Investment Outlook, June 2023

June 29, 2023

Recession or Not?

2022 was the worst year in the market in over a decade, with the bond market index down more than any year recorded. So far this year, the S&P 500 is up over 13%. Is this rally simply a positive rebound to 2022’s over-reaction, or are investors rewarding companies for a new, upcoming growth cycle? Investors and experts alike are split as to where we are today and where we are going.  To add to the confusion, there are credible indicators suggesting we are heading for a recession and other indicators reflecting a healthy economy that is coming out of pandemic stresses and is poised for future rewards. Here are the competing points of view:

Heading for a Recession:

Some investors see a recession as inevitable this year. The Federal Reserve has raised interest rates 10 times over the past year to slow surging prices. Both the speed and extent of these rate hikes will inevitably crush demand and lead to a recession. For these investors, it is no surprise that the following indicators are flashing recession risks.

1. Leading indicators are weak. The Conference Board’s Leading Economic Index (LEI) has historically predicted economic tops and bottoms. The latest May reading is the 14th decline from the peak. Six of the 10 indicators signal a declining situation for the economy. The most negative include credit conditions, consumer expectations for business conditions and the ISM Index.

2. The Institute for Supply Management (ISM) Index is contracting. Speaking of the ISM, their Purchasing Managers Index (PMI) is a key indicator of business conditions. Both the Manufacturing and Services PMI indices have been falling for over a year. The Manufacturing index is now below 50, signaling recessionary conditions and the most recent Services index reading sits right at 50, perhaps on its way further down as well.

3. The Yield Curve is Inverted. Then we have the inversion of the yield curve, in which short term rates are much higher than long-term rates. The difference between the current yield on 10-year Treasury bonds and 3-month Treasury bills has been negative (inverted) since October 25th last year. Usually, investors demand higher rates for lending money longer. An inversion happens when the Fed hikes short-term rates to a level in which investors in longer- maturity bonds get concerned that higher short-term rates will crush future growth. With this concern, longer maturity bond rates fall predicting that rates will have to come down in the future. An inverted yield curve has been a somewhat reliable leading indicator of economic weakness, inverting before the last 8 recessions, but also inverting a number of times in which no recession followed.

All three of these indicators often predict upcoming recessions. After 14 months of aggressive monetary tightening to slow inflation, these indicators support those who believe that a recession is the inevitable cost of that policy.

We Will Avoid a Recession or It Already Happened:

On the other hand, perhaps the recession already occurred, and conditions are already on the upswing. Easing financial conditions, improving consumer sentiment and the stabilization in housing suggest that economic risks have eased.

1. The Labor Market Remains strong. Labor market strength continues to confound our Federal Reserve. In the hyper-inflation of the 1980s, the job market was already weak before the Fed even started its tightening journey. Today’s job market has historically low unemployment levels not seen since the early 1960s. Labor participation rates keep increasing and job quitters continue to decline. In the latest reading, wage growth for the month of May declined to 0.3%— less than 4% annually— a positive sign that the employment market is staying healthy and inflationary pressures are declining.

2. Housing Demand is Rebounding. Construction on new homes jumped 22% in May, as homebuilders ramped up building single-family homes to meet strong demand from buyers. The National Association of Home Builders’ (NAHB) also reported that its monthly confidence index rose 10% in June. This is the sixth month in a row that sentiment has improved among builders, despite higher mortgage rates. Residential construction can be a powerful engine for our economy and these recent readings suggest construction will be fueling future growth.

3. Consumer Sentiment is Improving. From an all-time low of 50 last June— and most closely reached in 1980— the University of Michigan index of Consumer Sentiment has been steadily improving. The latest reading is 28% off the low and at its highest level in 4 months. While the current reading of 63.5 is still quite low by historical standards, the index reflects an improving trend consistent with coming out of an economic slowdown or recession.

Which set of data is going to point the way to the future? It is not clear. We are in the camp that believes conditions will be improving going forward. Recall, that a year ago, GDP came in negative for both the first and second quarters of 2022. Other countries would have called this the start of a recession; our economic leadership did not do that (yet). We believe that last spring was, indeed, the start of a meaningful economic slowdown that has since shown up in different industries at different times. Last spring, we first saw the decline in the retail industry; more recently we are seeing struggles in industrial companies. In fact, second quarter profits this year are estimated to reflect a big decline in year-over-year earnings. We think that will be the bottom of this economic slowdown (dare we say recession?). In this scenario, the negative economic indicators are all accurate and reflect an economy that is already near the bottom of its slowdown.

The positive indicators show the “green shoots” of what the future will hold as parts of the economy continue to improve. Construction typically picks up early in a cycle and Consumer Sentiment often predicts the turn in economic data.  We think these data points support our conclusion that we have been in a slowdown that may be coming to its end before year-end.

The S&P 500 declined over 20% in 2022 (the NASDQ declined over 30%) as the Federal Reserve raised interest rates from 0% to 5%.  Rates were rising to battle inflation with an expectation that future economic growth would slow. As rates rose last year, both the stock and bond market fell, and, to our mind, fully discounted the inevitable economic slowdown. Historically, even though higher rates suggest company earnings are worth less for their future growth, markets do not crash over 20% into bear market corrections just because interest rates go up. Instead, we believe the markets last year were already adjusting for a recession. So far this year, companies have primarily reported earnings that are lower this year than they were last year. The market is still rewarding these stocks because investors are looking to what future growth can be from these depressed levels. We see higher corporate earnings in late 2023 and 2024 and believe the market can continue to move higher.

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