Economic indicators point to a slowdown of activity in the U.S., but where are we really in the cycle?
At this point it isn’t even conclusive the U.S. economy is in recession except by the textbook definition of two consecutive quarters of negative GDP growth which was reached in the second quarter. Consumer spending grew in those two quarters, but the second quarter was slower than the first, which was slower than the fourth quarter of 2021. It feels like the economy is losing steam.
But a recession is not so simple to call. The official determination is made by the Business Cycle Dating Committee of the National Bureau of Economic Research. It takes so long to make a determination that the recession is frequently over before the NBER commits to its starting date.
A recession is a broad-based decline in economic activity, typically thought of as a widespread fall in output and increasing unemployment. You know a recession when you see one.
The challenge in 2022 is that unemployment remains at a 50-year low. The number of people with jobs continues to grow, but even this is misleading. The U.S. economy lost 23 million jobs in about two months after the pandemic began. Even two years later there are half a million fewer people working. Yet, GDP is clearly bigger than early 2020. Companies are straining to keep up, which partially explains elevated inflation. Even though many businesses are experiencing slowing demand, most remain understaffed and need to continue hiring.
U.S. indicators clearly measure a slowdown, bordering on a recession. Consumer spending appears to be decelerating and companies are responding by cutting inventories, reducing discretionary spending, and considering selective layoffs. It is widely believed there will be further rate hikes at least through year-end, leading to a Fed Funds rate of around 3.50%. The Treasury yield curve is flat to slightly inverted, suggesting that investors believe an economic slowdown will limit future rate hikes.
If there are visible signs of a sustained economic slowdown, it is possible the Fed pauses to reassess and that is what has stock investors suddenly more optimistic. The Fed’s measure of “core inflation” (excluding food and energy) is rising around 5%, far ahead of its 2% objective. We would consider ourselves lucky if a 3.50% Fed Funds rate was sufficient to bring inflation to the 2% range. The risk to stock investors is that additional rate hikes may be necessary.
One difference between the current situation and recent bear market bottoms is that the Federal Reserve is committed to further interest rate hikes while past bottoms have occurred during periods of falling interest rates. This is significant because interest rates help steer the economy, but with a lag. The market is a discounting mechanism that anticipates changes by six to nine months, but it seems logical to us that we should be at least that far away from cuts in interest rates. However, some market observers believe that could happen early next year as the Fed switches from fighting inflation to reinvigorating the economy. Fed governors are considering smaller rate hikes to avoid over-tightening but seem more inclined to eventually pause rate hikes than to reverse course and cut rates.
But this is just informed guesswork. Don’t waste your energy trying to predict the unknowable. Even the once-legendary Elaine Garzarelli got it right just once—calling the 1987 crash. Focus on the few things under investors’ control, such as owning good companies at reasonable prices -- like the three companies profiled in the September 2022 issue of the Investor Advisory Service newsletter.
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