Analyzing recession risk … what do GDP numbers and jobs reports tell us? … the latest on consumer health … tailwinds for bulls … headwinds for bulls
At the most basic level, what makes your portfolio rise or fall over the long-term?
It’s the strength (or weakness) of the earnings of the companies in your portfolio.
And what will impact their earnings over the coming 12-18 months?
Well, as we stand today, one of the biggest influences is whether the Fed’s rate hikes will tip the economy into an earnings recession.
And this is where expectations diverge for many bulls and bears.
Will we or won’t we get this recession?
Regular Digest readers know that I lean bearish in today’s market. We’ve highlighted many of the reasons why in issues this fall.
But one of the most dangerous things you can do is decide on a market/economic narrative and become blindly loyal to it.
I’ve done this to my own detriment over the decades. After forming a market belief, I’ve unconsciously looked for data to support that belief, while ignoring other data. It’s only in retrospect (after suffering the consequences of my blind-spots), that I realized logical counterarguments had been in plain sight all along.
So, let’s begin today by looking at the argument for why the Fed’s rate-hiking won’t tip the U.S. economy into a recession, and see if we can poke holes in it.
Goldman Sachs predicts we’ll skirt a recession
The investment bank says there is only a 35% probability of a recession in the next 12 months.
From chief economist Jan Hatzius:
The US should narrowly avoid recession as core PCE inflation slows from 5% now to 3% in late 2023 with a 1/2pp rise in the unemployment rate…
Why is our recession probability – while more than twice as high as the unconditional probability of entering recession in any given 12-month period – still clearly below 50%?
One immediate reason is that the incoming activity data are nowhere close to recessionary.
The advance GDP report showed 2.6% (annualized) growth in Q3, nonfarm payrolls grew 261k in October, and there were 225k initial jobless claims in the week of November 5.
To be fair, there’s more to Hatzius’ argument. But for brevity’s sake, we’ll limit our discussion to what we just quoted.
Let’s start by looking at Hatzius’ point about GDP.
At face value, he’s absolutely correct – U.S. GDP climbing at a 2.6% annualized growth rate suggests there’s no recession anywhere in sight.
But there’s way more happening beneath the surface of this 2.6% figure, and Hatzius knows it.
Frankly, I’m surprised this was one of his points.
A handful of components make up a GDP figure: 1) consumption spending, 2) capital investment, 3) government spending, 4) the trade balance (exports relative to imports)
If you’re looking at the GDP to track recession risk, you’d focus on “consumption spending” because this makes up about 70% of the U.S. economy.
With that context, let’s look under the hood at the 2.6% annualized Q3 GDP figure that Goldman cites as a reason we’ll avoid a recession.
The only saving grace of the GDP report was its headline +2.6%.
As it turns out, Net Exports added 2.8 percentage points, and for the wrong reasons.
Excluding Net Exports, the domestic economy’s GDP growth was -0.2%
Changes in our trade balance inflated the Q3 GDP number. Due to the strength of the U.S. dollar, the dollar value of exports rose relative to our imports.
So, what really happened with domestic consumption?
Final sales to private domestic purchasers were flat (less than 0.1% annualized). Worse, this is a continuation of a negative trajectory.
Back in Q4 of 2021, final sales to private domestic purchasers came in at +2.6%… in Q1 2022, it dropped to +2.1%… in Q2 of 2022 it dropped to 0.5%…
And here we are at effectively 0% in Q3.
Meanwhile, there was strong growth for services (probably due to pent up demand for vacations post-Covid). Let’s give credit where credit is due.
But purchases of goods were weak with durable goods falling at a -0.8% annual rate. Meanwhile, non-durable sales fell -1.4% annualized.
We’re going to skirt a recession because of this?
But Jeff, this is the past. What matters is the future!
True. Unfortunately, the future includes even more economic tightness from previous Fed rate hikes that haven’t yet fully made their way into the economy.
Okay, well, what about the Goldman’s second point about the nonfarm payrolls grew 261k in October?
Again, at face value, this is a strong point. It’s difficult to have a recession with such a strong labor market.
But here again, there’s lots going on under the surface.
As we detailed here in the Digest, this 261K growth comes from the “establishment survey.” That’s the popular name for Labor Department’s payroll survey.
But this isn’t the only gauge of our labor force. The Bureau of Labor Statistics conducts a phone survey, called the “household survey.”
The biggest difference between these two metrics is the establishment survey measures the number of positions on business payrolls, while the household survey measures the actual number of employed workers by calling households.
It turns out, this “strong” +261K payroll number is hiding a more concerning truth about the economy:
Our labor force is trading full-time employment for part-time employment, and an increasing number of workers are taking two jobs to make ends meet.
But perhaps the most shocking stat in the household survey was the disparity between full-time and part-time workers.
In October, full-time workers declined by 433,000 while part-time workers increased by 164,000.
Tracking this data back to March, the US has lost 490,000 full-time employees while gaining 492,000 part-time employees. 126,000 of those workers became multiple jobholders.
The quick sum-up is that the number of actual working Americans hasn’t changed a great deal since March.
But what has changed is the number of people losing their full-time employment, having to take lower-paying, part-time jobs. And within that group, about 25% are working two jobs to make ends meet.
Again we ask, does this reflect a labor market strong enough to avoid a recession?
Moving on from Goldman, what do we learn by shining a spotlight directly on the condition of the U.S. consumer?
This is the critical question anyway.
Last week, we learned that the U.S. consumer is still strong. Here’s the AP News trumpeting our resilient domestic shopper:
Americans stepped up their spending at retailers, restaurants, and auto dealers last month, a sign of consumer resilience as the holiday shopping season begins amid painfully high inflation and rising interest rates.
The government said Wednesday that retail sales rose 1.3% in October from September, up from a flat reading in September from August.
But here’s a question…
If I bought a new Lamborghini…on my credit card…would you assume I’m in great shape financially?
Now, I might be in great shape, or I might be dreadful shape. But to answer that question, we’d need to look at whether I could afford the Lamborghini, as well as the overall net condition of my financial assets.
As a corollary, yes, the U.S. consumer is still spending…but is doing so thanks to snowballing debt as savings-account values dry up.
Last week, we learned that households increased debt at the fastest pace in 15 years, in large part due to a massive ramp-up in credit card usage.
The credit card balance collectively rose more than 15% from the same period in 2021, the largest annual jump in more than 20 years, according to the New York Fed.
And what about how much consumers are saving?
As red flags go, this could be a big one.
The personal saving rate — meaning personal saving as a percentage of disposable income, or the share of income left after paying taxes and spending money — fell to 3.3% in the third quarter…
That is the lowest level since the Great Recession and the eighth-lowest quarterly rate on record (since 1947).
Debt-fueled spending can prop up the economy for a while, but at some point the emperor be revealed to have no clothes.
Remember, as the Fed hikes interest rates, it also hikes the APR on credit cards…which now clocks in at an eye-watering average of 16.27%.
At some point, the pain of this interest rate applied to a snowballing credit card balances will be too great for many consumers. They’ll have to curb spending or default.
Either way, that spells trouble for the economy and corporate earnings.
To me, this seems like a car speeding toward a brick wall, not a reason to applaud the “resilient” U.S. consumer whose strength will keep the country from falling into a recession.
But let’s be balanced and point toward several things that might support earnings and your portfolio
In recent weeks, both the U.S. dollar and the 10-year Treasury yield have fallen significantly.
The dollar has fallen more than 6% since late-September. That’s a big move for the world’s most important currency in just a handful of weeks.
Meanwhile, the 10-year Treasury yield has fallen from nearly 4.23% back in October to just 3.79% as I write on Monday morning.
These moves are wonderfully bullish for stocks.
And of course, if inflation keeps dropping in a meaningful way, that will be huge for the economy.
(But this is tempered by a Fed that seems intent on more hikes – even if they’re slower – as well as rates remaining at high levels for a long time to come.)
Finally, bulls appear to have the sentiment advantage today. The pervasive bearishness from earlier in the year has weakened as bulls eye reduced rate hikes, historical figures about market gains in the year after a 20%+ loss, and the assumption that inflation has peaked and is on its way out.
Don’t discount this: Sentiment is a powerful thing.
Overall, if you lean bearish as I do, you’ll want to keep your eye on all of this. If the current trajectories of the dollar and the 10-year Treasury yield continue, if inflation keeps cooling, and it the bulls continue to assert themselves, it should warrant a greater openness to bullishness. Remember, the worst thing we can do is cling to a market narrative “just because.”
But for now, these factors reflect the potential for nearer-term stock market gains, not a source of economic strength that will avoid a recession and drive more robust market gains deeper in to 2023.
We’re running long, so just one more bullet…
We’ve tried to be evenhanded by considering some bullish arguments today that support the “no recession” narrative, but we haven’t gone on the offensive
What would going on the offensive look like?
Well, as I write the spread between the 2-year Treasury yield and the 10-year rate reached negative 74 basis points. That’s the most extreme level since the early 1980s.
An inverted 10/2 yield curve has preceded the last eight recessions. If we go further back in time, the inversion has preceded 10 out of the last 13 recessions.
Sure, an inverted yield curve doesn’t always predict a recession, but that is no reason to ignore it. Especially when the reading is so extreme.
Ignoring that “check engine” light on your dashboard usually doesn’t end well.
Next, what about Quantitative Tightening (QT), which we profiled in the Digest last week?
This is the Fed’s efforts at rolling off its gargantuan balance sheet holdings. The last time the Fed attempted QT, it had to abandon its efforts after the S&P crashed 20% over three months.
Today’s level of QT is basically double the amount that contributed to that crash.
I haven’t read a single bullish analysis that explains why there won’t be any fallout from today’s QT.
Finally, there is the persistent hawkishness of the Fed.
Last week, St. Louis Fed President James Bullard said:
Thus far, the change in the monetary policy stance appears to have had only limited effects on observed inflation, but market pricing suggests disinflation is expected in 2023…
To attain a sufficiently restrictive level, the policy rate will need to be increased further.
Bullard might as well be saying, “Hey, Wall Street, please slow it down.”
Many bulls seem to be saying “Nope. I don’t believe you.”
But think about what that means…
This bullish response requires that Bullard is flat-out lying.
The more polite term we used last week was “poker face,” but it is what it is.
Now, this could very well be the case. Part of the Fed’s job is to manage expectations. And far be it for us to claim that a government employee might not be a paragon of honesty in this situation.
But betting that Bullard is lying is a high-stakes gamble – especially when you remember that bulls have been fighting the Fed all year…and have been wrong every time.
Bottom line: Until these three issues can be explained away, some additional caution is warranted as we look ahead to 2023’s economy.
Have a good evening,
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