Economic Monitor: Defining Recession
BY: Mark Drachenberg
One of the only things hotter than this Wisconsin summer and recent inflation data is the debate surrounding whether the economy has officially entered a recession. Some economists say, and have been saying for some time, that it has; others, including those at the White House, beg to differ. So, who’s correct? The short answer is, it’s complicated, and in this article, we’ll explore why.
The first half of this year has posed some undeniable and serious economic challenges, and investors have struggled to find guidance and reassurances in the face of them. The good news is, there are some indicators that may provide encouragement without turning a blind eye to current events. Let’s jump in…
Financial Markets
Did anyone hear that huge sigh of relief? After another awful inflation number in July, investors could not have been blamed for expecting the worst. But after an initial sell-off, the markets rallied and finished the month strong, even after the Fed raised rates another 75 basis points. Earnings have been stronger than expected, valuations have come down, and many sectors, such as technology, have been beaten up rather soundly, all of which combined to result in a better-than-expected month.
The Dow Jones Industrial Average gained 6.82%, while the EAFE gained 4.93% - notably, these were the worst-performing of the equity indexes in July. The S&P 400 and 600, along with the NASDAQ, all saw double-digit increases, while the S&P 500 just missed out at 9.22%. (To be clear, those are not year-to-date numbers; they reflect July performance only) Not to be left out, the Bloomberg U.S. Aggregate Bond Index gained 2.44%. While none of this means we’re out of the woods, it’s nonetheless nice to see some positive returns.
As we noted last month, the markets tend to bottom before or early in an economic downturn, and perhaps that’s simply what’s happening here. Fidelity’s Jurrien Timmer notes:
The average decline in a non-recessionary bear (market) is around 22% over 4 months. The average decline in a recession bear is about 35% over 19 months, so (a) totally different animal. At the worst point this year we were down around 25% over 6 months. Thus far, the market action has been completely consistent with a non-recession bear market. The decline has been all about valuation – the market’s P/E (price-to-earnings) ratio is down – but earnings have continued to grow.
Sounds encouraging!
Economy
So, are we in a recession or not? Historically, the biggest indicator of recessions has been two consecutive calendar quarters of declining gross national domestic product (GDP). Based on the preliminary numbers for the second quarter of 2022, that criteria has now been satisfied.
Unfortunately, though, things aren’t that simple. The National Bureau of Economic Research (NBER) is the “official” arbiter in deciding when a recession is underway or has previously occurred, and at this point, it hasn’t signaled that we’re there yet. The NBER defines a recession as “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Per that definition, it's hard to argue that we’re in a recession, given the healthy employment picture, reasonably strong (but slowing) industrial production, and robust consumer spending data.
Perhaps (probably?) this is why the markets have rallied in recent weeks, even considering the higher inflation numbers and the Fed raising rates.
- GDP: As stated earlier, if preliminary numbers hold, we will have seen two consecutive quarters of negative GDP growth. The good news is that estimates for the remainder of the year (and the year as a whole) remain positive, although they vary a fair amount. Numerous factors weighed on GDP in the first half of the year, with consumer spending and business investment generally having a positive impact, and government spending and inventories have a flat to negative impact.
- Inflation: The inflation print came in worse than expected, at an annualized rate of 9.1%, leading the Fed to hike rates by 75 basis points at its July meeting. It appears that inflation is finally peaking, though, as energy costs have come down (check the prices at the pump), commodity prices have fallen, and supply chains have begun easing. Additionally, excess inventory at stores like Target and Walmart has led to lower prices, which is good for consumers. With the Fed tightening policy and the supply of money falling slightly (as measured by M2), inflation may finally be headed in the right direction. It just remains to be seen as to how fast it will fall.
- Unemployment: So far, so good on the labor front. Wages have risen, though not dramatically, and new jobs continue to be created. We still have a long way to go to get back to the employment levels we saw pre-COVID, but progress is being made.
Fed Watch
The Fed remains front and center in the fight against inflation, raising the Fed Funds rate to 2.25% – 2.50%. It’s expected to continue ramping the rate to 3.00% – 3.50% by the end of this year or early next before taking a break. The Fed’s focus is on reducing inflation, but without reducing the money supply, it remains to be seen how effective it can be.
When news of the higher-than-expected inflation reading for June came out, many expected the Fed to raise rates by 100 basis points. Those fears eased as the data appeared to show that inflation was peaking, and that the Fed could continue with its plans for a 75-basis-point hike. Expectations are beginning to grow that the Fed may be forced to cut rates sometime in 2023, should the economy slow too much over the next six to nine months. The Fed will have to continue to be nimble as it sorts out the data in the hopes of causing a soft landing and avoiding a (deep) recession.
Outlook/Summary
While we are likely not in an “official” recession currently, we could enter one at some point over the next year. From a market perspective, that’s not necessarily a bad thing, as stocks tend to bottom shortly before, or shortly into, an economic downturn. Perhaps that’s part of the rally we’re experiencing now, although only time will tell.
We continue to look for ways to stay fully invested while taking advantage of current conditions. The fixed income markets have provided some opportunities to create a laddered bond portfolio, and we will continue to work in that space. Strong companies with healthy dividends continue to work on the equity side, along with tools like hedged equity funds. Dollar-cost averaging can also provide some long-term benefits.
We’ll continue to monitor the Fed, the economy, and other news as we move through the second half of 2022, to assess their collective impact on portfolios. To discuss your portfolio, please call the Wealth Management department of Lake Ridge Bank at (608) 826-3570. We look forward to speaking with you soon!