Why all the recession talk?
Inflation, inflation, inflation. After the Fed and media largely ignoring the mounting issue over the last couple of years, inflation hit pocketbooks and the media cycle with a vengeance this year. Consequently, the Fed was finally forced to act, and in trying to save face, has likely become a bit too hawkish (e.g., intent of raising interest rates rapidly.)
Are there any signs of relief or is inflation and the Fed’s response destined to crash our economy? There are signs that inflation is abating, the question now is, will the Fed notice?
The folks at Bespoke addressed this very issue highlighting that, “Just as the Federal Reserve pivoted at its June meeting to a much tighter bias, inflation data has moderated. Today's personal income and spending data showed that headline personal consumption expenditures data may have peaked, while core PCE inflation (stripping out food and energy) has steadily moderated from the highest levels of last year. In other words, the Federal Reserve is ramping up tightening as inflation data indicates that the outlook has improved materially. To be sure, core inflation is running well above target (just above 4%), but that calls for a different policy regime than the panicked tightening in 75 bps clips that the Fed attributes to runaway inflation expectations … The now uber-hawkish Fed could still be jawboning with the hope that words instead of actions can have a big enough impact on inflation near-term to allow them to not have to hike as much as they're projecting. Indeed, we've seen a huge plunge in equities and fixed income, one negative GDP print and possibly another on the way, and the Fed has still only hiked rates by 150-175 basis points. Powell and co. claim they're data-driven, and recent data -- including actual inflation readings like Core PCE and market pricing for inflation expectations -- suggests that further hawkishness in their actions, at this point, is not necessary.”
Torsten Slok, Chief Economist at Apollo, and guest speaker at our upcoming July Quarterly, echoed similar sentiments stating, “The bottom line is that inflation may stay elevated for another month or two, but given the trends listed above, the probability is rising that inflation going into the second half of this year could come down faster than the market currently expects.”
We have been on record for some time and remain in the camp that just as the inflation fervor/fears reached their peak, so too was inflation itself. Therefore, we expect relief in the coming months and a Fed that slows/pauses around election time.
Is a recession now inevitable?
First off, what is a recession. Bespoke defines it this way, “Broadly speaking, a recession is popularly defined as two consecutive quarters of negative GDP growth, although that is not the only way the [National Bureau of Economic Research] can determine a recession has occurred. For instance, we had negative GDP growth in Q1, but not because the economy was shrinking. Instead, it was because of a massive increase in inventories and trade balance. The “real” economy grew solidly in the first quarter. Point being, while generally two consecutive quarters of GDP declines define the start of a recession, it’s not a hard and fast rule.”
So, is a recession right around the corner? The answers and arguments are likely to be far more technical/theoretical than practically significant, but the odds still say no.
Ian Shepherdson, Chief Economist at Pantheon Macroeconomics thinks households’ large cash balances will help them overcome inflationary pressures and buoy the economy through the uncertainty. He stated, “Economic growth likely will be modest in the third quarter, but our base case remains that a recession is unlikely. If it happens, it will be brief and mild.”
Furthermore, the NY Fed recently released the latest data and conclusions from their model which centers on a key finding that an inverted yield curve between the 10-year Treasury and 3-month T-bill, accurately predicts a recession 12 months in advance and stated, “…the yield curve has predicted essentially every U.S. recession since 1950 with only one ‘false’ signal, which preceded the credit crunch and slowdown in production in 1967."
Their updated U.S. recession probability for the next 12 months, or specifically until May 2023, came in at only 4.10%, a very low number based on historical averages.
Recessions and the Stock Market
Other key thing we’d encourage investors to remember is that all recessions are not the same, nor are the markets responses. Yes, you can have environments such as the 1970’s or 2008 which were brutal recessions and very tough markets but those are not examples of a typical recession.
Furthermore, the onset/announcement of a recession does not mean moremarket pain.
Consider this perspective from respected analyst Tom Essaye who pointed out that he examined, “…the performance of the S&P 500 starting six months before the official recession began to six months after the recession officially ended. Of the eight official recessions since 1969, five had solidly positive returns over that time frame with an average return of 14.3%!”
Is this to say that recessions good for stocks? Not really, but then again, they aren’t as bad as you probably think. If one looks at the returns for the S&P 500 over the eight official recessions since 1969, the average return was -7.58% – with only the recessions from the 1970’s and 2008 posting losses of over 20%.
Considering those numbers, the fact that the S&P 500 is already down over 20% this year is why many, including myself, believe there is a good chance that most, if not all of any impending recession is likely already priced into the equity markets and therefore this sell off may very well be overdone.
Adding to the likelihood that markets are at least nearing a potential bottom are the latest sentiment readings and what historical context tells us comes next.
Our friends at Bespoke stated, “In this month’s survey (Consumer Confidence from the Conference Board, just 26.6% of consumers expected stock prices to increase over the next 12 months which was the lowest level in ten years (July 2012). Not only that, but the index of stock price expectations has also declined for six straight months. Consumers are not only bearish, but they’ve been persistent in their negativity.” They went on to note that the median six month and twelve month returns for the S&P 500 after such readings have been 4.7% and 16.4%, respectively.
I have no doubt you’ll see many headlines about what a historically bad start to the year this has been. But we are not investing because of what has been, but rather what will be. And what experience tells us is that in fact it usually is darkest before the dawn.
So yes, this quarter was just the ninth time post WW2 that the S&P has drop by 15% or more within that timeframe. And as we covered last week, the strong temptation is to allow our recency bias to kick in and choose to believe the most probable direction for the market will be down in perpetuity, but with a little perspective and knowledge of history we come to understand what is most probable is quite different. In the other quarters with 15%+ drops, the S&P was up 7 out of 8 following quarters, with average gains of 6.22% (the next quarter), 15.15% (six months later) and 26.07% (one year later).
As we celebrate Independence Day and this wonderful country, let’s both declare our own independence from unproductive mindsets and recall the other tough times this country has been through and our history of overcoming them.
Have a wonderful and safe 4th of July weekend,
Tim and the team at TEN Capital
P.S. Below is nice piece from Brian Wesbury on this topic should you want a little more reading for your long weekend.
We're Not Already in a Recession
Brian S. Wesbury, Chief Economist
Robert Stein, Deputy Chief Economist
Real GDP declined at a 1.5% annual rate in the first quarter and, as of Friday, the Atlanta Fed's "GDP Now" model projects zero growth in Q2.
We still think real GDP will turn out to be positive in the second quarter, but if you take the Atlanta GDP Now model at face value, it superficially appears that the odds of having two consecutive quarters of negative growth are close to 50%. That's important, because two consecutive quarters of negative growth is a rule of thumb that many people use for a recession.
We believe a recession is coming but the US is clearly not in one yet. In the first five months of the year, manufacturing production is up at a 6.6% annual rate, nonfarm payrolls are up at an average monthly pace of 488,000, and the unemployment rate has dropped to 3.6% from 3.9%. Meanwhile, in April, both "real" (inflation-adjusted) consumer spending and real personal income (excluding transfers) were at record highs. If this is a recession, we could use more recessions.
It's also important to recognize that real gross domestic income (real GDI), an alternative measure of economic output, rose at a 2.1% annual rate in the first quarter. The public pays very little attention to GDI because the government usually takes an additional month to report that data, after GDP is initially released. But, over time, GDI is just as accurate as GDP in describing the performance of the economy.
We're not saying everything is fine with the US economy. Obviously, inflation is taking a huge bite out of people's earnings. But the debate about whether we're in a recession should be about real economic pain, not academic-style semantics or whether we fit some technical definition. That's the reason the official arbiter of recessions, the National Bureau of Economic Research, weighs jobs, manufacturing, and real incomes, when assessing whether we're in a recession, not just real GDP.
We suspect that some of this debate is political, with some champing at the bit to claim there's a recession because they know it hurts the party of the incumbent president in a mid-term election year.
Again, we expect a recession, with a lag, after monetary policy gets tight. And tight it must get in order to wrestle inflation back down toward the Federal Reserve's 2.0% target. But that means a recession starting in late 2023 or in 2024, not now.
Even more unlikely is the notion that the US is on the cutting edge of a recession like the one in 2008-09. Bank capital is well above regulatory requirements and we don't have a mark-to-market accounting rule that will generate a "fire sale" in bank assets. Nor are we about to have a government lockdown of the private sector, like in 2020.
When it comes, the recession will cause economic pain for many. Recessions always do. But we expect something like the recessions in 1990-91 or 2001, when the unemployment rate went up about 2.0 to 2.5 percentage points, not like the soaring unemployment of the Great Recession or the 2020 Lockdown.