To Be or Not to Be
Shakespeare’s Hamlet character uttered these words wondering if he should continue to be, meaning to exist or remain alive, or not to exist. Hamlet’s debate was internal with himself, but a similar debate is now taking place on a much larger scale regarding a recession – are we in the midst of one or are we not? The preliminary GDP report for the second quarter showed negative growth, following negative growth during the first quarter of the year. Conventional wisdom is that two quarters of negative GDP growth is a recession. However, it can be argued while the economy appears to be retracting, at least on a real, or inflation adjusted basis, employment and industrial production remain strong while consumer spending has not collapsed. Are we in a recession or are we not? And if we are, how much does it matter to investors, especially those in the stock market?
The headline GDP number is reported on a real, inflation adjusted basis, but digging deeper into the GDP report shows the overall value of all goods and services produced increased by 7.8% compared to a year ago. Factoring inflation of nearly 9% results in a contraction of 0.9%, the headline number reported. Looking at these numbers, if we indeed are in a recession, it is shallow and fairly mild thus far. However, if it were to continue for a prolonged period then it could impact employment which in turn would lead to issues with consumer spending and housing, causing the recession to deepen further. While there is argument over whether or not we currently are in a recession, most economists seem to be in agreement the U.S. economy is losing momentum and the probability we will experience a recession is increasing.
There was a plethora of events during the past week, including earnings reports from major tech companies which currently make up a very large portion of the S&P 500 and therefore directly impact how the overall market performs. Alphabet (f.k.a. Google) and Microsoft earnings were worse than analyst estimates, but both stocks rallied since the reports were not as bad as feared but more importantly both gave positive outlooks. Apple and Amazon both had positive earnings reports beating lowered expectations and also provided positive outlooks. Earnings reports from these giants produced strong momentum for the stock market with the S&P 500 gaining nearly 4% on the week. The recent focus on the Fed and inflation is because higher interest rates lead to higher borrowing rates and inflation tends to damper spending, both of which would negatively affect corporate earnings. The market has been adjusting accordingly via the pullback experienced this year but if future expectations improve the market could reverse course. This is precisely what we’ve seen over the past six weeks as the S&P 500 has bounced roughly 11% from its lows in mid-June.
Much Ado About Nothing
Most of the time a three-quarter point rate hike by the Federal Reserve would be very big news but given the other events of the week it may be easy to overlook. Future expectations for interest rate increases have shifted dramatically in the past month as economic data is showing a slowdown in activity. In his remarks after the Fed meeting, Chair Jerome Powell stated there are signs of a slowing economy and future rate hikes will be data dependent. This was cheered by the markets as it is an indication that future interest rate increases are likely to be lower than previously expected; the most aggressive of the Fed’s actions to raise interest rates may now be behind us. Fear of the Fed raising rates too high and keeping monetary policy restrictive for too long was a concern causing headwinds for equity markets. While very much still a possibility, some of this fear seems to be alleviated with Powell’s comments. The markets, especially the bond markets which tend to be a good predictor of future activity, are indicating the Fed will continue to raise rates through the end of this year but will have to pivot and lower rates in 2023. It will remain to be seen if market expectations are correct or if the Fed will need to remain on a path of raising interest rates.
Future Fed action is ultimately dependent upon inflationary pressures, some of which may be beginning to abate. Oil prices have pulled back slightly and moderated (but still remain stubbornly high.) Many commodities experienced price decreases of 20-30% during the month of June. Comments during recent corporate earnings calls also indicate pricing pressures seem to be abating. The government’s inflation reports reflect changes in price levels over a certain period of time, either month-to-month or year-to-year. Compared to a year ago, prices are markedly higher but given what seems to be a stabilization in prices recently, future inflation readings, especially once we get into 2023, could show lower changes in price levels. This could be a catalyst for the Fed to reverse course, especially if at that time we are in a recession. Ironically, the stock market is viewing the prospects of a recession positively since recessions tend to be deflationary as demand decreases, often causing prices to drop or at least stop increasing. Inflation and higher interest rates have created the biggest weight on the markets this year, so if the prospects for continued inflation are waning it could prove to be a boon for investors.
After all of the excitement in the markets this past week, a quieter week may come as a welcome reprieve. Earnings reports continue in earnest and it is earnings that drive the markets over the long-term, which is why so much attention is being given at this critical juncture. The major economic release of the week is the employment report on Friday, expected to show the labor market remains robust with low unemployment. A high level of employment produces higher wages and inflation, further complicating the work of the Fed. In order to engineer a soft landing, the Fed needs to reduce wage pressure while not causing substantial harm to the employment situation.
The recent mini-rally is leading to improvement in investor and consumer sentiment, both of which had reached historically low levels. If sentiment continues to improve, which we expect it will on the heels of last week’s activity, it should help provide further thrust for the markets. Should investors care if we are in a recession or not? Markets tend to be a leading economic indicator; they will tell you what the economy will do. The economy will not tell you what the markets are going to do. If you would like to discuss your portfolio to ensure it is positioned for whatever occurs in the markets and economy, please do not hesitate to contact us.
Have a wonderful week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
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