These conditions serve as the foundation—the jumping-off point—for the second quarter and beyond. But given the rapidly evolving nature of so many key factors, the obvious question is: In what direction do we go from here?
Our analysis points to three potential scenarios that may unfold going forward.
Scenario One: Things get better
One outcome is that economic conditions improve significantly, setting the stage for continued economic momentum coupled with lower inflation and shifting to a neutral or accommodative Fed policy. Likely developments we would see include:
Banks stabilize. In this scenario, additional signs that the impact of recent regional bank failures hasn’t spread beyond the banks affected in the first quarter would alleviate concerns about the financial system’s health. Depositors would regain confidence that their savings/deposits are secure and banks’ willingness to lend money could expand back to pre-bank failure levels.
Inflation continues to moderate. As the quarter ended, the Fed’s preferred gauge of inflation—the core PCE index—showed inflation rising by 0.3% in February. That was a smaller increase than expected and lower than the 0.5% increase in January. In an improving environment, goods inflation would continue to decline. In contrast, services inflation becomes “unstuck” and begins to fall steadily–likely prompting the Fed to cut rates.
Consumer confidence gains momentum. Even in the face of bank failures and continued high inflation, consumers show resilience—with reasonably strong confidence levels and opinions about their financial situations. If inflation moderates and the uncertainty around banks dissipates, we expect those readings to improve even further.
Stocks and bonds benefit. Equities perform well, led by financials and cyclical stocks that have traditionally benefited from a strong economy. Defensive stocks struggle as the economy remains healthy. The U.S. dollar falls, giving a boost to international stock returns. The yield curve steepens, and corporate bonds benefit.
Scenario Two: Things get worse
An alternative scenario involves deep and ongoing banking issues that spread well beyond just the few institutions impacted thus far and a slow or ineffective policy response to that worsening crisis. In that environment, key developments we would likely see include:
Access to credit dries up. Noted above, as a result of the failures of SVB and Signature, banks became less willing to make loans during the first quarter. A deeper banking crisis would greatly slow or even stop the flow of loans—drastically reducing consumers’ and businesses’ ability to spend, expand and grow.
Unemployment rises sharply. Significantly lower demand would spur layoffs that cause unemployment to spike. Currently, small businesses’ optimism and outlook for the future are at levels often seen during recessions (see Exhibit 8). Given that, even a small decline in demand could cause pessimistic businesses to pull back.
Economic growth contracts. Historically, when bank loan activity falls, economic growth follows suit. And typically, the sharper the decline in loans, the more significant the decline in GDP growth.
Investors flock to quality. Investors would favor assets perceived as having the highest quality prospects in a struggling economy—such as long-term Treasury bonds, large-caps (mega-cap tech, in particular), and defensive sectors that can better withstand an economic downturn. Equities would suffer, with financials, small-cap stocks, and cyclical sectors likely seeing the worst damage in the weak environment. International markets would lag the U.S. as foreign investors would flock to the perceived safety of U.S. assets.
Scenario Three: Things stay mostly the same
A slowdown in credit creation would characterize a third potential path due to lingering concerns about the bankingsystem, but one that stops well short of becoming a serious, systemic problem. Hallmarks of this essentially “middle-ground” scenario between the two other outcomes would likely include:
Reasonable consumer confidence. Consumer confidence would hover roughly around its recent levels, as no data or developments would be conclusive enough to increase or decrease overall confidence greatly. As a result, consumer spending and household finances would remain on their current healthy track. Consider, for example, that despite numerous media reports about the sharp rise of credit card debt, card balances per capita have essentially reverted to their pre-pandemic trajectory rather than risen to an alarming level (see Exhibit 9). As a result, consumer spending and household finances would remain on their current healthy track.
Additionally, compensation has remained relatively strong and above trend. Therefore, the need for U.S. workers to borrow is lower than normal, making a slowdown in bank lending activity less of a drag on consumers.
Slower–but positive–job growth. Small business owners may appear pessimistic, as noted earlier, but their actions support an outlook of continued job growth. For example, small businesses are still hiring and are not planning on raising prices from current levels—both of which suggest conditions where the job market remains healthy while inflation dissipates. As seen in Exhibit 10, average six-month job growth has remained above trend and shows more of a leveling off in recent months than a dramatic reduction.
Slower—but positive—economic growth. Less lending and credit creation would likely slow the economy. But the momentum from consumers could delay or even prevent a recession, particularly given the relatively strong economy now. As Exhibit 11 shows, nominal GDP growth in recent quarters has been historically robust (even as it has slowed.) A further slowdown from these current levels would not mean a recession is imminent or even assured. Rather, in an environment in which other factors stay reasonably healthy, the economy would be more likely to generate positive nominal growth.
Notably, the market appears to agree with this premise as we start the second quarter. Typically, bond investors predicting a recession might expect the Fed to cut interest rates by 300 to 400 basis points. Today, however, the market is looking for rates to be cut far less—by only around 200 basis points. We believe that outlook reflects a soft-landing scenario much more than it does a recessionary outcome.
A choppy market
Stocks will likely trade in a range if the future is essentially “more of the same,” without making new highs or new lows—and frustrating both bulls and bears as a result. Tech stocks and shares of higher-quality companies would likely lead, thanks to their access to capital markets and generally healthy balance sheets, while financial stocks and small-company shares (and other cyclical sectors) would remain under pressure. The dollar would also likely be range bound. Internationally, China would present opportunities from the reopening of its economy as its own domestic story plays out and becomes a driver of equity market returns.