By Jim Reardon | August 15, 2022
The drumbeat of recession grew louder as quarter 2 ended. The US economy shrank for a second straight quarter as high inflation undercut consumer spending and Federal Reserve interest-rate hikes stymied businesses and housing.
The June inflation rate at 9.1% year-over-year was at a 40-year-high.
In June, the real consumer price index (CPI) rose 9.1% from a year earlier in a broad-based advance, reflecting higher gasoline, shelter, and food costs. Economists projected a 1.1% rise from May and an 8.8% year-over-year increase, based on the Bloomberg survey medians.
This was the fourth-straight month that the annual CPI figure topped estimates reaffirming that price pressures are widespread throughout the economy and taking a toll on real wages, which are down the most ever in data back to 2007 according to Bloomberg.
Real gross domestic product (GDP)
A key part of the current inflation problem is linked to the trillions of dollars in fiscal stimulus injected into the economy in 2020 and 2021 to stimulate the recovery. Consider the relatively long period without recession during the decade long period of prosperity that followed the Great Recession of 2007-09. Then, the Covid recession of 2020 came as a shock because the economy was virtually shut down.
This was also accompanied by the Federal Reserve buying well over a hundred billion dollars in bonds each month since the height of the pandemic. The subsequent surge in economic growth and stock prices caught many by surprise. That recession was extremely deep, very broad, but the shortest on record.
Real GDP is a comprehensive measure of U.S. economic activity. GDP measures the value of the final goods and services produced in the United States (without double counting the intermediate goods and services used up to produce them). Changes in GDP are the most popular indicator of the nation's overall economic health.
The chart above includes the latest GDP overview from the Bureau of Labor Statistics.
The chart provides a way to visualize real GDP change since 2007. It uses a stacked column chart to segment the four major components of the GDP. A dashed line overlay shows the sum of the four, which is the real GDP itself. It reflects the seismic effect of the Covid shutdown in 2020 and the aftermath of the unbridled government spending that resulted.
The U.S. Bureau of Economic Analysis (BEA) reports both real and nominal GDP. It calculates real U.S. GDP as an annual rate. It excludes imports and foreign income from American companies and people. It's similar to the Consumer Price Index but is weighted differently.
Real gross domestic product (GDP) decreased at an annual rate of 0.9 percent in the second quarter of 2022 according to the “advance” estimate released by the Bureau of Economic Analysis (BEA). This follows a first quarter real GDP decrease of 1.6%. (The advance estimate is subject to revision in August.) The smaller decrease in the second quarter primarily reflected an upturn in exports and a smaller decrease in federal government spending.
Does Two Down Quarters of GDP Mean a Recession?
With real Gross Domestic Product (GDP) falling again in Q2 2022 after declining in Q1 2022, some have concluded that the economy is in a recession. There is a basis for this conclusion: the data show that, over the past 75 years, there’s been a U.S. recession every time real GDP has fallen for two consecutive quarters.
However, in Q2 1947 and Q3 1947, real GDP did decline without a recession. Over those 75 years there have also been two recessions without back-to-back declines in real GDP, namely the 1960-61 and 2001 recessions. This two quarters idea originated in a 1974 New York Times article by Julius Shiskin. Shiskin provided a laundry list of recession-spotting rules, including two down quarters of GDP. Over the years the rest of his rules somehow dissipated, leaving only "two down quarters of GDP" behind.
It isn’t as simple as two down quarters of GDP = Recession.
Like most rules of thumb, it's far from perfect. It failed in the 2001 recession. At the time and until July 2002, data showed just one down quarter of GDP, leading policy makers to claim there had been no recession. Yet, later that month, revisions showed GDP down for three straight quarters. Complicating matters further, with the benefit of time, we now know that GDP actually zigzagged between negative and positive readings, never showing two negative quarters in a row during that period.
In fact, a better rule of thumb for defining recession is a period when the economy sees four straight months of job losses, since that rule has been much more accurate. However, like the GDP-based definition, that rule is too narrow. The determination of a recession goes well beyond GDP. The official determination of the recession's start date will have to await a wider variety of upcoming data releases. It is always announced months after the recession has begun.
Personal Consumption Expenditures (PCE)
Over the time frame of the chart (below) the Personal Consumption Expenditures (PCE) component has shown the most consistent correlation with real GDP itself. When PCE has been positive, GDP has usually been positive, and vice versa.
Here is a snapshot of the PCE-to-GDP ratio since the inception of the quarterly GDP in 1947. Over the time frame of the chart (above) the Personal Consumption Expenditures (PCE) ratio of 70.7% is at a record high.
Recessions often follow these consumption highs.
ISM Manufacturing Index: Slower Expansion in July
The Institute for Supply Management (ISM) reported that its Purchasing Managers’ Index (PMI) for manufacturing companies ticked down slightly to 52.9 in July from 53.0 the month before.
As the inset chart above indicates, factory activity continues to grow but at its slowest pace in two years, an ominous sign of weakness in the U.S. economy.
While readings above 50 are interpreted as growth, the latest reading was the weakest since June of 2020. In addition, the index declined for a third consecutive month. Of most concern, the ‘new orders’ index slid 1.2 points to 48—its lowest level since May 2020.
On a positive note, the report stated there was some relief on the inflation front. Most of that was due to the recent decline in energy prices which translated to a 71 cent decrease in gasoline prices in July. Clearly, there are times when the reality of the economy is uncoupled from the GDP.
Lead U.S. economist at Oxford Economics Oren Klatchkin wrote in a note, “The recovery’s best days are clearly in the rear-view mirror, but this doesn’t mean an economic downturn has begun.”
ISM Services Report: Faster Growth in July
Companies in the vast ‘services’ side of the U.S. economy continued to grow in July, according to the latest data from the Institute for Supply Management (ISM).
ISM's number at 56.7 came in above the investing.com forecast of 53.5 percent.
Growth continues — at a faster rate — for the services sector, which has expanded for all but two of the last 150 months. According to the Services PMI®, 13 industries reported growth due to an increase in business activity and new orders. The reading was a surprise to the upside—economists had expected the index to drop to 54.
In the details of the report, the new orders index rose 4.3 points to 59.9—a four-month high. The report supports the Fed’s view that a “soft-landing” for the economy may indeed be possible.
The reading suggests the economy continues to expand despite growing headwinds. Orders and production rose, hiring improved, some prices have gone down and inflation pressures eased somewhat.
The overall demand for labor remains strong
In a red-hot report of the U.S. labor market, the July employment report came in much stronger than expected. Employers added a whopping 528,000 jobs in July and the unemployment rate fell back to pre-pandemic levels, according to the Bureau of Labor Statistics (BLS). Hires and total separations were little changed at 6.4 million and 5.9 million respectively.
The unemployment rate ticked down to 3.5% from 3.6%, matching the lowest level since the late 1960’s.
The increase in hiring was broad based and blew past the Wall Street median estimate of 258,000 new jobs. Stephen Stanley, chief economist at Amherst Pierpont Securities noted, “If the economy is rolling over, the labor market had apparently not gotten the memo yet as of the end of June.”
While the report was a strong report, there are growing signs that this strength may not last. One concern in the report, more people continued to drop out of the labor force. The number of job openings decreased from 11.3 to 10.7 million according to the US Bureau of Labor Statistics.
InvesTech Research reports that Initial claims for unemployment are indicating that the labor market has started to soften. Jobless claims during the first half of the year began rising and announcements of jobs cuts had been increasing over the second quarter.
Claims rose to 255,000 in July’s release, compared to its record low of 171,000 reached in April. While this is still a relatively low level, it is concerning that initial claims have jumped by +84K from its low while the average increase at the start of recession historically has been +46K. Jobless claims are likely to continue rising as announcements of jobs cuts have been increasing over the past quarter.
The Labor Department reported job openings slipped from 11.3 million in June to 10.7 million in July—its third consecutive month of declines. Job openings have fallen by -10% from the March peak.
The last time job openings were below 11 million was November of last year. This was the fourth consecutive decline and the largest drop on record outside of the pandemic lockdowns.
Over the past 21 years, declining job openings have been a leading indicator of recession.
Layoffs remained near their historically low levels.
Seema Shah, chief global strategist at Principal Global Investors stated, “All the jobs lost during the pandemic have now been regained.” However, that doesn’t necessarily translate into good news for the stock market. The strong jobs report gives the Federal Reserve the green light to continue its rate-hike trajectory.
Now the Fed has little choice but to tighten policy by aggressively hiking rates to curb inflation. Having missed the opportunity to raise rates last year, that materially increases the risk of pushing the economy into a full-blown recession. The Fed is now faced with risking recession in order to tame inflation.
The Trend in Quits
Following the Great Recession of 2009, Quits began increasing in 2010, and the rate accelerated in 2013 and continued to rise. Layoffs & Discharges fell after the Great-recession and leveled out for many years until the COVID-19 pandemic caused layoffs and discharges to reach all-time highs.
The number of people quitting their jobs topped 4 million a year ago for the first time ever, part of a pandemic-era trend known as the “Great Resignation.” Before the pandemic, the number of people quitting their jobs averaged fewer than 3 million per year.
Within separations, quits at 4.2 million constituted less than 3% of the total nonfarm sector, layoffs and discharges (1.3 million) were little changed.
Further compromising jobs is that Small Business Outlook and Manufacturing Expected Conditions are at abysmal levels, lower than the Great Financial Crisis of 2008.
Recession: Are We There Yet?
The Economic Cycle Research Institute (ECRI) purports to be the leading authority on business cycles. According to ECRI, a cyclical downturn in U.S. economic growth began in May of 2021 and has been underway for more than a year. This slowdown, combined with a Fed that is far behind the curve on inflation, has made the proverbial “soft landing” unlikely.
Over the years, ECRI pioneered the development of leading indicators and composite indexes in order to define in more recent decades, a repeatable and systemic process that has helped establish an unrivaled track record of timely recession predictions.
In May of 2022 – when most economists were still expecting a soft landing, ECRI was warning people in a CNN op-ed to prepare for recession that could begin as soon as this year.
With the Fed now hiking rates aggressively, the bond market is no safe haven. Equities and bonds are riskier than usual, and surging inflation means that cash under the mattress is losing its purchasing power. It’s time to be on guard.
According to ECRI, a recession is a self-reinforcing downturn in economic activity, such as when a drop in spending leads to cutbacks in production and thus jobs. This triggers a loss of income that spreads across the country and from industry to industry, hurting sales.
The proper definition of recession cannot be limited to GDP and industrial production, but must also include jobs, income and spending, all spiraling down in concert. To keep it simple, just look for the "Three P's" - a pronounced, pervasive and persistent downturn in the broad measures of those factors.
Any trustworthy definition of recession needs to encompass the key elements of the recessionary vicious cycle - output, employment, income, and sales. While all government data are subject to revision, simultaneous reliance on all four of these aspects of the economy provide a reliable focus.
Economists at Bank of America’s Global Research team have a different perspective. They aren’t expecting an official ‘recession’ call anytime soon.
(Chart from BofA Global Research via Yahoo Finance).
Six of the main variables explains why they’re not expecting the NBER to declare a recession anytime soon - all six measures are up since the start of the year!
They note that the National Bureau of Economic Research (NBER), (which is the official arbiter of recessions) broadly defines a recession as a “significant decline in economic activity spreading across the economy, lasting more than a few months.”
Having established the facts about recession, we'd like to know where we are in this business cycle. We’ve seen negative GDP numbers this year, and we have already seen four straight months of payroll job losses. That is one suggestion that the economy is on a recession track.
But, while the final determination of recession might be delayed by a year of more, ECRI’s leading indexes have never been this weak outside a recession. If this is indeed a recession, policy makers would be remiss in assuming that this is an economic slowdown rather than a vicious recessionary cycle.
Simply put, if an economy is in recession, economic stimulus - such as quick Fed rate cuts and tax rebates - can be provided without much concern about inflation because recession always kills inflation. This happens because people have less money to spend, therefore businesses cannot easily raise prices, especially if consumers are forced to spend even more on food and energy.
But, if we are in just a slowdown, the same type of stimulus could set off an inflationary spiral. That's why it is essential not to be misled by a flawed rule of thumb or imagine that it makes no difference to policy whether or not we are in a real recession. This is even truer in an election year, when politically expedient, and potentially dangerous economic policy prescriptions are in vogue.
Recessions Vs. Inflation & Interest Rates
Finally, the bond market is signaling a downturn in the business cycle. The Federal Reserve has been raising the Fed Funds Rate through 2022 and until June the rate on the 10-year Treasury rose in unison. But since June the 10-year has been falling, thus closing the spread with the Fed Funds Rate. The bond market is telling the Fed that recession is coming and that higher rates won't last.
Recession is not a certainty, but one of the most reliable indicators of an oncoming recession in the near future is the Treasury yield curve. If the economy never experienced recessions, it would make sense for there to be an upward sloping yield curve for Treasury rates, with the lowest interest rate associated with the shortest-term debt and the highest interest rate associated with the longest-term debt.
What Is an Inverted Yield Curve Suggesting?
To tie up one's money for a longer period normally requires a greater return (higher interest rate) because of the time value of money. An inverted yield curve happens when short-term interest rates on 2-year treasury bonds become higher than the interest rate on 10-year treasury bonds.
When the spread between these two rates turns negative, (as it is above) the market is casting a strong signal that economic forces (a recession) is going to cause short-term rates to drop along with the long-term rates.
Some forecasters prefer to use the 10-year minus 3-month Treasury yield spread instead, arguing that it is a more reliable indicator. Though that yield spread has not yet inverted, it appears to be well on its way toward inversion. As investors begin to take on more fear about a recession, Treasury yields on the longer end (including the 10-year) should remain steady or continue sliding downward.
Meanwhile, Treasury rates on the short end are still running higher as a bet that the Federal Reserve will need to push their key Fed Funds rate significantly higher in order to combat 40-year-high inflation. The point here is that the Fed appears to have a fairly long way to go to catch up with the 3-month and close the gap with the 2-year.
And with inflation as high as it is, the 3-month and 2-year rates will likely continue higher still, further inverting the 10-year minus 2-year spread and eventually inverting the 10-year minus 3-month spread. Once both of these spreads become inverted, it will be a strong signal that the economy is headed toward a recession.
Recession: Good News Or Bad News?
Here is a riddle for you: When is bad news actually good news?
A: Bad news can be good news when a bad event incidentally brings about a good result as a byproduct.
No investor welcomes a recession. Recessions are typically like tornadoes, damaging everything in their path. Normally during recessions, interest expenses rise, stock markets tank, commercial real estate occupancy declines, and corporate bond yields spike.
Paradoxically, an average recession could actually be good in some ways. The recent environment of rapidly rising interest rates is not good for business endeavors as existing debt is steadily refinanced at higher rates, interest expenses will steadily rise, eating into cash flows. Not only will future investments be less profitable, but they will likely deliver less to the bottom line.
After a decade of low inflation, low interest rates and expanding earnings and profit reports the day of reckoning is coming to the markets. The storm clouds of an oncoming recession may actually (eventually) have a silver lining for investors because it will most likely eliminate the two problems of rising interest rates and too-high inflation.
Many commentators worry that inflation is not going to substantially cool down anytime soon even though the economy is headed toward a recession. In other words, they fear an extended period of stagflation.
In our estimation, this fear is unlikely to manifest. Consider two points:
First, as pointed out by macro analyst Eric Basmajian, inflation as measured by the Consumer Price Index( CPI) almost always peaks in the middle of recessions, not before they start. This is true of periods wherein inflation is relatively benign such as the 2000s as well as periods in which inflation is running wild, such as the late 1970s and early 1980s.
Second, after every recession over the last century, including ones during which inflation was running hot, the rate of inflation declined. Recessions have an excellent track record of killing inflation, at least temporarily. They diminish demand, allow supply chains time to normalize, and give room for inventories to build back up.
If the economy goes into recession in the near future, it is virtually certain that the Consumer Price Index (CPI) will come down from its present lofty level. The only questions are (1) how much it will come down and (2) whether it will stay down.
Much the same story could be told about interest rates. After recessions, interest rates decline. There is a clear track record here.
This treasury bond chart (above) shows that recessions drive interest rates lower in their wake even during long-running inflationary periods. From the late 1960s to the early 1980s, inflation was in an uptrend, but recessions caused Treasury rates to fall.
Corporate bond yields act in a similar, though not identical, way:
The chart above shows that corporate bond yields spike during or immediately prior to the recession. During recessions, when capital markets crash and liquidity dries up, corporate bond yields spike and prices drop as investors panic-sell in fear of rising defaults.
But in the wake of recessions, (and typically for multiple years afterward), corporate bond yields end up lower than they were before the recession. Lowering bond rate environments are good for bond investors as bond prices rise.
Historically the 20 Year Treasury Bond rate represented by the iShares 20+ Year Treasury Bond exchange traded fund has averaged nominal price returns of 8.67% in the 52 weeks following oversold bottoms in the last 20 years.
So, when is the bad news of inflation actually good news for investors?
It's when an oncoming recession appears likely to push interest rates down and crush problematically high inflation.
Forward looking indicators are forecasting a decline in growth and a recession in the business cycle.
We have studied market cycles for many years. There is one thing we do know: long range stock markets are cyclical. Economic activity is cyclical in nature. The stock market is one of the leading indicators of economic conditions. We avidly follow and respond to the changes in market trends when they occur.
Recessions are a necessary, natural, and expected cyclical occurrence.
The takeaways from this discussion:
- The Treasury yield spread is showing increasing likelihood of an oncoming recession in the near future.
- Recessions have an excellent track record of causing inflation and interest rates to fall in their wake.
- Though corporate bond yields spike during recessions, (specifically, market crashes and panics), they then almost always decline to lower levels than where they were before the recession.
- Recessions have a cleansing effect on inflation, debt, leverage, and excessive exuberance.