US economy in shock 0.9% contraction - doubts grow over Fed's 'soft landing'

US GDP contracted by 0.9% on a quarter-on-quarter (annualised) basis, which was far below the consensus expectation of a 0.5% increase. Given that the economy contracted by 1.6% in the first quarter, the US has now entered (subject to data revisions) what some economists call a ‘technical recession’. The National Bureau of Economic Research, the body responsibility for deciding whether the US is in a recession, is likely to decide otherwise.

Rob Clarry, Investment Strategist at wealth manager Evelyn Partners, comments:

After the White House took the unusual step of releasing a blog on its website last week that outlined the definition of a recession, speculation that we would see US GDP fall for a second quarter in a row, resulting in a ‘technical recession’, started to increase.

Today’s release proved this speculation to be well founded, as the US economy contracted by 0.9% on a quarter-on-quarter (annualised) basis. This was driven by weak readings for investment, government spending, and inventories. However, importantly, consumer spending held up. This is arguably the most important indicator of underlying growth, so this can be taken as a positive from a disappointing set of data. In addition, labour markets remain robust providing further support to the economy.

Despite this negative reading, we don’t think the US economy has entered a recession yet. The NBER is tasked with deciding this and the indicators it tracks include real personal income minus government transfers, employment, various forms of real consumer spending, and industrial production. None of these indicators are pointing towards a recession at this moment in time.

Looking forward, the US economic outlook will be shaped by how the economy handles higher interest rates – the full effects of which can take between 12-18 months to feed through in the real economy – and how long it takes to bring inflation under control. It’s clear from yesterday’s FOMC meeting that the focus remains on taming inflation, although for the first time the FOMC statement referred to “softening spending and production indicators”, indicating that its members are cognisant of mixed data on the growth outlook.

The Federal Reserve continues to face a challenging balancing act in bringing down inflation without damaging economic growth – and this data points to an increasingly narrow path for a soft landing. The next few months will be crucial in seeing whether inflation eases. If it remains elevated, we will see the Fed continue to prioritise inflation at the expense of growth, which will push the US economy closer to a broader economic slowdown.

Bottom line: In our view this doesn’t change the Fed’s plans to continue tightening monetary policy through 2022. Although we now see a lower probability of interest rate surprises to the upside, which is likely to be a positive outcome for global stock markets.

Our base case remains that the US economy will avoid a recession (as defined by the NBER) this year, but we are mindful of the downside risks to this view.