40% Recession Risk — Why Mark Zandi Says the Economy Is “Fragile”

Caroline, so good to be with you. Thanks for the opportunity.

No. No. I mean, it was a good report, no doubt about it. 115K was better than I anticipated. But, you know, some months up, some months down. I still think the underlying rate of monthly job growth is somewhere around 50,000 jobs. And that's not consistent with stable unemployment. I do think unemployment will start to drift higher. The other thing to mention, Caroline, we've got to also look at the participation rate because one reason why unemployment is not higher is because people are stepping out of the workforce. The participation rate is falling very rapidly. And if you account for that, just assume, for example, that the participation rate had held steady over the past year, the unemployment rate today would be closer to 5%. So, in my mind, the labor market is still a vulnerability in the economy, still very soft, and recession risks are still very high. But I'll take it. It was a good number.

It's cooling. It's not cracking. I mean, the difference is layoffs. We still don't see businesses laying off workers. They're still quite reluctant to hire workers. Hiring rates are still very low across most industries. They've cut back on hours, so hours worked remain low, kind of consistent with what you'd see in a recession. Cut back on temp jobs, another indication of some pullback. But those are all consistent with a cooling labor market, not a cracking one. And that would require layoffs, and at this point we haven't seen it. And that's why we continue to avoid an economic downturn.

Well, it is in the labor market. I mean, I do think the labor market is soft, and I do think the amount of slack in the labor market continues to increase. That goes back to my point about the participation rate and unemployment. The unemployment rate continues to drift higher, you know, not every month, but cutting through the volatility of the data. Participation rate continues to decline. So, that's a very significant vulnerability, but I'll throw into the mix this now increasing inflation. Inflation is now picking up, you know, quite rapidly for obvious reasons, the Iran war, and of course the pass-through of the tariffs and other factors. And it's high, and it's starting to cut into people's purchasing power. Their after-inflation incomes are now falling. I mean, real disposable income, that's after tax, after accounting for inflation, is no higher today than it was a year ago. So, there's been no growth in purchasing power, and that's going to get worse. It's going to start declining, and if that's the case, then consumers, they'll start turning more cautious and even start pulling back, and that risks those layoffs. Businesses might start laying off. So, I would say the labor market is still this kind of soft spot in the economy, but I'd throw into the mix now these high rates of inflation, which will continue to become more of an issue unless the Iran war comes to an end here pretty quickly.

Well, yeah. I mean, I think they're consistent with what I just said. You know, I'm looking at it from a 30,000-ft level down, and that would be consistent with companies like you just mentioned that would be, you know, starting to struggle here. Yeah, particularly, you know, companies that cater to lower- and middle-income Americans. I mean, high-income, high-net-worth, well-to-do Americans, no problem. They've got plenty of savings, and they're drawing down their savings. I don't know if you've noticed, Caroline, but the saving rate is as low as it's been since, you know, right before the financial crisis. You know, you have to go all the way that far back in time. And that's high-income, high-net-worth households drawing down that saving to supplement their purchasing power to maintain, you know, their spending. But lower-income and to some degree middle-income Americans, they don't have those resources. They don't have the excess saving. They're living more paycheck to paycheck. And so, if they have to put more of their hard-earned dollars into the gas tank, they have less to spend on everything else, and that's what we're observing. You can't get that gym membership. You can't, you know, go to the fast-food restaurant. You know, you're going to have to trade down. You can't have beef. You got to have chicken. You know, those kinds of things. So, that's very, very consistent with the point I'm making about inflation and purchasing power.

Well, you know, the stock market's not the economy, particularly today. Currently, I mean, in my 36 years as a professional economist, you know, the stock market's never been more disjoint from the economy. A big part of that is obviously artificial intelligence. AI, you know, what's driving the stock market train is these big hyperscalers and chip companies and everything, all the companies that, you know, play into that space. And that runs on its own dynamic. It has nothing to do with the economy. And that's half the market cap, you know, is sitting right there. The other thing that's driving things is, you know, I think investors are really focused on the president, thinking that the president, this is his MO, will, if push comes to shove, if something seems like it's not working, going off the rails for the economy, will pivot, you know, declare victory and move on, and he's got his eye on the equity market. So, you know, stock investors are looking at the president, the president's looking at the stock market, and so far that's worked out pretty well. And I would say that doesn't feel like a stable, what economists would say, equilibrium. You know, it's kind of like a hall of mirrors, but I think that's also playing a role. I'll throw in one other factor, and that's the tax cuts. They are real. They are deficit financed, but those were massive tax cuts to businesses, the most significant being full depreciation of investment. That's why we're seeing, you know, in part the big investment boom. Also, of course, AI is driving that. So, there's a lot of factors at work. The economy is kind of low on the list, but having said all of that, you know, if we go from a cooling economy, a cool labor market, to a cracking economy, you know, the stock market will ultimately reflect that and stock prices will head south. So, we're not there yet. That's another reason to think that we'll be able to navigate through without a downturn, but, you know, I think that is certainly a risk.

I mean, in the backdrop that we have now, yeah. I mean, the economy continues to move forward. The other thing is that, you know, maybe helping out here in this inflationary environment is that businesses are passing through. You know, they're passing through these price increases now, and so that helps to support margins and corporate earnings, which obviously are the key to stock prices. So, yeah, in the current state of the economy, the stock market can, you know, it'll hold its own. It can't keep rocketing higher to the degree that it has been, I don't think, right? Valuations are awfully high. Price-earnings multiples are, you know, about as high as they've been in history except for perhaps during the internet bubble, which didn't end so well. So, you know, I don't know that investors should count on these kinds of returns going forward, but it can hold its own. But, you know, if in fact inflation does become an issue for consumers, they do start to pull back, businesses respond by starting to lay off workers, that's a whole different ball game, and the stock market will ultimately reflect that.

Well, I think we should be able to navigate through. I mean, the economy is resilient. I mean, and what's going on with artificial intelligence is real. It's, you know, it's driving a lot of investment spending, and the run-up in stock prices is real, and that's led to an increase in wealth. And so, if you're among the well-to-do that own the stocks, you're doing quite well. You're wealthier and you're able to spend. So, you know, all those things should help us to navigate through. I am assuming, when I say this, though, that the Iran war does start to wind down here quickly in the next few weeks, a month or so. When I say wind down, simply that the Strait of Hormuz opens, and we start to see tankers flow through, and oil prices come in to a more meaningful and sustained degree. You know, I'm assuming that. If that's the case, and we don't get hit with anything else that, you know, kind of comes from left field that's off the radar screen, we should be okay. We should be able to navigate through. We are a resilient economy, but we are vulnerable, it is fragile, it is precarious, and, you know, if the war continues to drag on into the summer months, then recession will become more likely than not.

Yeah, so if you're asking, what is the probability that the economy will enter into a recession at some point in the next 12 months, in the next year? I'd say 40%. So, not 50, so it still says no recession, but 40's awfully high. Just for context, in a typical economy, what economists would call the unconditional probability of recession is closer to 15%, 1-5%. So, 40% is very elevated, very uncomfortable, it gives you a sense of how close I think things are to the edge here, but it's still less than 50%.

Well, I hesitate to break that down. That's too high a level of precision for me, Caroline. They're all in the pot, you know, we got this big pot of stuff that goes to driving the economy. The labor market is a big part of it, the higher inflation related to the war in Iran, and the higher energy prices, that's part of it, the weak consumer confidence, you know, that's all part of it. So, you know, it's a brew of stuff, very hard to parse that into different buckets and say, hey, this is the part that's due, here's of the 40%, this is what is driving that 40%, but, you know, all those things together add up to an economy that's still growing, you know, but it's precarious growth.

Yeah, that's another reason to be a little nervous here, right? I mean, we came into the year thinking that the Fed was going to cut rates. It looked like inflation was going to roll over and that the labor market was still soft, and, you know, the Fed would use this as an opportunity to bring rates down another 25, 50, 75 basis points, get it back to the so-called equilibrium yield. That now doesn't look likely at all, you know, even with the president's protestations and the new Fed chair, I just don't think there's an appetite on the Fed to cut interest rates in the face of these high rates of inflation. It doesn't argue yet for rate hikes, but I think the key there is inflation expectations. If inflation expectations start to rise to any meaningful degree, I think at that point then rate hikes become more likely than not. And if you look into the bond market and what bond investors think, so for example, if you look at the five-year break-even, so you take the interest rate on the five-year Treasury and look at that relative to the yield on five-year Treasury inflation-protected securities, TIPS. That's at the high end of the range that's prevailed, you know, over the last four or five years. It's not out of the range, but it's at the very high end of the range. I suspect if that starts breaking to the high side and we start seeing that move up, then the Fed will start thinking about rate hikes and that'll become more part of the conversation. But at this point inflation expectations, thank goodness, remain where they are, and the most likely path forward here is no rate cuts and no rate increases, just a stable Fed, which again, as I said, is, you know, some reason for concern in the context of a weakened economy. The Fed's just not going to come to the rescue here like it would typically if things don't stick to script.

Well, look, for most retail investors, they really should look through this, right? I mean, you have to have a longer-term horizon. You can't get caught up in the ups and downs and all arounds. And you should be investing for the long run. That means, you know, 10-year, 20-year, 30-year horizon. And if that's the case, then, you know, I think you should be on autopilot in terms of your saving and how you invest. So, I wouldn't get caught up too much into the ups and downs and all arounds in the current situation. I'd be looking through that. So, now if you really feel like you want to, you know, play those ups and downs, I'd be cautious, right? I mean, the stock market's come a long way in a very short period of time. Valuations, as I mentioned earlier, are very, very high. The economy is vulnerable to a downturn. The Fed's not going to be friendly here, at least not in the near future. So, all those things would suggest to be more cautious than not.

I'm nervous. Go ahead, Caroline.