Is The U.S. Already In A Recession And Does It Matter For Stocks?

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Two straight quarters of economic contraction have set fire to the debate about whether we have already descended into recession. While two consecutive quarters of GDP decline provide a good rule of thumb, the National Bureau of Economic Research or NBER has historically been the final arbiter of dating the business cycle. The evidence does not point to a recession by the NBER’s definition yet, but the risks of economic contraction are rising, and economic growth has been weakening. This space flagged the rising probability of a coming recession back in March, so the increasing pressures on economic growth, unfortunately, are not a surprise.

The impacts of Covid continue to make the economic data more challenging to interpret. The lockdowns caused a historically massive annualized contraction in economic activity followed by an enormous bounce in growth after reopening. In addition, GDP includes some pieces like trade that can swing based on the actions of other countries. So while the headline GDP has contracted for two quarters, final sales to private domestic purchases grew in the first quarter and held steady in the second quarter. This measure excludes the impacts of trade, inventories, and government spending, so it does a better job of measuring the activity of the US private sector. By this measure, the economy is slowing but is not yet shrinking.

The unemployment rate is one of the most straightforward arguments against a current recession. We just don’t experience recessions when the unemployment rate is this low. A simple real-time method to determine if the economy is already in a downturn is the Sahm Rule, which uses a rise in the unemployment rate as a signal. The Sahm Rule also shows no sign of a current recession.

An excellent high-frequency indicator for the strength of the labor market is initial claims for jobless benefits since this data is released weekly with only a short lag. Initial jobless claims have been moving higher, but the level so far is consistent with slowing job growth rather than reducing the number of jobs. The July jobs report will be released on Friday and is expected to show that unemployment held steady at 3.6% while the pace of job increases slowed.

Why do so many people feel so bad if we aren’t in a recession? The Misery Index can provide some powerful insights here. The Misery Index combines the unemployment rate with the inflation rate. While the unemployment rate remains on the low end of historical levels, the inflation rate is elevated at 9.1%. The price of everyday items like most food items and gasoline have risen at a much sharper pace. This increase in the cost of essentials puts a particular squeeze on lower-income households but is not enjoyed by anyone.

Looking at year-over-year household income growth after inflation is instructive to get into a more detailed discussion about why people generally feel pessimistic despite very little joblessness. This data set includes essentially all the income received by households, from wages to investment income. In addition, one series includes transfer payments. All the government assistance distributed to provide a cushion during the impact of the Covid lockdowns shows up clearly in the data with transfer payments. While the after-inflation amount of income excluding transfer payments is 1.4% above last year’s level, it has been fading. Once transfer payments are included, the purchasing power of American households has fallen by 3.2% year-over-year, thanks to rampant inflation.

Even if it is correct that the economy is not in a recession now, the odds are high that it could slip into a recession over the twelve to eighteen months. While it is impossible to time the stock market bottom, using an improvement in economic activity as a signal has been a recipe for underperformance. Stocks have typically been 28% above their trough by the time the economy bottoms. In eleven out of the last twelve recessions, the S&P 500 has bottomed before the recession is over. The only outlier was the 2001 recession which was associated with the bursting of the technology bubble. Stocks have usually bottomed about six months before the economy but have bottomed as much as ten months before the economic decline is over. During the 2001 recession, stocks hit their low nine months after the economy.

Almost any economic data set will show ugly economic data is consistent with better forward returns from stocks rather than poor returns. This phenomenon is due to stocks typically selling off in advance of poor data and moving higher in anticipation of better times ahead. Consumer sentiment provides an example of the same behavior. If you were somehow able to time buying at the low in the University of Michigan Consumer Sentiment index, the following year has had a median return of over 22%!

Investors should focus on an asset allocation that provides the financial means to persist through the market volatility and the likely economic downturn. Aside from holding some safe and liquid assets to cover living expenses during economic and market turmoil, this downturn should be a long-term buying opportunity for those able to add to stock positions. Within stocks, investors should focus on quality companies that can survive the looming recession and thrive once the turmoil passes. A company’s ability to increase prices without destroying demand for its products is also critical.


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