Economic Commentary – Recession Worries

We start with the acknowledgement that multiple commentators are predicting a recession, and multiple sources – sometimes the same ones – are predicting a significant further drop in the stock market. .

Recessions do not just “come along” out of some sense of a predestined business cycle; they have real and specific causes.

Recessions are sustained periods of reductions in economic output across the economy, not just in a handful of industries. The reduction in output means decreases in profits, which is the key determinant of stock market values over time.

Profits are determined by several key elements, and recessions occur because one or more of these elements is hurt.

As 2022 began, we were still recovering from the recession which was caused by the Covid lockdowns. The stock market reflected that reality and was up significantly. As we write this commentary, however, the broad stock market is down roughly 18% from the previous high, and recession fears have risen.

But while recessions cause stock market drops, stock market drops don’t always mean there’s a recession. We have to look at those elements and contributing factors mentioned above to see whether we’re in, or approaching, a recession.

None of the key indicators are signaling recession. The manufacturing index, new orders for durable goods, non-farm payrolls, personal income and corporate earnings reports to date are all solidly positive.

Real GDP (after inflation) is down in the first quarter, but only because inflation rose faster than GDP. GDP rose 6.5% in the first quarter, and is up 10.6% from one year ago.

So, why is the broad market down significantly? The simple answer is uncertainty on how the Fed is going to handle inflation.

One of the Fed’s primary tools is its control over short-term interest rates, and if the Fed gets it right, managers and investors can plan for the future without an imminent recession.

The stock market’s drop is being driven by uncertainty and lack of confidence, not by an imminent recession. Accordingly, we believe the market is more likely to “correct” upwards than downwards in the weeks ahead.

This leaves inflation as the biggest real worry, and how the Fed deals with it will tell us where the economy is heading. Yes, the Fed could cause a recession but we doubt they will. It is much more likely that inflation will continue at least through year-end, but there is no need nor logic to suggest a recession this year.

All of this creates opportunities for tactical moves and inevitably will present buying opportunities. More information will come, and we will keep you informed as we learn more.

Recession Worries

We start with the acknowledgment that multiple commentators are predicting a recession, and multiple sources – sometimes the same ones – are predicting a significant further drop in the stock market. But we also start with acknowledging that predictions like this are very common; they just don’t all get heightened press coverage. There’s an old joke that economists have predicted five out of the last four recessions. Meaning, if you predict recession enough times, you’ll be right at least once, but that doesn’t make you a fortune teller or prognosticator. The key question for this commentary, therefore, is whether a recession is imminent.

The media reality of our age is that exaggerated statements, hyperbole, or even simple statements which reinforce an already-presumed narrative get more coverage. The economic reality can be, and often is, much different.

Recessions do not just “come along” out of some sense of a predestined business cycle. There are real causes of recessions that are much more specific than “it’s been X months since the last one, and therefore we’re do for one .” Recessions are not the simple product of trends or cycles; they have real and specific causes.

Recessions are sustained periods of reductions in economic output across the economy, not just in a handful of industries. The reduction in output means decreases in profits, which is the key determinant of stock market values over time. Increase profits, and the value of those companies (stock prices) increases. Decrease those profits, and the stock price drops. Profits are determined by: 

a) there being a demand for a company’s product or service

b) the company being able to sell those products or services for more than it costs to provide them.

Recessions occur because one or more of these elements is hurt: demand decreases, the company can’t produce its products/services, or costs of doing so start to exceed the sales price. Management mistakes, tax increases, heightened regulations, government policy mistakes, and interruptions in the flow of information in the economy are all contributing factors.

As 2022 began, we were still recovering from the recession, which was caused by the Covid lockdowns; we have not yet attained the economic level we would otherwise have attained. We are still behind the curve, so to speak, and the economy was continuing to grow to reclaim that lost ground. The stock market reflected that reality and was up significantly. As we write this commentary, however, the broad stock market is down roughly 18% from the previous high, and recession fears have risen.

But while recessions cause stock market drops, stock market drops don’t always mean there’s a recession. We have to look at those elements and contributing factors mentioned above to see whether we’re in, or approaching, a recession. So, here’s the rundown:

The ISM Manufacturing Index hit 55.4 in April

The manufacturing sector continued to expand in April. Seventeen of eighteen industries reported growth. The two most forward-looking indices – new orders and production – both dropped a bit, but both still signal growth ahead.

New Orders for Durable Goods Rose 0.8% in March

New orders for durable goods rose 0.8% in March, following good numbers for February. Unfilled orders continued to rise, hitting a record high, so manufacturing activity is still strong.

Nonfarm Payrolls Increased 428,000 in April

Nonfarm payrolls rose 428,000 in April, beating expectations, and the total number of hours worked rose 0.4% in April, achieving a new record high.  

Personal Income Rose 0.5% in March

Incomes continued to rise in March. April shows a reduction, but it is due entirely to the withdrawal of government transfer payments. On a broader basis, excluding government transfer payments, personal incomes are up 8% from one year ago.

79% of S&P 500 Companies Reporting Earnings Beat Expectations  

The ultimate measure of whether stock prices are justified is corporate profit levels. These bellwethers are signaling continued strength in the economy. 

These numbers are hardly indicative of a recession or even the approach of one. Much has been made of the report that real GDP (GDP after inflation) fell in the first quarter. While that’s true, that statistic can be highly volatile, and it is impacted by inflation. Looking just at the nominal level of GDP, it increased 6.5% in the first quarter and is up 10.6% from one year ago. The “real” GDP number is negative because inflation spiked. Actual economic activity increased in the first quarter; it’s just that inflation increased faster.

We are led to the question, if there’s no recession, why is the broad market down significantly? The simple answer is uncertainty on how the Fed is going to handle inflation. Roughly 6 months ago, the Fed Chairman was calling inflation “transitory,” and now it’s a serious issue consuming Fed meetings. Such an about-face, along with dramatic changes in the estimate of how many rate increases are needed, destroy the market’s confidence in the Fed’s ability to control inflation with reasonable measures.

One of the Fed’s primary tools is its control over short-term interest rates, which in turn impact the interest rates corporations and consumers face. They are a cost of doing business and thus impact corporate profits. They are also used to calculate the present value of corporate profits. So, they are double-edged.

If the Fed raises rates at a reasonable level to control inflation and on the timeline the market expects, then corporate managers and stock markets can plan accordingly. If the Fed raises rates by more than expected and/or sooner than expected, managers and investors can’t plan well, and profits may ultimately be hurt.  

The market’s current swoon is clearly signaling it doesn’t know what the Fed will do, and thus how profits might be affected. The market is assuming a negative outcome which really is not yet in evidence. The stock market’s drop is being driven by uncertainty and lack of confidence, not by an imminent recession. Accordingly, we believe the market is more likely to “correct” upwards than downwards in the weeks ahead.

This leaves inflation as the biggest real worry, and how the Fed deals with it will tell us where the economy is heading. In this regard, politics plays an issue. In an election year, we doubt the Fed will err on the side of too much monetary tightness; yes, they could cause a recession, but we doubt they will. It is much more likely that inflation will continue at least through year-end, but there is no need nor logic to suggest a recession this year.

All of this creates opportunities for tactical moves and inevitably will present buying opportunities. We are only partway through the first-quarter earnings season with another Fed meeting shortly. More information will come, and we will keep you informed as we learn more.