Talking Ourselves into Recession

The main question in the markets is whether the economy will enter recession. There is a wide range of forecasts, ranging from we are already in recession to a short and shallow recession in late 2022/early 2023 to a deep, prolonged, and nasty recession in 2023. The economy has been slowing in the face of many challenges discussed in this blog. Regardless of where the economy is, the markets have already talked themselves into recession. The stock market is in bear market territory based on the fears the inflation fighting Fed will raise interest rates to infinity and beyond! However, the data continues to send mixed signals. Labor markets remain tight while inflation is persistent. Corporate earnings have been resilient. If we are in recession, it is certainly an unorthodox one!

The National Bureau of Economic Research (NBER), the official arbiter of recessions, defines recession as a significant decline in economic activity that is spread across the economy and lasts more than a few months. The market’s back of the envelope definition of recession is two consecutive quarters of negative GDP growth. The final 1Q22 GDP was -1.6%. The Atlanta Fed’s 2Q GDP forecast has deteriorated from an initial +2% to -2%! Wall Street’s forecasts show similar declines. If the 2Q GDP forecasts are correct, the back of the envelope says we are already in recession!

However, looking at past recessions, the NBER’s starting point for recession coincides with a spike in unemployment. For those arguing for no recession (at least not yet!), look no further than this morning’s employment report. The economy added 370,000 new jobs in June and the official unemployment rate remains at a historically low 3.6%. The most recent JOLTS (Job Opening and Labor Turnover) report shows 11.3mm job openings exist. These numbers are hardly recessionary! However, the Labor Participation rate remains anemic, coming in at 62.2 vs a pre-Covid 63.3. The Great Resignation has significantly distorted the labor markets. Millions of people remain out of the workforce. Perhaps employment is not the steady economic signal of recession that it traditionally has been? A tight labor market would be a recessionary oddity!

On the other hand, inflation remains persistent and pervasive. The Fed has made fighting inflation its top priority. The fear, which is justified by history, is the Fed will go too fast and too far with rate hikes, pushing the economy into recession. The current flatness of the yield curve reflects this. The 3-month T-bill yields 1.946%; the 2-year note yields 3.10% and the 10-year Treasury note yields 3.08%. This blog has focused on three sources of inflation: supply chain, labor, and commodity/energy prices. As expected, there has been improvement in the supply chain. Consumer demand has shifted back to “normal.” This has relieved some of the pressure on goods inflation. Afterall, there are only so many microwaves one can buy! Increased goods manufacturing and lower commodity prices have helped. The Bloomberg Commodity Index peaked on June 9th and has declined 15.7% since then. Certainly, China’s lockdown is partially responsible for the commodity decline. With China reopening, this decline in commodity prices may be short lived. While the commodity price declines are welcome, the BCI is still up 16.55% year-to-date! Nonetheless, the supply chain issues should continue to diminish over time.

Inflation in the service sector has spiked as well. Just look at the travel sector. Airports are packed, supply (pilots!) remains constrained and ticket prices have soared! This may represent just a shift in inflationary prices as opposed to a decline. As discussed above, the labor market remains incredibly tight. Average Hourly Earnings grew 5.1% in June, still a lofty, worrisome level. For those hoping this morning’s employment report might allow the Fed to become less aggressive, the growth in the average hourly earnings number put that to bed. Finally, energy prices have come down with the other commodities. The price of a barrel of oil peaked around $140 and recently traded below $100. Today, it trades at $104. Logically, a slowing economy will reduce the demand for oil. However, the supply/demand situation will remain stretched for the foreseeable future. I see little relief from the Russia-Ukraine war and the continuing burdensome regulatory environment that has impaired the energy markets. While prices may decline in the near-term, supply of energy will remain politically problematic in the long run.

In short, the rate of change in inflation hopefully may have peaked. The question that remains is whether the level will remain elevated. So far, inflation has proven to be more persistent and pervasive than the Fed has hoped. Thus, the fear of the Fed!

The equity markets have been very volatile, as anticipated, and will remain so through the summer. The major equity indices have all broached bear market declines of 20%. Year-to-date, the S&P 500 is down 17.87%. This blog has long discussed the basic dividend and/or cash flow discount models. Boiling out all the Greek letters in the complex formulas, the models can be simplified into a simple fraction with earnings in the numerator and interest rates in the denominator. Earnings vs. Interest Rates. The year-to-date declines in the equity markets can almost entirely be explained by the increase in interest rates, manifested in the dramatic decline in the S&P 500 from 25 to 15 times earnings. Earnings for the S&P 500 have held up reasonably well.

Is there more potential downside for the equity markets? Maybe. While the Fed has been very clear it will remain aggressive until it sees improvement in inflation, the consensus for rate hikes is largely reflected in the markets. Indeed, this week’s 2.5% rally in stocks was driven by increasing evidence of a slowing economy, leaving the hope the Fed won’t have to go too far. But, if the economy is slowing, what does that mean for corporate earnings, our numerator. Corporate earnings have been resilient. In the 1Q, companies were able to pass through cost increases to consumers. Will that remain the case in 2Q and full year 2022? Interestingly, despite ample evidence of a slowing economy, overall estimates for S&P 500 earnings in 2022 and 2023 have modestly increased! Based on current earnings estimates, the 2023 S&P 500 eps is forecast to grow roughly 9% over 2022. Let’s hope the forecast proves true.

Can we avoid recession? The markets have been trying to talk themselves into one! The good news is we will be getting valuable information regarding earnings and inflation starting next week. 2Q earnings season begins on Monday. This will not only reveal 2Q earnings but will provide valuable insight to future earnings. If earnings do in fact hold up, the downside to the equity markets is probably limited from here. If the earnings reports and future guidance weakens materially, then our numerator will lead to further downside in the equity markets. In addition, CPI and PPI for June will be released next week as well. This will help to clarify the Fed’s action plan. In the near-term, it’s all about earnings and inflation!