Second-quarter U.S. GDP confirmed what many already knew: Economic conditions are worsening. Real U.S. GDP contracted at a 0.9% annual rate in the second quarter after tumbling 1.6% in the first quarter.

Most people associate two negative quarters in a row with recession, given that until 2020, this had been the case for all 11 recessions back to 1948. That said, this measure is only a guideline. For example, the National Bureau of Economic Research (NBER) quickly deemed the two-month contraction at the start of the pandemic in 2020 a recession, making it the shortest recession in history, with a 3.4% drop in GDP for the year--the worst drop since 1946. This was despite duration, one of the three criteria--depth, duration, and dispersion--that the NBER uses to qualify a recession, not being met.

On the other hand, the NBER didn't call a recession in 1947, despite two negative quarters in a row, given the dispersion criterion wasn't met. Defense spending had declined after World War II and inventories were drawn down, but the impact did not result in losses in employment, consumer spending, or production.

This time may be similar, with some sectors of the economy still showing strength despite growing weakness.

Economic Weakness Hasn't Touched All Sectors

After GDP expanded at an average rate of 5.7% in 2021--its highest in 37 years--economic activity has slowed considerably. But while GDP has contracted for two consecutive quarters, losing $124.6 billion, or an annualized 1.3%, from its peak in fourth-quarter 2021 and thus meeting both the duration and depth criteria, we do not see that, on its own, as enough for the NBER to determine a recession. The impact has not spread across many economic sectors, so the dispersion criterion has not likely been met.

The disturbing 1.6% drop in first-quarter GDP stemmed from weakness in trade and inventories, though domestic activity, excluding trade and inventories, was healthy, with real consumer spending and fixed investment up an annualized 1.8% and 7.4%, respectively, in the quarter. High prices and interest rates have since hurt affordability and, as we expected, damaged domestic activity through June.

The drop in second-quarter GDP largely resulted from a large drop in private inventory investment, in response to a pullback in household demand and significant declines in residential investment as high prices and borrowing costs weakened real estate activity. Nonresidential investment in structures was also down sharply, for the 10th quarter in the past 11.

Federal government nondefense spending in the second quarter also fell by 10.5%, reflecting the sale of crude oil from the Strategic Petroleum Reserve, which resulted in a corresponding decrease in consumption expenditure. The oil sold by the government goes into inventories, with no direct net effect on GDP.

But the weakness has not spread across all sectors of the economy. Consumer spending in real terms rose by 1.0% in the second quarter--one-third its historical rate back to 1948, but still in positive territory. Trade rebounded from its first-quarter drop as exports in both goods and services outpaced imports. Moreover, the U.S. jobs market remains tight, averaging 383,000 job gains over the last three months through July, with the unemployment rate at 3.6%. And U.S. households still have, in aggregate, healthy savings, while a lot of business debt has been locked in at low interest rates with long duration, to pad the economy with some cushion against the blow.

Avoiding Recession--A Toss-Up

While the U.S. economy may have evaded a recession in the first half of the year, whether it can continue avoiding a recession in the next 12 months feels like a toss-up.

According to S&P Global Ratings Economics' Business Cycle Barometer report, its dashboard of leading indicators through June signals that U.S. economic momentum has continued to worsen (see "U.S. Business Cycle Barometer: The Party's Over," July 27, 2022). In our analysis, seven out of nine leading indicators in non-positive territory signals a weakening of economic conditions and may signal a recession. Indeed, within one year before the last three recessions--in 2001, 2007, and 2020--the proportion of non-positive signals in our dashboard surpassed 60%. Having five negative signals, as we do now, is an especially strong marker of an impending slowdown in the economy.

Our base case had already assumed a low-growth recession next year, with GDP at just 1.6% and the unemployment rate climbing. Assuming the second half of this year holds to our June forecast, factoring in the much weaker first half of 2022, this year's GDP would be just 1.8%, and much lower than our June estimate of 2.4%.

The significant inventory drawdown in the first half of 2022 may result in a nice boost in the third quarter, heading into the holiday season, suggesting GDP coming in closer to 2.0%. But the Fed likely plans to ruin the party, continuing to front-load rate hikes before consumer prices top its 40-year record high reached during Volcker times.

The health of the U.S. economy also continues to face challenges from extremely high inflation and supply-chain disruptions, exacerbated by the Russia-Ukraine conflict. Combined with higher borrowing costs as the Fed's monetary policy rocket flies higher, affordability has weakened. Many households and businesses are tightening their budgets.

Heading into 2023, the odds of significant declines across several measures of economic activity--including employment, personal income, and industrial production--that would lead the NBER to call a recession are down to a flip of the coin. Our qualitative assessment of recession risk over the next 12 months is 45%, within a wider range of 40%-50%. Our quantitative augmented term spread model of recession risk is also higher, running between 22% for the 10-year/three-month, 28% for the 10-year/one-year, and 28% for the 10-year/two-year through July 31. We see risks closer to the top of that range heading into 2023 as cumulative rate hikes take hold.

Our odds that the economy may avoid recession are slim. If the Fed decides it has done enough and pulls back on rate hikes later this year, that may save the economy from recession over the next 12 months. But if the Fed pulls back on tightening too soon, a much more severe recession could be in store later on as inflation becomes more persistent.