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

[00:00:00] Speaker 1: We just got the most important economic data point of the week. Here to break it down for us is Mark Zandi, Chief Economist at Moody's Analytics. Mark, great to have you back. Thanks [00:00:07] Mark Zandi: so much for being here. Caroline, so good to be with you. Thanks for the opportunity. [00:00:12] Speaker 1: So Mark, 115,000 jobs were added in April, much more than expected. The unemployment rate held steady at 4.3%. You've warned in the past that recession risks are high. Does this change your [00:00:24] Mark Zandi: view on the economy, Mark? 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. 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 [00:01:14] Speaker 1: still very high. But I'll take it. It was a good number. What's the difference between a cooling labor market, though, and one that's about to crack? And which one are we in now? [00:01:25] Mark Zandi: 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, you know, some pullback. But those are all consistent with a cooling labor market, not a cracking one. And that would require less. And at this point, we haven't seen it. And that's why we continue to avoid an [00:02:01] Speaker 1: economic downturn. You've said in the past, though, and it sounds like you still believe it, that the economy is fragile beneath the surface. Where is the clearest evidence of that showing up in this economy [00:02:13] Mark Zandi: right now? 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. They continue. The unemployment rate continues to drift higher, you know, not every month, but, you know, cutting through the volatility of the of the data. Participation rate continues to decline. So that that's a very significant vulnerability. But I'll throw into the mix this now increase in 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. There are 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 and start declining. And if that's the case, then consumers, they'll start turning more cautious and even start pulling back. And that risks the those layoffs. Businesses might start lying off. So I would the labor market still this kind of the soft spot in the economy. But I'd throw into the mix now this 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. [00:03:38] Speaker 1: And we did see some signs of a pressured consumer out of earnings reports this week. We had McDonald's saying there's a pullback in the lower income consumer. We saw Planet Fitness say that there lower membership signups. We saw Zoetis say that customers are more price sensitive. Shake Shack sounds like maybe that was more beef prices and and weather disruptions. But Kraft Heinz said that people are essentially running out of money by the end of the month. Do you look at those as kind of canaries in the [00:04:04] Mark Zandi: world? Yeah, well, yeah, I mean, I think they're consistent with what I just said. You know, I'm looking at the from a 30,000 foot level down and that would be consistent with companies that like you just mentioned that would be starting to struggle here, particularly, you know, companies that cater to lower and middle income Americans. I mean, high income, high net worth, well to new Americans. No problem. They've got plenty of savings and they're they're drawing down their savings. I don't know if you've noticed, Carolyn, 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 houses 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, 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 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 you got to have chicken, you know, those kinds of things. So that's very, very consistent with, you know, [00:05:18] Speaker 1: the point I'm making about inflation and purchasing power. Yet, Mark, the stock market is near all time highs. So when does the weakness at the low end start to matter more for the broader economy and for stocks? [00:05:33] Mark Zandi: You know, the stock market's not the economy, particularly today and currently. I mean, in my 36 years as a professional economist, you know, the stock market's never been more disjoint from the economy. And 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 that 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 M.O., 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 so well. That's worked out pretty well. And I would say that doesn't feel like a stable, what economists would say, equilibrium, you know, that'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. That's the, they are deficit finance, but those are 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 [00:07:27] Speaker 1: is certainly a risk. But markets can still work or stocks can still work in this weaker economic [00:07:34] Mark Zandi: backdrop that you're talking about. Unless there's a recession, right? 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 is 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, yeah, in the current state of the economy, the stock market can, you know, it'll hold its own. I 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 in 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 ballgame in the stock market will ultimately reflect that. [00:08:35] Speaker 1: As we think about recession risk, what's the most likely path from here? [00:08:41] Mark Zandi: 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 driving a lot of investment spending and the run up in stock prices is real. And that's led to 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 not 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. And when I say wind down, simply that the Strait of Hormuz opens and we start to see tankers start to flow through and oil prices come in to 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. We are, it is fragile. It is precarious. And, you know, and, you know, if the war does start, continues to drag on into the summer months, then recession will become more [00:09:50] Speaker 1: likely than not. So if you had to give it a percentage, what is it in terms of the recession risk? [00:09:58] Mark Zandi: 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 percent. So not 50. So it still says no recession, but 40 is 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 [00:10:34] Speaker 1: less than 50%. How much of that 40% has to do with the labor market dynamics that you've been talking about? And how much has to do with the higher energy prices? Well, I hesitate to break that. That's too [00:10:49] Mark Zandi: high 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, there's, it's a brew of stuff, very hard to parse that into, into bucket, into different bowls and say, Hey, this is the part that's due. Here's of the 40%, what, this is what is driving that 40%. But, you know, all those things together, you know, add up to an economy that's, it's, it's still growing, you know, but it's a precarious [00:11:32] Speaker 1: growth. Okay. One thing we haven't touched upon is what all of this means for the Fed. Are cuts off the table at this point or just delayed? Yeah, that's another reason to be a little [00:11:42] Mark Zandi: nervous here, right? I mean, we came into the year that 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, on the Fed to cut interest rates in the face of these high rates of inflation. I don't, I don't, 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. And so for example, if you look at a five year break even, so you take the interest rate on the five year treasury and look at that relative to the yield on treasury, 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, 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, move up, then the Fed will start thinking about rate hikes and I'll become more part of the conversation. But at this point inflation expectations, thank goodness, remain, remain where they are. And the most likely path forward here is no rates, no, no, no, no, no rate cuts and no rate increases, just a stable Fed, which again, 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, like it would typically [00:13:38] Speaker 1: if things don't stick to script. Okay. So bottom line for the everyday investors watching this, does this jobs report, does that 40% chance of recession, does some of these concerns that you [00:13:51] Mark Zandi: have change anything for stocks right now? Well, look, for most retail investors, it's 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 around. 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 it 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 around in the current situation, I'd be looking, looking through that. So now if you really feel like you want to, you know, play, 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 [00:14:57] Speaker 1: more cautious than not. Okay, I think this is a great time to transition to our rapid fire game of this or that. Are you ready, Mark? Quick questions, quick answers. I'm nervous. Go ahead, Caroline. You've played before. I know you can do it. Here we go. I can do it. Market high. Market high is justified or stretched? Stretched. Market momentum, real or fragile? [00:15:22] Mark Zandi: There's a lot of momentum. All bird, new bird. I think there is a fair amount of speculative activity in the market. Another reason to be nervous about market valuations and another argument for being [00:15:36] Speaker 1: cautious. Recession risk, rising or overstated? [00:15:43] Mark Zandi: I think they're stable, but they're not overstated. I think we're uncomfortably high. We've talked about 40%. I think that that encapsulates my thinking. Interestingly enough, Caroline, it's been hovering around 40% now for the past, really since last year, since the tariffs. So it's been, you know, elevated for quite some time. So stable recession risk, but uncomfortably high recession risks. [00:16:08] Speaker 1: Soft landings, still possible or slipping away? Yeah, no, it's still possible. That's the most [00:16:14] Mark Zandi: likely scenario we should be able to navigate through, assuming that the war winds down here relatively soon and nothing else comes out of left field to knock us off the tracks. Consumer spending, resilient or cracking? Depends on which consumer. High-end consumer, no problem. You know, resilient, they're the folks that own the stocks, the AI stocks, and they're wealthy and they're feeling it and they're spending and drawing down savings. Lower income households, a real problem. I'm going to have to make some pretty hard choices here given the high gasoline and grocery prices. Middle-income Americans, they'll navigate through and that's why no recession, but you know, they're not, they're not happy about it. They're pretty uncomfortable and you can see that in the consumer sentiment survey. So the answer is it depends on which consumer we're talking about. Labor market cooling or weakening fast? I'd say it's cool. It feels like it's kind of stabilized a bit here in the last, since the beginning of the year. You know, job growth seems to have stabilized, hiring rates have stabilized, there's no layoffs. So the living market's soft, it's cooled, so, but it's not cooling. I think it's [00:17:17] Speaker 1: kind of just holding its own at this point. More dangerous right now, inflation or slowing growth? [00:17:23] Mark Zandi: Oh man, they're both a problem. I mean, the most very obvious though, is the inflation. I mean, that's a real problem. I mean, the consumer, if you look at inflation as measured by the consumer expenditure deflator, that's the measure of inflation the Fed uses to set monetary policy. That's what they put the 2% target on. We're now sitting at over 3% and it's headed north. There's no doubt about it because of what's going on in Iran and the pass-through of the continued pass-through of the tariffs to prices. So that makes me, you know, particularly nervous at this point. While at the same time that the labor market, what's soft, it has kind of stabilized, inflation has become more of a problem. And I think that could be a bigger problem if it doesn't turn around soon. Again, [00:18:07] Speaker 1: going back to, we've got to see this war end. Okay. So just quickly, Fed's next move, a cut or a hike? [00:18:16] Mark Zandi: You know, as you can tell from our previous conversation, I don't think they're going to move for any length of time. I think if pressed, and it sounds like you're pressing me, Caroline, you're pressing me hard. I'd say it's going to be a cut probably at the very end of the year, maybe into early next year. I do think, I am assuming the war winds down quickly and the inflation starts to roll over by the end of the year, and we're still left with a weak labor market. And the current federal funds rate target, the rate the Fed controls is still quite elevated relative to historical norms. And I expect that to normalize. So I'd say, but I don't say with any confidence, I would say the next move is a cut rates, but not for a while. Higher oil prices, temporary shock or bigger problem? It's a problem. You know, you know, if the war winds down here, the straight opens, prices will come in, but they're not going back to where they were before the crisis. There's now a risk premium built in price. Insurance companies are going to demand a higher premium for those tankers to have traveled through the straight because, you know, something could go off the rails at any point in time. The traders are going to demand a risk premium. So, you know, we were at 60 bucks a barrel-ish, you know, before all this, we got as high as 120. We're now sitting at 100. If you told me that the war is over by Memorial Day, then I say by the end of the year, we're at 80, but we're not going back to 60 [00:19:38] Speaker 1: for the foreseeable future. Tariffs, inflationary or recessionary? [00:19:44] Mark Zandi: They're both. That's the problem with tariffs. They're bad policy. You know, anything, they're broad-based tariffs across the board tariffs. They weaken growth and they raise inflation. You can see it. Just go take a chart, look, take a look at the chart of jobs since the Liberation Day back last April. It's gone nowhere. Even with today's numbers, it's gone nowhere. And inflation is accelerated. There's nothing worse, you know, than in terms of policy, than broad-based tariffs. [00:20:09] Speaker 1: AI solving or creating more problems? [00:20:13] Mark Zandi: I, you know, I think it's going to, well, we need it, right? Because AI is going to generate productivity gains. We need those productivity gains for lots of different reasons. That's the elixir that drives the growth in people's living standards. So we need those productivity gains. There's going to be some bumps, no doubt about it. You know, maybe not the ones that people think, but I think, you know, abstracting from the, from the bumps, we'll look back and say, hey, this was a [00:20:41] Speaker 1: very good thing. One word to describe how you're feeling about the economy right now. [00:20:49] Mark Zandi: Uh, nervous. I'm nervous about the economy, but, but I've been, I've been nervous now for quite some time a year. So just, you got to put that into perspective. I, you know, usually I'm an optimistic guy. I feel pretty good about things, but you know, past year or so, I've been, uh, very nervous about how things are going and how, how can we not be in the context of a war in Iran that's creating such havoc throughout the world. It just, you know, it makes me, the word is nervous. Mark Zandy, [00:21:17] Speaker 1: chief economist, Moody's analytics. Always a pleasure. Thank you so much. Anytime, Caroline, take care now. Appreciate it. If you enjoyed the street talk, check out our full interview with Sam Stovall, where he explains why you might want to think twice before selling in May and going away.