The global equity market has risen in two of the last three weeks with the MSCI World Index climbing 1.6% last week. In the United States, the tech-heavy NASDAQ surged 4.6% while the S&P 500 gained 1.9%. Technology stocks have been more stable of late as the U.S. 10-year real U.S. Treasury yield has also stabilized. Non-U.S. markets posted positive returns as well with Japanese stocks jumping 1.8% while European stocks eked out just a 0.3% gain as investors digested the potential closure of the Nord Stream II pipeline. Emerging market stocks rose 0.9%.
Some investors are saying that the U.S. economy is already in a recession with real gross domestic product (GDP) already shrinking 1.6% in the first quarter of 2022 and the Atlanta Fed’s GDP now tracker suggesting a 1.2% contraction in the second quarter of 2022. Yet, the Federal Reserve stated in their minutes that they believed that second quarter growth was rebounding at a moderate pace. One side will be wrong.
Traditionally, two quarters of negative economic growth are thought to be consistent with recession. However, in the 2001 recession, the U.S. economy never experienced two consecutive quarters of decline. During the Global Financial Crisis, it was determined that the economy entered a recession in December 2007, but the economy did not experience two consecutive quarters of contraction until the fourth quarter of 2008. In both periods, consecutive monthly job losses were the better metric in terms of calling a U.S. recession.
Leading economic indicators and the lesser-known Sahm Recession Rule suggest that a U.S. recession is still more likely in 2023 than in 2022. This gives the Fed a narrow window of time to still “stick the landing” where inflation comes down without a recession, but it will require a skillful composition to get the timing right with monetary policy often operating with a notable lag.
Can the Fed “Stick the Landing?”
When we think of the Federal Reserve lately, we tend to think of an Olympic gymnast who is trying to “stick the landing” for the perfect score. Unfortunately, being able to “stick the landing” is often a difficult task for both gymnasts and the Federal Reserve. In the Federal Reserve’s case, a “perfect score” means raising interest rates to the point that it cools off the U.S. economy and inflation starts to come down but without tipping it into a recession. That is little historical precedence for this (see figure 1).
|Fed Tightening Period||Fed Funds (Effective)||Consumer Price Index (%)||NBER First Recession Month||Number of Months START *||Number of Months END**||Real GDP Drop (%)||Inflation Drop (%) After Two Years||Policy-Induced Recession?|
|Start||End||Type of Cycle||Start||End||Chg Change in FF (bps)||Start||End||Chg Change|
|Jun-04||Jun-06||Fast||1.03||4.99||396||3.3%||4.3%||1.0%||Jan-08||43||18||-3.8%||0.7%||Monetary Policy Not Primary Driver|
|Oct-15||Jan-19||Slow||0.12||2.40||228||0.2%||1.6%||1.4%||Mar-20||53||13||-10.1%||-0.2||Monetary Policy Not Primary Driver|
However, inflation expectations are dropping as both investors and consumers are expecting the global economy to slow. This can be seen clearly in commodity prices with both copper and aluminum prices having fallen sharply in June (see figure 2). Crude oil prices and gas prices may eventually come down more materially as well. This is what the Fed wanted…to bring down prices through monetary policy expectations. What it doesn’t want is to over tighten and create a “hard” landing for the U.S. economy where growth contracts substantially and the unemployment rate shoots past a level that is consistent with full employment (an unemployment rate of 5.0%-5.5% is traditionally considered to be full employment). Therein lies the problem. Or problems.
The first problem is trying to accurately predict the level of interest rates that the economy can handle with the impact of monetary policy often felt within the economy with a notable lag (often as much as a year or more). We can see this uncertainty playing out in real-time with some investors saying that the U.S. economy is already in a recession while the Federal Reserve stated in the June Federal Open Market Committee minutes that, “the information available at the time of the June 14-15 meeting suggested that U.S. real gross domestic product was rebounding to a moderate rate of increase in the second quarter after having declined in the first quarter.” Both sides cannot be right.
The U.S. recession camp is pointing to the already reported negative 1.6% real GDP print in the first quarter of 2022 and the Atlanta Fed’s GDP Now tracker that is showing second quarter 2022 growth tracking at minus 1.2%, which would be two consecutive quarters of contraction. That is often thought to be the definition of a recession, but that is not entirely correct. According to the National Bureau of Economic Research, which is the official arbiter, recessions are “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” If we look at the Global Financial Crisis, the U.S. economy entered recession in December 2007, but it wasn’t until the fourth quarter of 2008 that the economy experienced two consecutive negative quarters in a row. During the March 2001 to November 2001 recession, the economy never experienced two consecutive quarters of decline. During those two recessions, several months of consecutive job losses were the better metric (see figures 3 and 4).
That complicates the situation with non-agricultural payrolls officially a coincident economic indicator. Meaning that the monthly employment report tells investors where the economy is, not where it is going. In the month of June, the U.S. economy added 372,000 jobs and the unemployment rate remained at 3.6%. In the first half of 2022, the U.S. economy added an average of 457,000 jobs a month. That seems to imply that the U.S. is not yet in a recession. Likewise, if we look at a lesser-known recession metric called the Real-Time Sahm Recession Rule indicator, which highlights when the three-month moving average of the national unemployment rate (or U3) rises by 0.5 percentage points or more relative to its low during the previous 12 months, it is not pointing to an imminent recession (see figure 5).
We have also mentioned in the past that the leading economic indicator index remains positive, which is not consistent with a recession. During eight of the last nine recessions, the index was below zero on a year-on-year percentage basis prior to the onset of recession. Right now, it is at 3.05%...coming down rapidly but still positive (see figure 6).
Interestingly, the leading economic indicator also leads the Sahm recession indicator by about six to nine months. If we use these metrics together, they suggest that we may be about six to twelve months away from seeing consecutive job losses and possibly a recession (see figure 7).
This gives the Fed a window of time to possibly still pull off the perfect landing, but it’s a very narrow window and monetary policy operates with about a year lag. So perhaps we are not yet in a recession, but the policy that drives us there may already be in place. Unfortunately, only time will tell.
The question then becomes how much of a rise in unemployment is the Fed willing to tolerate in order to achieve price stability? That is a tough one to answer…. while Chair Powell has said that the Federal Open Market Committee FOMC) might need to see a few upticks in unemployment before reconsidering, it is rare that the unemployment rate rises just a few ticks. During the seven recessions that occurred between 1970 and the Global Financial Crisis, the unemployment rate rose by an average of 3.0% (see figure 8). If we use that average as a starting point, then a Fed-induced recession might bring the unemployment rate up to about 6.5%.
As a result, futures are now pricing in rate cuts in 2023 and strategists are suggesting that stocks may rally in the back half of 2022 as the market sniffs out another Fed pivot. The risk of course is that the Fed does not reverse rates because they remain worried about elevated inflation and simply decide to pause or to slow the pace of rate hikes and still push towards a neutral rate of 4.0% over time and continue to unwind their balance sheet. That could potentially delay the much-anticipated year-end stock market rally. Hopefully, the Fed “sticks the landing” with inflation trending lower and growth slowing but not contracting, but we think it is best to maintain a defensive portfolio tilt until the Fed is closer to finishing its composition. For further insights on how a recession might impact U.S. stocks, please see our Weekly Market Update | Are We There Yet?
What Should U.S. Investors Watch in the Week Ahead?
All eyes will be on the June consumer price index (or CPI) report on Wednesday. The consensus is calling for headline inflation to rise from 8.6% to 8.8% while core inflation is expected to fall from 6.0% to 5.7%. While economists typically focus on core inflation, we suspect that another hot headline inflation print will further solidify expectations for another 75 basis-point rate hike from the Federal Reserve as their July 26-27 FOMC meeting.
Lastly, second quarter 2022 earnings season will kick off this week with several of the big banks announcing earnings. For the second quarter, earnings-per-share (EPS) are expected to be 4% higher year-on-year. Interestingly, consensus earnings estimates are still calling for 10% EPS growth in 2022 and 8% EPS growth in 2023. These estimates do not seem aligned with the building recession narrative, so investors will be looking for corporate guidance for any signs of potential troubles or difficulties maintaining margins in the face of rising input costs.
|Index||Weekly Chgchange in percent||YTDyear to date change in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||20.0 bps||157 bps||178 bps||3.08%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months12 month change in percent||Div. Yield division yield in percent|
The Week Ahead
|7/12||6:00||NFIBnational federation of independent business Small Business Optimism||JunJune||92.5||93.1|
|7/13||8:30||CPIConsumer Price Index YoY year on year||JunJune||8.8%||8.6%|
|7/13||8:30||CPIConsumer Price Index Ex Food and Energy YoY year on year||JunJune||5.7%||6.0%|
|7/14||8:30||Initial Jobless Claims||7/9/2022||235k thousand||235k thousand|
|7/15||8:30||Retail Sales Advance MoMMonth over Month||JunJune||0.9%||-0.3%|
|7/15||8:30||Retail Sales Ex Auto and Gas||JunJune||0.2%||0.1%|
|7/15||9:15||Industrial Production MoMMonth over Month||JunJune||0.1%||0.2%|
|7/15||10:00||U of Mich.University of Michigan Sentiment||JulJuly P||50.0||50.0|
|7/15||10:00||U of Mich.University of Michigan 5-10 YrYear Inflation||JulJuly P||3.0%||3.1%|