by Larry Hatheway | June 28th, 2022
A growing number of economists forecast recessions in the US, UK, and Europe. Many central bankers are also openly contemplating recession risk. And financial markets have rapidly discounted the risk of recession, most visibly via dramatic declines in government bond yields over the past several weeks.
Yet the consensus of economists and pundits believes recession may only arrive in 2023. We suspect it will arrive sooner. Indeed, it may already be at our doorstep, and certainly seems likely before the end of this year.
Is that a big deal? Does it matter much whether a recession comes sooner or later?
We think it does, for the following reasons.
First, despite large setbacks in global equity and credit markets this year, investors are ill-prepared for an imminent contraction in economic activity. Analysts’ expectations for 2022 corporate profits growth over the remainder of this year are absurdly high. Valuations are not recession-proof. Investors have not fully discounted probable revenue and earnings disappointments before year-end 2022.
Second, barring recurring shocks or an unlikely persistence of inflation, an earlier recession implies an earlier recovery, an earlier restoration of risk appetite, and an earlier rebound in corporate profitability. While timing short-term market ups and downs is a fool’s errand, misjudging the cycle altogether is a lost opportunity. Recession timing matters for investors.
Third, the sooner recession arrives, the sooner inflation pressures will dissipate, and the less central banks will have to tighten. In other words, an early recession is preferred to a later recession because the former is apt to be a shorter and shallower downturn than the latter. That, too, is ultimately a source of investor opportunity.
So, why do we think recession will arrive earlier?
Simply put, that is what the data tells us. Globally, consumer expenditures are slowing, whether in the US, Europe, or China. Spending booms facilitated by transfer payments, job gains, and economic re-opening are fading under the pressure of rising prices and falling real wages. Business capital expenditures are tailing off even faster. Fiscal policy is restrictive. Sticker shock is curbing the appetite for consumer durables, such as autos and housing.
According to the Federal Reserve Bank of Atlanta’s July 1 GDPNow report, the US economy probably contracted -2.1% in the just-concluded second quarter. That follows a -1.6% decline in GDP in the first quarter. Consecutive quarters of falling GDP are not the definitive measure of a US recession (the National Bureau for Economic Research defines a recession as broad-based declines in output, consumption, and employment). Also, the first quarter contraction was mostly about rising imports and falling inventories, rather than weakness of final demand.
In contrast, the second quarter slump is all about a spending slowdown. According to the Atlanta Fed, real (inflation-adjusted) household expenditure growth decelerated to just 0.8%, down from 1.8% in Q1, 2.5% in Q4 2021 and a blistering 7.9% for all of 2021. Even worse, real gross private domestic investment (business spending on plant and equipment) appears to have plunged at over a -15% rate last quarter, according to the Atlanta Fed’s estimates.
Thus far, employment has held up in the face of spluttering demand. Friday’s US employment report will provide further evidence on the health of the job market. The good news is that massive unfilled vacancies — presently about 11 million nationwide — provide a cushion to enable those willing to work to find a job even as employers withdraw opportunities. A shortage of skilled labor may also make firms reluctant to layoff employees. For those reasons the labor market, which is traditionally a lagging indicator of the cycle, may show even greater resilience even after a recession has begun, helping to soften the blow.
As noted, the consensus of economists only foresees a recession in 2023. Why might that be the case? The most plausible explanation is that historically US recessions have followed a tightening of financial conditions, such as rising real interest rates (courtesy of tighter monetary policy), or ensue from falling asset prices, negative wealth effects, and a higher cost of capital. That means that recessions come, roughly, 18 months after central banks tighten policy.
That is the historic norm, but it feels like an odd way to analyze (and forecast) today’s business cycle. The slowdown in demand that is now unfolding is not primarily the result of monetary policy restraint, nor does it mainly reflect falling asset prices.
Rather, the main source of today’s flagging consumer and business spending is high prices, coupled with the shortages of physical and labor inputs that have pushed prices higher. Importantly, wages are not keeping up with prices. In recent months, average real hourly earnings in the US are falling close to -3% annually. Across various industries, from autos to airlines, and from high tech to business services, shortages of material and labor inputs are resulting in soaring prices and a reduced willingness of companies to spend.
High inflation is increasing uncertainty, making consumers and businesses think twice before taking on more debt or engaging in discretionary spending. US consumer and CEO confidence measures are at all-time lows, which is odd given near-record unemployment, but is more understandable against the backdrop of four-decade highs in inflation.
In short, economists, pundits, and investors are correct to anticipate recession, but are using the wrong approach to anticipate its arrival. Recession is probable not because monetary policy will become restrictive by this time next year, but because purchasing power is crumbling today. Add in falling household wealth and a rising cost of capital for companies and the scene is set for demand to slow to ‘stall-speed’ well before the Fed or other central bank policies become genuinely restrictive.
If that is correct, then ‘recession now’ is vastly underappreciated by company analysts and the investors who follow them. According to FACTSET, the consensus of company analysts has trimmed earnings estimates for the Q2 US S&P500 earnings season, but has increased earnings estimates for the second half of 2022. After a pedestrian 4.1% rate of earnings growth for the second quarter of this year, the consensus forecasts more than a doubling of S&P500 profits growth to 10% in the second half of this year. Based on the historical record since the late 1940s, such an earnings acceleration would only be likely if GDP growth were accelerating. Put differently, aggregate profits growth has never been positive, much less accelerated, when the economy was moving into recession.
For worn investors hoping for a bottom in global equity markets, an imminent recession is unnerving. Nor can they take much comfort in valuations. Trailing measures of price-to-earnings multiples are in line with long-term averages. Following their large selloffs in the first half of 2022, Stocks may be cheaper, but they are not yet recession-proof cheap.
But not all is gloomy. An earlier-than-expected recession would bring about relief from inflation pressures by restoring greater balance between demand and supply in the economy. By doing so, it would lessen the need for aggressive central bank tightening, thereby making the downturn shorter and shallower than would otherwise be the case.
‘Recession now’ may not be what investors were hoping to hear. It makes the coming few months even more challenging. But it is probably preferable to the alternative of recession later.