Confused about whether the U.S. is in a recession? One should be.
The United States’ National Bureau of Economic Research (NBER) has not declared that there is a recession officially even though the old definition most economists use - which is two quarters of contracting GDP growth - indicates the U.S. is in one as of the second quarter.
The NBER defines recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” They declared the last official recession in the U.S. from February to April 2020 and it was the shortest in U.S. history.
The focus of markets is changing rapidly. Year-over-year readings in inflation used to be the primary data point. Now, markets and politicians are looking for month over month to decipher what is happening or posturing for their own narrative.
There now is discussion about whether the current economy is truly in recession due to some of the abnormal factors at play, including a robust labour market.
Here is what we know of the economy
The crux of what is happening is that GDP became inflated over the last number of years in an extreme way, with severe central bank rate cuts bringing short-term interest rates close to zero alongside tremendous fiscal stimulus. The purpose of these emergency measures was to tie the economy over during the beginning months of the COVID crisis, when there were widespread shutdowns. This created one of the lowest unemployment rates in North American history well as one of the most challenging supply chain stories in modern history.
Interestingly, the U.S. employment participation rate has been showing a significant decline which has exacerbated the lack of workers. It is not measured in the unemployment rate and could be thought as a bit contradictory.
Investors are now seeing valuations coming off from an inflated period for most asset classes. (real estate, stocks, bonds). Repricing of valuations is a normal part of investing and certainly when interest rates are going up, this adversely impacts the valuations of equities.
What is unusual here is that it is all happening together based on the sharpness and quickness of these interest rate rises. Rising consumer debt levels and credit levels could outpace income gains or asset gains. This is something to watch as it trickles through the economy.
Is it possible that the U.S. Federal Reserve could avoid the new definition of recession because of the strong labour market? In my opinion it is possible but not likely. Shallow recession? What typically makes recessions bad is that people lose jobs and suffer hardships. People spend less, businesses cut back on their investment, and industry slows. We are not there yet but it is something to monitor, especially in the higher growth technology arena where capital raising is frozen with slowing growth and job cuts and hiring freezes are getting announced progressively.
Are we out of the woods?
These rate hikes most likely will have a delayed reaction before kicking in. We will know more in the fullness of time. Excess inventories are an issue with many retailers as consumers habits are changing rapidly. People are pivoting from consuming goods to services. Immigration would be a helpful ingredient to calm some of the inflation we are having but that is not an instant fix.
Given that there are so many aspects at play in the economy and in life currently, balanced thought and diversification of different risk factors is key here in the world of portfolio management. With fixed income having been plagued with low yields for over 10 years and having one of its worst performances in modern history year to date, there is a strong argument that asset class performance could start to diverge and resume a negative correlation of returns between bonds and stocks. A lot of the pain in investment grade bond prices is mostly factored in and will likely provide a better offset against the equity market if it falters for the remainder of the year.
In any case, positioning oneself as if we were in a soft recession by focusing on the quality fundamentals of businesses at reasonable valuations and nibbling into fixed income with now attractive yields as a safety mechanism is the prudent course of action if the economy falters.
Jonathan Pinsler is Senior Portfolio Manager and Senior Investment Advisor with TD Wealth Private Investment Advice