Defying Predictions: The Elusive U.S. Recession and the Evolution of Economic Indicators

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• Economists have been predicting a recession since 2022. So why are we not seeing one well into Q1 of 2024?
• Manulife Investment Management’s Chief Economist and Strategist Frances Donald argues that the classic economic indicators she (and many others) use to make recession predictions may not be as relevant as they once were. But she doesn’t think we should reject the patterns in historical data completely.
• A probable U.S. economic downturn is imminent now (based on an entirely different set of factors), but opportunities will exist for savvy investors.

The drivers of the U.S. economy are undergoing a series of structural shifts. Technological advancements, energy transition, demographic changes and geopolitical tensions are like tectonic plates grinding against each other, constantly creating fresh challenges and opportunities.

“The value of macro changes over time,” says Frances Donald, Chief Economist and Strategist at Manulife Investment Management. “It is not constant. But sometimes it is more relevant. It is relevant at inflection points in the cycle, and it is relevant at bottoms, tops, and when we’ve had big developments. We’re about to enter an easing cycle. There have only been five in my lifetime.”

Frances thinks we recently went through the “most aggressive tightening cycle of many of our lifetimes, by some measures.” But now, we’re experiencing an easing cycle that “requires a change in asset allocation outlook,” she adds. “It requires a change of narrative.”

Frances joined Alan Dunne for a Global Macro episode of Top Traders Unplugged to discuss why she expects a recession in the US economy this year, the macro forces that have shaped the past few years — and why her outlook is different now. 

Signals and surprises

Alan asks Frances whether she has been surprised at how resilient the economy was through 2023.

“Surprised is putting it mildly. I was straight-up wrong,” she admits. “I was the most wrong I’ve ever been in my career and it’s hugely humbling and uncomfortable, especially when you are sitting around a table every morning looking at attribution reports.”

She and the team at Manulife Investment Management are investigating the reasons why they went wrong and whether they need to “pivot their frame of thinking.”

Frances does have some compelling explanations for why most economists called for a recession last year and why (almost) everyone is pulling that call. 

She explains that the leading indicators of recession are largely manufacturing-based. At the end of 2022, data suggested that manufacturing was starting to decline. 

“When that happens, your standard economic model tells you that a manufacturing recession portends a services recession,” she says. “That’s why almost all traditional economic models are heavily weighted towards manufacturing. Even though in the U.S. where manufacturing is only 10% of GDP, the manufacturing sector is a really solid leading indicator.”

The global recession still hasn’t washed up on U.S. shores

Manufacturing declined so much in late 2022 that it fell into a global contraction. On average, it takes about three months for this kind of contraction to hit the services sector, so it made sense to predict an impending downturn. 

“The conditions for a 2023 recession were so in place that you saw massive conviction around that view,” Frances adds. “But manufacturing did not bleed into a recession in the United States. It did across vast swaths of Europe. We have a whole bunch of European economies in recession and a whole bunch more that when Q4 GDPs come out will be in a recession.” Developed market economies, like her native Canada, are clearly in a recession by a number of metrics.

That’s why the “no-recession call is extremely U.S.-centric,” she adds. “Nowhere I go in the world are people questioning a soft landing versus a hard landing, [unless] they’re U.S.-focused.”

Frances says that for 18 months, we’ve been living through the largest, longest global manufacturing recession in modern economic history. And yet in the U.S., it hasn’t bled into services. Meanwhile, the manufacturing recession “almost looks like it’s troughed,” she says. “We’re beginning to see the manufacturing indicators going upwards.”

So she thinks that anyone who believes that manufacturing is a “helpful economic signal on the way down” should abandon their recession call. 

History still matters … right?

The challenge for economists (and a hot topic of debate) is whether to abandon the view that manufacturing must bleed into a services recession. 

One camp argues that the interest rate sensitivity in the U.S. economy is lower because of the construction of its housing market. Thus, the lag between manufacturing and services is zero and the relationship is broken.

The other camp believes lags from interest rate hikes are long and variable. The average time from the first rate hike to the impact on the economy is two years. 

Frances says economists who called for a 2023 recession believed “the lag and the impact of interest rates would be faster and sooner” — assuming that because the rate hikes were so aggressive, the lag would definitely be shorter. But that wasn’t the case.

Even though her 2023 forecast was wrong, she doesn’t want to make future predictions without using well-accepted economic principles. Frances says she has trouble “throwing out every existing historical example” of recessions resulting from certain leading indicators. 

“I can’t do that,” she says. “I can handicap it and say there are elements that are different. But sometimes I see other strategists in the media saying, These crazy people with their idiot calls.

It’s not crazy to look back on history and [point out] the standard economic relationship between things; therefore, we have to consider the wealth of probabilities.”

From bear, bull and base to probability: New models and new realities

Frances thinks it’s crazier to abandon historical events and patterns completely. 

But in practical terms, “we have become much more scenarios-based than we ever have been,” she says. Frances moved her team away from “base,” “bear” and “bull” cases and toward  probability-based forecasts. They spend more time thinking about “ways to develop central scenarios over time in a world where we don’t know if our standard economic models work.”

She points out that the Bank of Canada just announced a new economic model for 2025 after using only two models for its entire existence. 

“When large institutions say we need to rethink the standard relationships between variables, I think that’s really significant,” she explains. 

“But I can’t say the standard relationships go to zero,” Frances continues. “Given how bad a lot of the leading economic indicators are and how aggressive the rate hiking cycle is, for me to [predict] just two shallow quarters of negative GDP is throwing out a bulk of what we know has historically been true about economics.”

Will an American recession even matter?

“This call seems bearish, but the U.S. is still one of the better economies in 2024,” Frances notes. “Even as I can say out of one side of my mouth that we do have a technical recession, I also am much more comfortable in U.S. assets.”

“The challenge is that we are speaking about the economy in absolutes, but it is and always will be a relative trade,” says Frances. “It’s why I wrote a piece that said having a U.S. recession call doesn’t matter — because the recession may look different. And because of the desynchronized nature of manufacturing and services, we could enter a U.S. recession with manufacturing accelerating, which would be bananas.”

It’s also possible we could experience a recession because services are in recession but the manufacturing sector is not. “So, if you’re a bottom-up stock picker, you’re looking at an opportunity there, given that this is desynchronized,” she says.

The second issue? The current economic cycle is being led by emerging markets, which is atypical. 

“Europe is already in its recession and may actually exit it before the U.S. heads into a recession,” Frances notes.

The desynchronized nature of what some would consider a bearish economic outlook means that there’s still a host of opportunities that exist. 

And of course … inflation

“We haven’t talked about the inflationary risks either, which I think may end up being far more important than whether GDP is negative or not and for how many quarters,” Frances says. “We have a range of indicators that suggest we may, in the next six months, actually undershoot; that the momentum may actually push [inflation] sub-2% slightly before rising back up on the other side.”

So depending on one’s investment horizon, capitalizing on that momentum may be a good move in the near term. But Frances wonders what will happen if we continue to have supply chain disruptions and inflation starts rising again, just as the Fed cuts rates. She thinks that empirically, there’s a case for such a scenario. 

“I know that it’s my job to have this recession forecast and explain it,” she adds, “But I would much rather say the balance of risk is toward a hard landing, not reacceleration.”

Whatever we call it, I have a hunch that 2024 will be a wild ride.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.