Highly Unusual Times
There have been many twists in the odd trajectory of the pandemic economy. Global supply-chains got snarled, workers were suddenly in short supply, demand for some items exploded then evaporated, entire industries were on the brink of disappearing, much of the Chinese economy shut down for a stretch, government stimulus payments injected money into the economy on a massive scale on multiple occasions…these are but a few of the unanticipated events that recently impacted the economy. In the aftermath, we are still struggling to return to normal.
The foremost problem has been the emergence of inflation. Price increases have broadly soared globally over the past year. “Transitory” supply-chain problems that began early last year turned out to be persistent. Simultaneously, excessively stimulative government payments designed to keep the economy afloat fueled a demand boom that worsened the global supply shock caused by the pandemic. Finally, Russia’s invasion of Ukraine exacerbated energy and food inflation around the world. These are the origins of the situation we find ourselves in today.
After erroneously waiting for inflation to die down on its own, the Federal Reserve finally sprang into action. Following two smaller interest rate increases earlier this year, the Fed became more aggressive in June and raised rates by three-quarters of a percentage point, the largest single increase since 1994. That put its benchmark interest rate at a range of 1.5% to 1.75% after starting from near zero. Additionally, the Fed is likely to make another 0.75% increase later this month, with markets expecting rate increases to peak around 3.5% by next March. Then later next year, investors anticipate that the Fed will head in the other direction and reduce rates again when cost pressures recede.
Inflation may have peaked already, in part from the rate increases that have already occurred. Slowing global growth from high levels and recent sharp declines in commodity prices, especially for food and energy, should cause inflation to decelerate. Additionally, the moderation in goods demand already underway stemming from the lowest ever recorded consumer sentiment and an easing in supply constraints will also help cool price increases.
With interest rates still increasing while inflation may be falling, concern has now turned to recession. While there is a committee of economists that officially decides when recessions begin and end, the layman’s definition is two consecutive quarters of negative GDP growth. Economic output in the first quarter of this year shrank at an annual rate of 1.6%, originally thought to be a fluke due mostly to a surge in the trade deficit. The Fed’s forecasting model, GDPNow, currently estimates that second quarter economic activity also declined by 1.6% annualized. The consensus among economists, however, is that it was positive by roughly 1%(the Fed model changes often and is continually updated as fresh data is reported).
If we are in or near a recession, it does not yet look like any other on record. Employment continues to be very strong, which is the opposite of what happens during a recession. At 3.6%, the unemployment rate remains near a 50-year low. Employers added hundreds of thousands of jobs each month this year, although at a slower pace recently. Initial jobless claims and continuing unemployment claims also show no sign of recession.
Unlike during a recession, corporate earnings remain strong. First quarter earnings grew 11.6% from the same period last year. Second quarter earnings are expected to be up over 5%. Forward 12-month earnings estimates have increased by 7.5% since the start of a year. The majority of companies are very healthy.
If there is a recession right around the corner, it must qualify as the most anticipated one ever. Maybe it’s even possible for us to talk ourselves into one. A recession that takes few by surprise would likely be relatively mild and not terribly long. Stocks may have already priced in that scenario, considering how much valuations have collapsed while so much of the economy remains strong and company fundamentals still continue to accelerate.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
