Summer Commentary

By TRG Advisors on August 10, 2022

On Recession, Inflation, and the Markets

On Recession

Today we have lots of noisy people shouting about whether or not the U.S. is already in a recession or will be in a recession this year or next.  It has become so ubiquitous that it seems every financial news outlet is asking every host and every guest to proclaim their “recession call.” 

And with all this increased chatter about recessions, it can lead one to believe it’s imminent and unavoidable.  Bloomberg’s own recession model shows the probability at around 40% and a little less than half (47.5%) of the economists surveyed in July expected a recession in the next twelve months.

The problem with the media focusing only on the probability of a recession is that, more often than not, they’re discussing “recession” like it is a binary outcome.  Either we don’t go into recession, and everything is fine, or we do go into recession and the world comes to an end.  As usual, the reality is somewhere in the middle.  Now, the severity of a potential recession, whether the probability of it is closer to “not so bad” or “really, really bad,” deserves attention.

First, let’s clarify the framework around the term:

To some, a technical recession is where we have two consecutive quarters of negative Gross Domestic Product (GDP) growth.  Guess what?  In the first quarter of 2022, the U.S. had a -1.6% decline in GDP, and the Q2 preliminary report flashed -0.9%.  So, you will certainly be hearing from some of our boisterous media “friends” that they told ya so.  Bad news for those quick to claim successful prognostication – these numbers are often revised.  But unfortunately, as we’ve pointed out before, no one really keeps score on their calls, so they’ll keep yacking.

However, the official call of a U.S. recession is up to a committee within the National Bureau of Economic Research (NBER), and they usually don’t make it official until we’re either well into (or even out of) an official recession.   It also uses a wide range of data rather than just focusing on GDP.

We believe we are undoubtedly heading into a period of slowing economic activity.  But, a slowing economy is not necessarily a devastating outcome.  Many currently constructive areas of the economy can withstand some amount of slowing.  So, if we are to head into a recession, it will be a mild or moderate one.

A usual sign of a severe recession is high unemployment.  Last Friday’s July jobs report was a blowout, with the 528k added jobs more than doubling the 250k consensus.  Though we are starting to hear about companies slowing hiring, this is not the same as hearing about massive layoffs and certainly not firing.  The unemployment rate hit a five-decade low of 3.5%, and we’ve been adding an average of over 400k+ jobs a month so far this year. 

In the latest data released by the U.S. Bureau of Economic Analysis (BEA), personal income also increased in June, while personal consumption expenditures, a measure of consumer spending, rose.  Put that together; it means more people are working, they are making more, and they are spending more.  Based on this, it certainly does not sound like we are in a recession. 

Looking at other measurements of economic activity, the ISM Manufacturing and Services indices are measurements used to see if the economy is expanding or contracting.  Anything above the 50% mark in either is considered expansionary.  The most recent numbers for both were above 50%. 

Additionally, banks are better capitalized than they probably ever have been, home values are not dropping precipitously, and company earnings reports this quarter have been better than expected.  These are all signs of current strength in the economy.

On Inflation (and why it may be “sticky”)

While we often hear about inflation measured by the Consumer Price Index (CPI), the Fed follows a different measurement, the BEA’s While we often hear about inflation measured by the Consumer Price Index (CPI), the Fed follows a different measurement, the BEA’s Personal Consumption Expenditures (PCE).  The Fed also has expressed that it focuses on “core” inflation (which excludes food and energy) instead of “headline” inflation (with food and energy) as it wants to measure longer-term, less volatile trends.  July’s CPI headline inflation came down to 8.5% from 9.1%, which is good news.  Yet the Core PCE (the Fed’s preferred measurement) for June was 4.8%.  The point is not to say that inflation is not high, but the number is much closer to the Fed’s stated objective of 2%.

Food and energy represent nearly 25% of CPI weights, so price relief in those categories is important for consumers. The more cyclical inflationary components, like gasoline prices and items included in the prices paid index, are exposed to more volatile factors like Food and energy represent nearly 25% of CPI weights, so price relief in those categories is important for consumers. The more cyclical inflationary components, like gasoline prices and items included in the prices paid index, are exposed to more volatile factors like inventories and spot rates. But it’s the sticky components to inflation, like rents (32% of CPI weights) and wages, to which the Fed anchors their mandate.

We firmly believe the majority of the currently high inflationary environment has much more to do with supply-side disruptions (our inability to get the stuff we want) rather than overheated consumer and business demand (there is money that needs to be spent). It’s important to note the Fed does not control the supply-side, and supply-side relief is necessary for broad inflation to retreat. While the Fed hopes to gain support from easing supply-side constraints, the Fed’s rate hike and balance sheet tools are geared toward attacking demand. Sticky components to inflation include rents and wages. We call these sticky because rents tend to be one-year contracts and landlords are reluctant to lower rent, while, similarly, workers are unwilling to accept lower wages. A tight labor market, rising home prices and broad demand trends have driven these sticky and meaningful components to inflation higher. And while lower commodity prices offer some support, there’s more to the story when it comes to the prices that consumers actually pay.

It is in situations like this that we start to have the debate about good news being good news or bad news (like the last jobs report).  We expect the Fed to maintain its commitment to fighting inflation and that they will probably raise rates another 75 basis points at their next meeting.

On Markets

July was a relief to what has been a rough year so far.  In July, the S&P 500 rallied +9.11%, the Bloomberg Barclays Aggregate Bond Index returned +2.44%, and the Russell 2000 Index (U.S. small-cap stocks) was up +10.38%. 

July’s market rally was in stark contrast to the prior month of June, a particularly tough month for markets when all of these same indices took a beating.  We think it’s important to point out that for those investors wondering if “getting out” might make sense during June, July’s positive returns were more than June’s declines.  Those who stuck through the worst month year-to-date were rewarded with the best month year-to-date.

None of this is to say that we are sounding the “all clear,” or that we should expect nothing but sunshine and butterflies for the foreseeable future.  Let us be clear: we expect more volatility ahead to both the upside and downside.  Since we have seen the rapid rally of equities off the June lows, it would make sense to see some recalibration of asset prices over the coming weeks.  However, just like those investors that didn’t “get out” during the dark times of The Great Financial Crisis of 2008-2009, and like those that didn’t “get out” during the pandemic shutdown of 2020, these last two months are proof that we don’t know exactly when markets will rebound and hit new highs.  But one thing is certain – they always have.

We would never be arrogant enough to say that equity markets have bottomed (as no one can or should make that call).  Nevertheless, as we often repeat:  as the markets decline, they become less risky, not more risky.  History has proven that things could go down further from the June lows, but it is also at least as likely that we have already seen the majority of the downside. 

As always, if you have questions or if there have been any material changes to your financial outlook, we encourage you to reach out and we’d love to set a time to talk.

Wishing you good fortune,

TRG