For the last year, Morgan Stanley Research has maintained that the U.S. economy is heading for a soft landing—a moderate economic slowdown rather than a full-blown recession. We still hold that view even as tighter lending standards have created a consensus opinion that recession may be inevitable. To us, data points in housing, the labor market, income and spending trends, and inflation bolster a more optimistic outlook.
Housing: The current housing cycle has been unique. Despite a record-breaking year-long decline in housing activity, the correction in home valuations has been mild. This has led to deteriorating home affordability, which has benefitted homeowners while hurting would-be first-time buyers. From a national perspective, it appears the cycle is bottoming, and home price appreciation will recover. As a result, the big drag on GDP growth from the housing correction should turn neutral by the third quarter of 2023, providing some cushion against growth slowdown in other sectors.
Labor Market: The April U.S. employment report provides ample evidence that the labor market is slowing, not headed for a cliff. The steady decline in job postings, with low unemployment rates since the second quarter of 2022, shows that the labor market is coming back into balance after the high unemployment rates of the COVID-19 pandemic, followed by the tight labor market of 2022.
Income and Spending: U.S. income and consumer spending are forecasted to have two very weak quarters in the middle of this year. Although first-quarter 2023 U.S. data indicate that consumer spending is slowing, income is the predominant driver of spending—and the fundamental factors underpinning income, namely the labor market, are slowing but not plummeting. Even as wage growth continues to slow, our forecasted path for inflation suggests that real wages will finally turn positive in the second quarter of 2023.
Inflation: The most recent April data suggest that core inflation continues to slowly recede, tracking in line with our year-end forecasts as well as the Fed’s March projections. We think the incoming data continue to support a Fed pause at the June meeting. After June, a variety of scenarios are possible, but we expect a gradual slowing in core inflation that will keep Fed rate hikes on hold until March 2024, followed by quarter-percent rate cuts each quarter.
Turbulence on the Horizon?
To be sure, the possibility of a recession remains a concern this year. Continued turmoil in the banking sector could have spillover effects if credit continues to tighten, reducing the borrowing ability of both businesses and individuals. Should credit growth slow more than expected, it would have broader implications for investment, consumption and labor. Against this backdrop, we expect the U.S. economy to fly very low to the ground, particularly during the second and third quarters of this year, so even a little bit of turbulence could push the U.S. into the hard landing of a recession.