chunk of the recession fears are already priced into equities.

Through Friday, the S&P 500 was down 23% from its early January peak. How close might that be to a bear-market bottom?

To put a finer point on it, U.S. stocks are already down 23% from their peak. Even if the Federal Reserve hikes us into a recession, history suggests equity prices are already a lot closer to the bottom than the top.

Speaking of the Fed, there is plenty to criticize about Jerome Powell, but we agree with the Fed Chair's recent comments that attacking inflation needs to be the central bank's top priority. Sustained high inflation would be much more harmful to the economy and to American families than a recession. Any financial planner worth their fees can tell you how destructive inflation can be to long-term financial health.

A recession, on the other hand, is far from a worst-case scenario. Consumers are in considerably better financial shape than is typically the case at this point in the economic cycle. Debt-to-income ratios are at their lowest levels since the 1990s. Home prices are at all-time highs. Wage growth is accelerating. Unemployment remains low.

Corporations also appear well-positioned to weather an economic slowdown. The U.S. banking industry is well-capitalized thanks to post 2008 regulatory changes. Corporate cash flows relative to GDP (13.5%) are near all-time highs. Most debt has been financed (or refinanced) at exceptionally low interest rates.

Finally, let's consider consumer sentiment, which fell to a record low earlier this month. Negativity is understandable given ugly year-to-date investment returns and triple-digit receipts at the gas station. But so far, pessimism has hardly dented consumer spending, which remains the largest component of GDP.