By Steven K. Lewis
This is a key question of the past few weeks and months, with a variety of data pointing to economic slowing. But the answer is far from conclusive.
A common assumption is that recessions are based on two consecutive negative quarters of GDP growth (which, based on Q1 and Q2, the U.S. now qualifies). If it could only be that simple. Officially, the National Bureau of Economic Research (NBER) makes a qualitative committee decision as to whether the U.S. is in recession. The inputs used coincide to some degree with The Conference Board’s index of coincident economic indicators, among some others. Also, recessions tend to be labeled after the fact, as the committee assigns a starting and ending month. How ‘official’ or not the recession is labeled may matter less to financial markets, which look at the probability of recession as much as the actual event, through impacts on earnings, interest rates, and the yield curve, for example. However, it can be a make-or-break definition politically, especially in an important mid-term election year. Having the economy defined under a recessionary cloud can cast incumbent leaders as failures, rightly or wrongly, which has tended to negatively impact parties in power. (The reluctance of leaders to acknowledge the rising chances of ‘recession’ this year is a case in point.)
In looking at the various recession-related components, we see a mixed story. Inflation has played a larger role this time, requiring a deeper look at after-inflation ‘real’ data more than usual.
▪ Negative. Manufacturing growth has decelerated, which has been hampered by the inability to get needed supplies and in some cases, enough workers. Regardless of the cause, it’s still weaker.
▪ Mixed. Housing has been a blend of strength in multi-family building (as developers are taking advantage of higher rents) and continued below-pace single-family construction. The latter has been the case for several years, exacerbating the shortages and higher housing prices. Nevertheless, a recession could cause a further fall back in construction, potentially worsening the current home inventory problem.
▪ Positive. Job markets remain strong, with payrolls and openings high and claims low. In fact, it’s uncommon to have a recession without labor weakness and layoffs. That these haven’t happened mean that it may not be a recession, or it just hasn’t happened yet. There are a variety of Covid disruptions still present that have affected participation rates. Personal income, industrial production, and retail sales also remain positive, especially on a nominal basis, while the after-inflation ‘real’ data a bit less so.
When we say, ‘it may not matter’ tongue-in-cheek, it’s worth noting that a quarter or positive 0.1% GDP growth is not that different from flat 0.0% growth, or even a slight decline of -0.1%. In that environment, differences by industry become more important. Cyclical sectors such as manufacturing and consumer goods/services tend to always fare worse when the economy slows. On the other hand, a more severe recession, with growth of negative -2%, for example, could tend to spread further throughout the economy beyond marginal spending, and take longer to bounce back from. The ‘artificially-generated’ Covid recession was a notable exception.
Stock markets have experienced drawdowns of up to -20% when a recession hasn’t happened, but -25% to -30% before actual recessions. So, the 2022 bear market low (-23.6% from Jan. 3 to Jun. 16 for the S&P 500) has been inconclusive, but not out of character for either case. So far, it’s been a price multiple adjustment. Bear market rallies (like July’s +9% rebound) can be seductive times to invest due to the chance of the bear being over and investors’ fear of missing out. While not a prediction of any kind, if stock earnings reflect their typical tendency to fall by -15% to -20% in recessions, that could be a catalyst for a second stage lower for the bear market before experiencing an actual bottom. But, again, after already falling -25% this year, a further move down doesn’t necessarily have to be dramatic. If all of this isn’t confusing enough, the good news is that returns 12 and 24 months after bear markets have been quite strong historically.
Interest rates are playing a unique role in this cycle also.The Fed is firmly committed to fighting inflation by raising rates significantly, even if a recession follows (and has essentially said as much). However, if inflation continues to peak and economic slowing persists, their ‘data dependent’ path may change. Usually, recessions feature policy easing and a lowering of interest rates. This is related to why inverted treasury yield curves can be predictive of recessions.
As is mentioned many times, whether we’re in a recession at this moment is most impactful on job prospects and corporate expectations. In this last quarter’s earnings calls, a variety of S&P 500 companies noted a paring back of hiring or capex in anticipation of a possible recession. Of course, such behavior can be self-reinforcing; lower spending out of ‘fear’ can spread more widely and enhance economic slowing already happening. Financial markets look to the future, though, which explains why stock market results during recessions have been mixed to even positive, as investors are already aware of the immediate problem and are looking ahead to the next cycle. Trying to time investments around the timing of a recession can be very difficult to impossible—one will always be a step behind.
