Are We There Yet?
Whether this question brings up good or bad memories, we have all been asked or have personally asked this question while attempting to reach a vacation destination. This will be a popular question in 2022 as consumers have stepped up spending on services and travel and left behind purchases of durable goods such as furniture, appliances, and even cars. Following the pandemic in 2020, consumers are ready to build new experiences after sitting at home for almost two years. Airlines are booked (and struggling to keep up), vacation rentals have minimal vacancies, and roadways are busy this summer. Looking at the rate of spending on services, it is difficult to imagine that our economy could be in a recession or moving towards one. However, will this discretionary spending continue after the glory days of summer have passed?
Speaking of recession, are we there yet? It is difficult to avoid hearing the “R” word when you turn on the news, pick up a newspaper, or skim social media these days. Weekly Google search volumes for “recession” in the United States have spiked in recent weeks. A well-known rapper even tweeted to her followers asking when it will be announced that we are going into a recession. There are signs that we may already be in a recession or that we will be in one by year end. The technical definition of a recession is two negative quarters of GDP growth. First quarter GDP was -1.6%, and the most recent estimate for the second quarter by the Atlanta Fed is trending negative. If this is the case, we have technically been in a recession for the first half of 2022. This is one way to measure a recession though. Another is The National Bureau of Economic Research (NBER) method. The NBER definition of a recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months. Economic activity includes employment, personal income, industrial production, personal consumption, and retail sales. If you consider these factors, first quarter would not have been recessionary. The primary factors in the first quarter negative GDP were more imports (buying more goods) and a drawdown in inventories, which were both impacted by business and consumer spending. Employment remained strong and personal income increased. We do not believe we were in a recession during the first quarter due to these factors.
Looking at second quarter, there has been a slowing in our economic growth due to several factors. Inflation has hit the consumer directly through higher gas and food prices. While personal income has increased, real income after inflation has declined, which leaves less discretionary income for individuals to spend. In addition, financial conditions have tightened (less credit availability) with the Federal Reserve (Fed) starting its path to increase short-term interest rates and decrease its balance sheet. The cost to borrow increased especially in consumer loans and mortgages. The 30-year mortgage rate basically doubled from January to June (3% to 6%), making the average mortgage nationally cost approximately $800 more per month.
The primary goal of the Fed with these rate hikes is to clamp down on inflation by slowing demand, which could potentially put the economy into a recession. While recessions are not the desired outcome, we do need to get the supply/demand chain back in balance, and recessions achieve this to build a new base going forward. While we are still not certain that we are in a recession yet, we do believe the odds of going into one within the next 12 months have increased during the last quarter. The bigger questions are how long it will last and how severe (deep) it will be. We did have a “recession” in 2020 that lasted less than 3 months, but it was not caused by the typical business cycle. Instead, it was caused by the economic shutdown and the following unprecedented stimulus from both the Fed and the government. The U.S. has not experienced a business cycle (strong demand/short supply/FOMC tightening) like this since 2009. It has experienced a fairly stable economy for over 13 years. In many eyes, we are due for a business cycle reset.
While the Fed is attempting to achieve a soft landing (slow growth/lower inflation), it is walking a fine line, and it may be difficult to attain that goal. There has already been a 1.50% increase in short-term rates, and more are expected. Historically, it has taken three to six months to see the impact of rate increases on growth and inflation in the economy. The first increase was in March and looking at economic indicators in June, the U.S. is already experiencing slower growth, and inflationary pressures are subsiding. Manufacturing sentiment indicators have declined from the highs, consumer sentiment is at lows not seen since 1980, commodity prices have declined from the peak seen earlier this year, and real consumer spending has declined.
If we do enter a recession, we do not believe it will be deep and long-lasting. Unlike the recession caused by the Great Financial Crisis (leverage), consumers and businesses have strong balance sheets, and the financial industry is not highly leveraged with questionable credits and is well capitalized.
Since the beginning of the year, the bond market has begun to build in the Fed moves with the 10-year Treasury increasing from 1.5% to almost 3.5% and now settling back around 3%. This has led to the worst start of the year for treasuries since 1788. There was no place to hide on a total return basis. In turn, the stock market also declined in anticipation of higher inflation, a tightening monetary policy, and a slowing economy. Whether the worst is behind us is unknown, but on a valuation basis, the markets appear much more attractive today than at the beginning of the year.
To answer the question, “Are we there yet?” we do not know. However, we do believe that long-term investors need to stay the course to meet both personal and financial goals. Determining the appropriate investment allocation is the long-term driver, and a diversified portfolio of bonds, stocks, and alternatives is appropriate.