GAMBLING ON RECESSION ODDS

Elliott D. Pollack & Company 2023 Economic Outlook

In the fight against inflation, the Fed delivered seven interest rate hikes in 2022 which was the fastest increase of this magnitude in history and pushed borrowing costs to a 15-year high. This is all by design. Higher interest rates discourage spending by both businesses and consumers and reduced spending lowers economic activity. Decreased economic activity will lower inflation.

But the Fed is in uncharted waters. They have never tried to induce a recession in such a tight labor market. In 2022, the U.S. labor force grew by 2.6 million workers, there were 4.5 million jobs added and the current unemployment rate of 3.5% is the lowest in 53 years. But there are also presently 10.3 million job openings across the U.S. and only 5.7 million people unemployed. Fierce competition for employees has driven up wages and that is when inflation starts to stick around for a while because consumers are able to afford the higher prices for goods and services.

This huge gap in labor supply is also at the core of the concept that the Fed can achieve a “soft landing” for the economy. The idea is that the reduction in economic activity can deplete the gap of unfilled jobs and minimize actual job losses (current projections for the recession still predict 1.5 million to 2 million job losses across the country). So far, only job increases have occurred, meaning that there is little evidence so far that the interest rate hikes have slowed hiring. Wage growth has slowed though, which is a promising indicator in the fight against inflation.

The real estate market is taking the brunt of the hit delivered by Fed interest rate hikes. New home permits were down 18% across the State of Arizona last year and we believe they could decline another 20% in 2023. We also believe housing prices could fall another 10-15% in 2023. This will provide a modest reversal to our affordability crisis. But it will be nothing like the 2008-2009 housing crash. Home prices skyrocketed by over 80% in the last three years through May 2022. So, a 10% decline only puts us back to May 2021 prices and a 15% decline puts us back to March 2021 prices. That limits the number of homes that may experience low or negative equity, which was a widespread issue back in 2008. In addition to that, there were much stricter lending practices this time around, no subprime loans issued, and no excess supply of homes.

The consensus odds of a recession this year are at an all time high, though the timing, length, and severity are still being debated. It is way too soon to tell, but we have broken down the odds as we see it today into three scenarios.

1. We give the “Best Case” scenario a 20% chance. In this scenario, things work out for the Fed as planned. A soft landing. Inflation is brought back under control quickly and smoothly and we all live happily ever after.

2. We give the “Base Case” scenario a 50% chance. In this scenario, we are in for a rough ride, but the recession is short and shallow. It will take some time, but we get through it and the economic situation improves in 2024.

3. We give the “Worst Case” scenario a 30% chance. In this scenario, things get rocky. We end up with the actions of the Fed, fiscal policy, or black swan event causing things to be worse than anticipated. Geopolitics are hard to predict and have substantial impacts.

Our latest forecasts for the economy in 2023 have taken into consideration a slowing economy over the next 12 months. We still believe Arizona will be a preferred destination for new residents and industry, but our expectations for new employment have been tempered by the expected recession. As previously mentioned, new home development is also expected to decline substantially with the combination of affordability issues and higher mortgage costs reducing demand.

Greater Phoenix Economic Forecast

Population

1.9% INCREASE 2022

1.7% INCREASE 2023

Employment

3.9% INCREASE 2022

2.0% INCREASE 2023

Retail Sales

8.6% INCREASE 2022

3.4% INCREASE 2023

SINGLE FAMILY PERMITS

-27.5% DECREASE 2022

-20.0% DECREASE 2023