A Question of Recession
- Q2 GDP stronger than expected at 2.4%
- Inflation improving, but not fixed
- Data support opposing views on recession
- Fed may have one more hike, or not…
Written by Philip Rich, Chief Investment Officer, on August 1, 2023.
Most analysts have “dug in” to opposing positions on the question of whether the US is heading into a recession. Both camps can cite real data in support of their positions. The “advance” estimate of US GDP for the second quarter of 2023 came in at a surprisingly strong 2.4%. On its face, this would seem to support the argument that the US could experience a “soft landing,” and that the Fed may yet tame the forces of inflation without a recession. Personal spending was up 1.6%, with the larger part of that coming from spending on services. Spending on goods was also positive. Private investment was up, with equipment leading non-residential structures and intellectual property (patents, trademarks, and digital assets). Investment in residential structures was down 4.2%. Personal spending is a key driver of growth for the US economy, and the larger part of that is comprised of spending on services. The job market remains strong, and measures of inflation are improving but still above a level the Federal Reserve would find acceptable. GDP takes so long to calculate it winds up being a lagging indicator—some of the key data in this report relates to activity in April of this year—and it is subject to ongoing revisions even after the three initial estimates reported in the financial headlines.
At the same time, classical predictors of recession, such as a deeply inverted yield curve (short-term rates higher than those on longer obligations) and the Leading Economic Index (LEI), are indicating that recession is all but inevitable. The LEI has been negative for 15 months and is clearly below levels that have presaged past recessions. Analysts give weight to these measures because they have been such reliable predictors of recession in the past. It is also true that the optimists among us have regularly countered such signals with various “this time is different” arguments. Usually, the classic indicators prove correct. However, the differences this time may also be given more weight, because the global economy has not experienced the shock of a pandemic on the scale of COVID since the advent of globalization, and the US economy has never been subjected to the magnitude of fiscal and monetary stimulus that was used to counter the worst economic effects of the COVID shutdown.
Progress is being made in the fight against inflation, and, so far, that has occurred without a meaningful slowdown in growth and without any noticeable impact on unemployment—although some other areas of the job market are softening. Supply chains have substantially recovered, so one important source of inflation (supply shortages) has been resolved. At the same time, an important source of past counter-inflationary pressures (globalization) is now in meaningful retreat due to geopolitical tensions and a growing economic nationalism amongst world leaders.
So, what to believe? Believe, first of all, that predictions about the direction and momentum of anything as complex as the US economy, let alone the global economy, are notoriously unreliable. Also, pay attention to factors that both sides of the argument agree upon. For instance: monetary policy has long and variable lags before it impacts growth, inflation, and employment. As such, the opportunity for measures that tighten economic conditions to overshoot their targets is dramatic and a common feature of past Fed efforts to manage the economy. It is very possible that the effect of a year of rising rates has yet to fully impact the economy. Rational investors and business leaders are left where they often are—preparing for the worst while hoping for that soft landing.
- +209,000 jobs in June
- Unemployment holds at 3.6%
Payrolls rose 209,000 in June, and unemployment held at 3.6%, close to where it has been since March of last year. The monthly payroll additions have been moderating, and the average for the previous three months was 298,000. The number of openings per unemployed person is now down to 0.6; it had been well over 2 in the immediate aftermath of re-opening. The reported number of hours worked has come down, and wage inflation is moderating.
The “soft landing” argument sees monetary tightening impacting job openings without significantly increasing unemployment. However, it should be acknowledged that unemployment lags significantly behind changes in the direction of economic growth.
- CPI at 3.0% in June
- Fed still seeking 2.0%
The “all items” CPI index came in at 3.0% for the 12 months ending in June. That is the lowest reading since the COVID recession and significantly below the 9.1% posted one year ago. It remains above the target of 2% set by the Federal Reserve. The “core” index (all items, less food and energy) rose 4.8%. It has declined at a slower pace than the broader measure. Energy came down 16.7% over the past year, and food prices declined 5.7%. Gasoline is 26.5% lower than one year ago, although it ticked up 1.0% last month. Shelter is up 7.8% year-over-year, bolstered by home prices and mortgage rates. Energy has provided a tailwind as prices have declined over the past year, but that could transform into a headwind if oil continues to climb, as it did last month.
- Yield curve deeply inverted
- Fed still draining liquidity from financial system
- One more hike in rates?
The FOMC met on July 25 and 26 and raised their target for overnight rates by 0.25% after having “paused” for one meeting in June. The upper bound of the target rate is now 5.50%, the highest it has been since 2001. The Fed will continue to reduce its bond holdings, which has the effect of reducing liquidity (money supply) in the economy at a rate of $95 billion per month. The 10-year Treasury note currently yields 3.96%, so the yield curve remains deeply inverted. The duration and extent of this yield inversion have set records. The difference in yield between the 2-year note and the 10-year has at times exceeded 1.00%, and the inversion has now lasted over one year. This has been one of the fastest and steepest instances of monetary tightening in Fed history. There is no FOMC meeting in August which means that the Fed will have two months of economic data to digest at their meeting in September. Many analysts have expressed the view that the most recent rate increase will be their last for this cycle. We give even odds that they may go for one more hike, but their decision will really turn on the direction of economic indicators over the intervening weeks.
- S&P 500 up 19.8% YTD
- Very narrow market leadership
- Bond market impacted by rising rates
The S&P 500 has returned a remarkable 19.8% YTD at this writing. However, the great majority of that return is concentrated in a short list of very large technology companies. Just seven technology mega-caps comprise fully 28% of the index’s capitalization and a much larger percentage of its recent move upward. At times during this rally, these names have accounted for as much as 90% of the market index’s upward movement. Prudent investors and fiduciaries are not permitted to concentrate their investments in this same manner, and yet these benchmarks are routinely used to evaluate their performance. As an example, the manager of a diversified growth mutual fund is not allowed to invest more than 5% of the fund’s assets in any one company. Cap-weighted indexes like the S&P 500 have no such limitation. When the returns of the index are so concentrated in a short list of stocks, it is almost impossible for a manager of a diversified portfolio to keep up, since any diversification dilutes the returns of the market leaders. Such concentration can also pose risks for markets because indexes will suffer disproportionately should sentiment shift with respect to the market leaders. In the last couple of weeks, market gains have started to spread out beyond the short list of technology leaders. It would be a healthy development if that trend were to continue.
Bond investors have been challenged over the past year by a rising rate environment. When interest rates go up, the market value of bonds goes down—in direct relation to their duration. Longer bonds are more sensitive to interest rate moves than bonds with shorter maturities. In a year like this year, it was almost impossible to shorten duration enough to escape the negative effects of one of the fastest and steepest rate increases on record.
The most “comfortable” investment this year has been cash. Many cash equivalents now pay over 5%. However, investors should begin to prepare for a different rate environment in the future. At some point, the Fed will stop raising rates. At that point, investors with longer investment horizons may wish to own more intermediate-term bonds. Once the Fed is finished raising rates, its next move is often a cut, either because the tightening has engendered a recession or because inflation subsides. Either way, the longer-term investor may be wise to lock in some of the currently available rates before the environment changes. In six to twelve months, we could be operating in a very different rate environment.
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This information is for informational purposes only and does not constitute investment advice.
GDP – Bureau of Economic Analysis
Employment & Inflation – Bureau of Labor Statistics
Interest Rates – Federal Reserve
P/E S&P 500 – multpl.com
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