Hard or Soft Landing: A Definitive Expose
A holistic analysis of the past, present, and future of our economy to answer the question on every investor’s mind
Preface
Before I engage in this expose, I would like to take note of the general structure of this paper. Outside of this writing, I value utmost objectivity, rationality, and pragmatism in regards to research, analysis, and the construction of actionable beliefs.
As an introduction, I would like to get some context into why I’m writing this. This summer I had a lot of time to read, learn, and synthesize a plethora of economic concepts and news. This paper is not the hundreds of bullet points worth of notes that I took as I read and learned. It is also not the multi-faceted analysis that I stormed up for months as I synthesized everything. This paper is the final and concise result of the culmination of that synthesis, presented in an opinionated manner in line with the framework of a thought experiment. Let’s begin.
The State of the Economy: A Two Part Story
Today we sail in a broad sea of economic uncertainty. Soft landing or hard landing? That is the question of the year. In the next couple of paragraphs I will attempt to break down some of the leading indicators, expand on the market’s point of view, and conclude with my own points of view.
Part 1: Consumers
Let’s time travel back to 2020. After COVID hit, Washington infused the stock of consumer’s excess savings by an estimated $2.3 trillion. Key word: excess, as the Fed admitted to in hindsight during a 2022 report. This meant that as Q3 ‘21 started to roll around and final COVID restrictions were lifted, consumers were locked in and ready to deploy their stimulus checks. This was especially true for the bottom-half-income households, many of whom typically hold very little liquid wealth and an increase in liquidity may lead to notable changes in their spending behavior.
As this played out and demand surged, China’s lag in keeping up and Russia’s conflicts with Ukraine further shocked supply. This mix of fundamental drivers spelled one thing: inflation. At first the headline was “transitory inflation,” but investors increasingly worried and inflation didn't autocorrect itself fast enough. Therefore halfway through 2022, news headlines dropped the “transitory” part and the Fed was forced to take action.
Keep in mind that by this time, $1.7 trillion of those excess savings were still undeployed. Fast forward 12 months to June 2023 and that number was down to $900 billion. Fast forward another month: $500 billion. Although the number is still not out for August, taking July’s consumer spending rate leaves us with an educated guess of $100 billion.
On top of a steep depletion in savings, there’s another key indicator that points to possible trouble in consumer spending paradise: credit card debt. In Q2 ‘23, credit card debt surged 17%, topping $1 trillion for the first time in history. Headlines attributed the surge in credit card debt to inflation, but that simply does not make sense. This is because in Q1 ‘23, when inflation was even higher than during the second quarter, not a single extra percent was added to credit card debt.
Now that a looming recession has replaced inflation in the headlines, do you know what depleting savings accounts and a surge in credit card debt spells? A last hurrah.
And the latest data is starting to show just that. Despite final back-to-school and August-traveling cyclical spending pressures, US shoppers this summer started forgoing purchases of furniture, apparel, and electronics in order to afford basic goods. More than half of Americans are also switching to cheaper brands, while 90 million US adults are now struggling to pay for their usual home expenses.
To sum up, a deeper dive into consumer behavior and its underlying causes reveals that a large part of the reason we’re seeing resilient retail consumption is due to that $2.3 trillion extrinsic shock. The effects of this shock are still being felt today, but the fraction remaining today is quickly running out, and the tap will soon go dry.
Part 2: Inflation and Interest Rates
The latest inflation report reported a mere 0.2% MoM and 3.2% YoY increase in prices, continuously down from the highest peak of 9.1% YoY in June 2022. Although inflation has significantly slowed down in the majority of sectors, some sectors that stick out as stubborn outliers are the energy/oil and home/rental spaces. However, I don’t believe these are significant to the story line of this analysis due to the fact that the main drivers for both of these hot environments are unrelated and external supply/demand shocks. For oil/ energy inflation its Russia/Ukraine, OPEC+ cuts, and EL Niño heat waves, and for home/rent inflation its a long standing lack of supply, which we are slowly addressing.
If we had a stronger grasp of the root-cause of why consumers are behaving the way they are, as explained in Part 1 — along with the cooling inflation news — then we’d probably be facing a dovish Fed with a newfound pulse on the possibilities of a recession.
But we’re not. Instead, the Fed remained hawkish in its latest minutes report, raising the probability of a 12th 0.25% rate hike in September to 40%. This would mean possibly bringing the federal funds rate to 5.50–5.75%, a 22 year high. The Fed cites two reasons for these views:
- Resilient consumer spending.
- A hot labor market (unemployment rate/wages).
This doesn’t make sense though.
Touching on the first point, although a clear and valid indicator, it’s important to differentiate between correlated drivers and root-cause drivers. The 0.7% MoM uptick in consumer spending that made the latest headlines is a correlated driver, meaning that inflation impacts this number as much as this number impact inflation in a spiraling manner, and for that reason I don’t find it to be a quality indicator. Instead, if one breaks down the consumer’s balance sheet, one realizes that the root-cause drivers of that increase in spending are the remaining excess savings and last-hurrah use of credit cards mentioned in Part 1.
The second set of indicators are the latest 3.5% unemployment rate and the 1.1% YoY rise in wages. There is a couple important implications regarding this hot labor market. For starters, while there are multiple reasons for why unemplyment rates have been stubborn, the leading cause is the decreased labor participation rates, which skews the data towards the lower end. Moreover, the rise in wages is mostly due to old (COVID & China) and new (Russia/Ukraine) supply shocks, of which the old are more significant and increasingly dissipating. Lastly, as with everything, the labor market has cycles, and it’s just a matter of time before that also cools down.
Ultimately though, it's not a matter of whether the Fed will raise rates or not, or whether the labor market cools down or not. The matter at hand is that when those excess savings soon deplete past an inflection point and consumers rapidly tighten their belt, we’ll be running off a cliff of 20-year-high interest rates.
That sure sounds like a hard landing.
But who can blame anyone— It is Washington’s priority to keep the economic engine churning and our human nature to lose sight of root-causes, long term cycles, and lagging rippling effects.
All in all, in a similar manner that Washington’s capital stimulus during 2020 was overshot, I believe that the Fed’s latest interest rate hiking maneuvers is another overshoot. This is especially convincing considering the disconnect between the root-cause drivers showing an initial but undeniable cooling in the economy and the Fed’s hawkish views. And ultimately, in a similar manner that the 2020 overshoot led to the capital hemorrhaging that is now driving inflation, today’s overshoot will lead to certain near-future economic distress.
What’s next? The Interest Rate Paradigm Shift Theory
A smaller yet equally interesting debate occurring within capital markets is whether the current interest rates will be cyclical or secular. This short analysis of that second debate stands independently of the first, with one critical build on.
On the one hand, the cyclical school of thought points to cooling inflation, a looming recession, and the negative effects of quantitative tightening (i.e the regional bank crises). On the other hand, the secular school of thought points to the unsustainably-low interest rates of the past decade, the need for capital markets to sober up, and the rebound of fixed-income investment vehicles. Both sides have great points and I stand in a deeply conflicted state of mind, yet I will attempt to choose a side for the sake of the thought experiment framework.
In regards to the secular school of thought, this is what my heart tells me is right. Near-zero interest rates simply doesn’t make sense in regards to sustainability; the US economy was not made for such cheaply and easily accessible capital. We saw what happened in ’08 with mortgages, we’ve seen multiple corporate credit crunches, we’ve seen private equity leverage explosions and dividend recaps, and we recently saw an agency downgrade our $30.93 trillion national debt for the second time in history. All of this in large part because of cheaply and unsustainably accessible debt.
I am an adamant believer in the idea that everything — especially something as fundamental as interest rates — eventually returns to its equilibrium, and the current federal fund rates of 5.25–5.50% is almost right at that 50-year 5.60% median. This level makes sense. We should stay here for the sake of maintaining a long term healthy and sustainable economic future.
However, that is not what is going to happen, for two simple reasons:
- The timing is wrong.
- The market is inertly short sighted.
Regarding the first point, this is where that connection to the first debate comes into play, and by connection I mean the conclusion that the economy will soon cool down. The negative quantitative tightening effects of current interest rates might have been bearable if this paradigm shift occurred slowly during good fundamental economic conditions. However, with a looming recession, a weakening consumer, and the vast majority of equity investors bearing the pressure of costlier debt, there is no way anyone (apart from fixed-income investors) will support this shift.
But what about the long term sustainability? That’s where the second reason comes in: the market is inertly shortsighted. By engaging in a second-level study of the early stages of this most recent inflation crisis, I’ve come to the realization that the Fed’s claim of transitory inflation was right, but the market’s impatience and unwillingness to bear hardship forced the Fed to take action.
In essence, today’s higher interest rates coupled with tomorrow’s rapidly cooling economy will once again put us in an impatient and hard situation, forcing the Fed to take action and ultimately resulting in lower interest rates.
Concluding Thoughts
All things considered, as we continue to sail in this broad sea of economic uncertainty, it’s important to keep a guiding star and consider every outcome of this journey with a probabilistic lens. The fact is no one knows what will happen for certain, but we can look at drivers, digging deeper and deeper until there is no more drivers, and then take those root-cause indicators and connect them to build actionable beliefs.
I acknowledge the beliefs of a hard landing and a lower interest rate future are strong. However, I hold their truth basis loosely. This means that if the indicators that I determine to be important experience a seminal shift, I will continue to update and tweak my beliefs. Ultimately, these beliefs don’t reflect my optimism about the long term future of our economy, but instead my pragmatic skepticism and concern for the short term future of our economy.
I hope you enjoyed this piece and learned a thing or two. Please feel free to leave any comments or questions — I always love some challenging criticism and a little debate. Shoutout to my friend Catherine Mekhael for helping me think through this.
The content provided in this paper is for information purposes only and should not be construed as investment or tax advice nor as a recommendation to buy, sell, or hold any particular security. I believe the data in this paper is accurate, but do not verify its accuracy independently and do not warrant or guarantee that it is accurate or complete. I have no obligation to provide any updates or changes to the data. No investment decisions should be made using this content. Past performance is not indicative of future performance.
