When Does a Slowdown Become a Recession?

Leo Wealth

Written by Harmen Overdijk

The short answer is no one knows. However, we can look at macro-economic trends to see where the economy and more importantly, markets, are potentially headed.

Why is it important to gauge the risk of a recession? Because in a recession people tend to lose their jobs, personal incomes recede and consumer spending falls. This means that companies will struggle to maintain their profits, which is not good for their share prices. At the same time demand for credit falls, central banks typically cut interest rates and bond yields tend to come down, which is positive for the performance of fixed income. Therefore, from an asset allocation point, understanding the macro environment is important.

While markets will always go up and down, an important rule-of-thumb is that so long as the economy is not in a recession, you should stay invested in equity markets.

The soft-landing narrative dominated markets in May, with both equities and bonds rallying throughout the month. Meanwhile, the U.S. dollar weakened, and the Euro appreciated.

Energy prices were the worst performing commodities as a moderation in oil demand kept a lid on prices. Meanwhile, the stabilization in the global manufacturing cycle powered the industrial metals rally further.

A Recession Delayed, Not Avoided

The U.S. has avoided a recession over the past two years, and data for the labor market is not yet pointing to an imminent rise in the unemployment rate. 

Global economic growth has incrementally improved while inflation has fallen significantly in developed economies over the past 18 months. Interest rates are likely to start falling this year.

Global equities have risen nearly 30% since late-October. The financial results of NVIDIA, the company that is benefitting the most from heavy generative AI infrastructure investment, continues to point to a possible sustainable source of new aggregate demand. Considering these facts, it is not difficult to see why many investors expect a Goldilocks economic outcome. Over a short-term time horizon, we agree that the path of least resistance for the global stock market is higher until the outlook for the labor market deteriorates more significantly.

However, our assessment is that the monetary policy stance is tight, which means that something must change for a recession to be eventually avoided.

The U.S. avoided a recession in 2023 due to the deployment of excess household savings and a strong contribution to growth from fiscal spending. Fiscal thrust is set to be negative this year, and multiple measures of excess savings now point to their exhaustion. Forward-looking indicators of the U.S. labor market are no longer pointing to significant excess labor demand which, along with rising consumer loan delinquencies, supports the view that excess savings have been spent. Business loan lending standards remain tight, and aggregate U.S. credit growth remains very weak.

There is a path to a soft landing, but it is a narrow one. Many things need to go right to avert a recession: The labor market needs to rebalance, cyclical spending needs to stabilize, loan delinquency rates need to stop rising, inflation needs to fall back to target, and growth in the rest of the world needs to improve. On the positive side, Fed policy could surprise and turn much more dovish, especially if Trump becomes President again. Artificial Intelligence could start increasing economic productivity faster than expected. Therefore, we are currently neutral on global equities; unlike our bullish stance at the start of this year.

Soft Landing for Inflation

There is some evidence that the recent resurgence in inflation is cutting into consumer confidence and spending. The pain is greatest for young consumers, who are lowest on the income ladder and most indebted relative to their ability to spend. Meanwhile, compared to high-income earners, equity markets are making new highs and residential property prices keep going up. This split is compounded by the fact that young households are more likely to rent, and rents refuse to come down, while the top-income households have locked in low-rate mortgages. Given the concentration of wealth and income in the U.S., spending by well-off households is more than enough to keep the economy expanding, even as those at the bottom get squeezed. This is likely a key issue in the upcoming U.S. Presidential elections.

The big question is when will slower spending in specific sectors lead to broad enough layoffs to tip the whole economy over. We believe firms will cut prices before they stop hiring, as evidenced by many staple companies. Broad measures of employment are slower but remain strong.

We don’t think inflation is reaccelerating. After falling sharply from its peak in 2022, core inflation rose in the first quarter of 2024. Some have interpreted this as a sign that the economy is starting to overheat again. With the unemployment rate still near its historic lows, it would be foolhardy to completely rule out a second wave of inflation. So far, the evidence does not point in that direction. For one thing, the recent tick up in inflation has probably been exaggerated by seasonal adjustments and does not seem to be carried forward into the second quarter of the year.

Another inflation wave would cause long-term inflation expectations to move higher. This makes it more likely than not that the Fed will eventually find itself behind the curve in easing monetary policy. If that happens, a soft landing will be more difficult to pull off.

A Recap of Q1 Earnings

First quarter corporate earnings and sales growth were generally strong, but there are some nuances. Q1 earnings growth numbers were skewed upward by the exceptional performance of the Magnificent Five. Earnings of the “lower 495” have contracted. On a positive note, margins have stabilized, and earnings growth is expected to broaden in the next quarters. Sectors whose growth has been lagging this quarter will rebound.

Corporations have been making dedicated efforts to return value to shareholders, using free cash flow to increase dividend payments and share buybacks. Some even announced their first dividends this quarter. The combination of low expectations, improving efficiency and a commitment to shareholder returns created a tailwind for equity markets in the past month.

Company CEOs are optimistic about the economy. Development of AI applications is in full swing, but few companies are monetizing them yet. Consumer spending is strong although slowing.

Robust U.S. consumer spending has been shielding the U.S. economy from the effects of tighter monetary policy for nearly two years. However, bifurcation has been evident for a while now: It is affluent consumers who are spending, while lower-income Americans are under pressure from rising prices of food, gas, and other necessities. Earnings growth is decent, and projections for the remainder of the year are positive. While this outlook warrants optimism, it also creates a high expectations bar and is somewhat inconsistent with the recent deterioration of macro-economic data (PMIs, retail sales, consumer confidence, and industrial production).

Are Companies Making Money From AI?

The best companies are not only generating solid earnings but doing so more efficiently. Profit margins are high and stable at pre-pandemic levels. Some even experienced margin expansion. Taking one of the leading U.S. giant tech firms as an example, sales climbed 15% last year while expenses rose just 5%. High-quality companies can thrive in a high-rate environment. Beyond big tech, 40% of S&P 500 companies mentioned Artificial Intelligence on their Q4 2023 earning calls, compared with just 20% a year prior. Dedicated AI-driven business plans will lift corporate efficiency in the long run.

Work on Generative Artificial Intelligence models is in full swing, and infrastructure companies are enjoying hefty profits from other companies’ Capex investments. However, monetization of applications for the broader corporate sector is likely still a few quarters away.

America’s Small Companies

Small-cap stocks’ deep discount relative to the S&P 500 is not the generational buying opportunity it may appear to be on its face. While the size premium discovered by Fama and French is real, it is mainly attributable to the outsized success of a handful of public companies that migrated from small- to mid- and large-cap status as they grew.

The problem now isn’t that the U.S. no longer incubates disruptive and innovative companies, it’s that those companies have much more access to capital away from the public equity markets than they did in the size factor’s heyday. The most promising companies are being bought by the largest tech companies, which have been on an acquisition spree since the mid-2000s; staying private, which allows founders to retain control while obtaining the funds to scale their businesses; or going the IPO route once they’re already large and have already realized much of their promise. With VC firms and large tech firms skimming the cream from the small-enterprise pool, the quality of listed small-caps has deteriorated, as indicated by the much lower returns over the past decade, and we do not expect this divergence to turn around soon.

A Soft Landing for the Rest of the World

Last year, the global economy experienced a “Great Decoupling,” as growth in the US rebounded but growth in most other major economies remained weak. However, starting in April, a convergence of sorts has occurred. This can be seen in the narrowing in growth projections, economic surprise indices, and the PMIs. The convergence in economic fortunes has led to a tightening in interest-rate differentials. This, in turn, has resulted in a modestly weaker US dollar. Slightly cooler economic data from the US accounts for part of the convergence. So far in Q2, Goldman’s US Current Activity Indicator has averaged 0.5% compared with 0.9% over the previous four quarters.

The bulk of the narrowing gap in growth expectations can be attributed to stronger data in a few other major economies. European economic surprise indicators are now outpacing those of the U.S., thanks mainly due to the stabilization in global manufacturing activity, lower energy costs, and rising real wages.

Chinese growth has also improved over the past few months on the back of rising exports. The export PMI hit a 9-month high in April. The question is if China’s export boom will last. The Biden administration has increased tariffs on Chinese imports and the EU is threatening to do the same.

Is 2024 China Similar to the U.S. in 2009?

Has China’s equity market seen a structural low in January? There are quite a few similarities between the position China is in now to where the U.S. was in 2009.

In 2023, China experienced a full-blown real estate crisis and on the back of that it experienced effectively a “banking crisis” similar to what happened in the US in 2008. Except that in China, it wasn’t the banks but the property developers who went under as they de facto acted as the country’s largest mortgage banks.

Because of this and the crackdown on tech companies in the past few years confidence in Chinese equities has hit an almost 20-year low. With valuations at multi-year lows there is ample opportunity for outperformance in the coming years. Especially when domestic appetite for investing in stocks increases. In the past year, household savings have gone up as people stopped investing in property and in many so-called wealth management products, which were property related. This has not led yet to an increased interest in investing in equities but that could very well happen.

It is easy to forget now, but confidence in the U.S. market was not exactly at a high point either in February 2009. As highlighted above, there are several concerns for the Chinese economy in the near term as the effects of the real estate crisis will continue to have a negative impact on the economy. However, for making equity market investments, you need to keep in mind that the stock market does not equal the economy. If economic growth was the key driver for equity market performance than China should have been a top performer the last 20 years. It wasn’t. Often it is an improvement from low expectations that generates outsized returns.

Investment Conclusions

The path to a soft landing remains in place, but it is a narrow one. The most likely outcome is that the global economy will undergo a “transition” somewhere in 2025 once labor markets cool to the point that unemployment starts rising. Stocks typically peak a few months before recessions begin. If concerns over inflation subside before concerns over a recession resurface, stocks can continue moving higher.

After the recent rally, valuations have increased at a time where we are closer to an economic slowdown. We think there is more upside in global equity markets but we are neutral on global equities versus other asset classes. We think a well-diversified portfolio should be a combination of equities, fixed income, commodities and alternatives at this stage.

Portfolio Positioning

We kept our current portfolio positioning in May, emphasizing quality, safety, and diversification characteristics at the portfolio level. We believe these tilts will help portfolios weather volatility in the coming months.

In the current climate in which we are neutral on equities and more positive on fixed income, we favour a diversified portfolio that does not overweight the magnificent 7 or U.S. stocks. We believe that our focus on global exposures across all asset classes – stocks, bonds, commodities, hedge funds, and private credit – will work best in the second half of this year.


The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market.  They are methods used to help manage investment risk.

Smaller capitalization securities involve greater issuer risk than larger capitalization securities, and the markets for such securities may be more volatile and less liquid.  Specifically, small capitalization companies may be subject to more volatile market movements than securities of larger, more established companies, both because the securities typically are traded in lower volume and because the issuers typically are more subject to changes in earnings and prospects.

Securities of small and medium-sized companies tend to be riskier than those of larger companies. Compared to large companies, small and medium-sized companies may face greater business risks because they lack the management depth or experience, financial resources, product diversification or competitive strengths of larger companies, and they may be more adversely affected by poor economic conditions. There may be less publicly available information about smaller companies than larger companies. In addition, these companies may have been recently organized and may have little or no track record of success.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments are often sold by prospectus that discloses all risks, fees, and expenses.  They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain and should not be deemed a complete investment program. The value of the investment may fall as well as rise and investors may get back less than they invested.

Hedge Funds are unregistered private investment partnerships, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives) and are NOT subject to the same regulatory requirements as mutual funds, including mutual fund requirements to provide certain periodic and standardized pricing and valuation information to investors. Hedge Funds represent speculative investments and involve a high degree of risk. An investor could lose all or a substantial portion of his/her investment. Investors must have the financial ability, sophistication/experience and willingness to bear the risks of an investment.

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