Recession

Recession Watch: Is a soft landing still possible?

Recession is a four-letter word in the world of finance. The superstitious won’t even utter it out loud, in fear they may accidentally conjure an evil spell.

But right now, recession is on everyone’s minds and it’s important to address.

Countless news sources and publications, after a series of Federal Reserve interest rate hikes, have spent the last month speculating whether it’s imminent. Others confidently assert its already here. And after two and a half years of pandemic shocks, supply chain disruptions, and now inflation, another period of challenging financial conditions isn’t the news anyone wants to hear.

But what is a recession, exactly? The National Bureau of Economic Research, founded in 1920, is a private non-profit in charge of defining exactly what that is. When you see recessions indicated on GDP charts? That’s who decides where those go.

 

FRED chart showing U.S. recessions since 1920

But how do they reach those conclusions, exactly? And more importantly: What does that mean for all of us with jobs, retirement accounts, and financial plans?

To answer these questions, we once again turn to EdgeRock Portfolio Manager, Rob Foss.

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Rob, let’s talk recession. For most of us, it’s something you feel through declining stock values, and then one day it’s announced in the news. Tell us: What exactly is a recession? And are we in one now?

The short explanation? A recession is a lack of economic growth. The NBER has many indicators that they use as a gauge, including, but not limited to, output, employment, and manufacturing activity. However, they also have a very simple definition which essentially amounts to, “a significant decline in economic activity that is widespread across the economy and lasts more than a few months.” (National Bureau of Economic Research, 2022)

As for whether we are in one now? It is certainly possible, but you never know until you are already in one or coming out of one. Economic conditions have tightened considerably, as evidenced by the widespread increases in interest rates and slowing growth metrics. The Federal Reserve of Atlanta currently estimates that 2nd quarter GDP will be -1.2% (Federal Reserve Bank of Atlanta, 2022). If correct, this represents a 2.8% decline from the first quarter, and I think the current economic environment could officially be called as a recession.

Many people have pointed to the strength of the labor market as an indication of not being anywhere close to being in an economic downturn. Unfortunately, employment is a bit of a lagging indicator. The labor market does not need to weaken substantially (more than 1 or 2 percentage points) to aid a recession. The Wall Street Journal put out a great article a while ago that pointed out we’ve had jobless recoveries before so in theory we could have a recession with no change in unemployment (Hilsenrath, 2022).


Clearly not all recessions are the same. They’re caused by different factors and have varying effects. Can you help give us context for the current state of the economy?
 
Entering 2022, the U.S. economy was in pretty good shape but still recovering from the effects of COVID-19. Not only did we have loose monetary policy in the form of quantitative easing and low interest rates, but we had extraordinarily supportive fiscal policy via direct stimulus payments to individuals and businesses. The combination of the two accelerated demand which is part of the reason why inflation jumped significantly and remains high. I think this recession (if we are in one or entering one) is or will be caused by the textbook example of restrictive policy, which is defined by interest rates rising above growth levels. This is being done to lower inflation. Unfortunately, inflation is also being caused by lack of supply, which is due to the lingering effects of the pandemic and Russia’s invasion of Ukraine. Not much can be done about supply-side inflation at this point.


Recent Federal Reserve actions are clearly having an effect. After raising interest rates 0.75 percent during their June meeting (the largest such increase in 28 years), a number of upward inflationary trends seemed to get halted in their tracks. Was this as big of a shock to markets as we’ve been reading? Are further drastic measures necessary to stamp out inflation? What are our chances for a “soft landing”?

With yesterday’s CPI reading, it appears that inflation is still rising but I do believe most economists when they say that price pressures could subside in the coming months. For example, commodity prices have come down dramatically and inventories have risen. The FED has done a good job at communicating what they plan to do (tighten and continue to tighten economic conditions). This was well-interpreted by the financial markets, which is why risk assets had a very weak first half of the year. This sell-off was, and is, orderly because financial markets are still functioning well. With the benefit of hindsight, I would not characterize anything as a complete shock. Other than continually raising the FED funds rate and running off the balance sheet, there is not much else the FED can do to combat inflation. It is also important to keep in mind the FED can only affect demand and not supply.

I think the definition of “soft landing” is starting to change a little bit much akin to “transitory” circa 2021. There is no question that economic activity will slow, but the big unknown is, how much it will slow and when it will turn around? Unfortunately, recessions are inevitable and are part of the economic cycle. The earnings reports for the second quarter should shed a lot of light the overall health of businesses and consumers.

Here is the silver lining: People need to keep in mind financial markets are very forward-looking. In previous recessions, say pre-2000s—but I am guessing here—bear markets came after, or in conjunction, with recessions. Now, since contemporaneous data is widely available, we are in a trend where the opposite seems to be true. Bear markets come before a recession is officially called. I think it could be argued that a mild recession is at least partially priced into today’s valuations.



Another interesting economic condition at the moment is the strength of the U.S. dollar. As of this writing, it’s currently at parity with the Euro for the first time in twenty years. What is causing this phenomenon and what does this mean for American businesses and markets?

 

The economic outlook for much of Europe is very poor and might even get worse. The U.S. is still viewed as a bit of a haven, so you have individuals and institutions selling the EURO and buying U.S. dollars. This can be explained mathematically as a function of inflation and interest rates, but those relationships don’t always hold.

A strong dollar is great for importers but not very good for exporters. Any person or business buying in USD should be fine going forward, but those selling products priced in USD (think commodities) are facing a bit of headwind.



And finally, let’s get specific: How do all these factors affect investors and retirees? We’ve seen the major indices in steady decline since the start of the year. Should we expect more of the same in the coming months? And how do you positioning EdgeRock portfolios to address these conditions?

Not only do fundamentals matter for investing, but fundamentals also matter for financial planning. Contractions and bear markets are part of the market cycle. Before making any serious moves with money, I always ask clients to review the fundamentals of their Summit Plan. At EdgeRock, our plans are designed around client objectives and goals. This translates into items such as risk capacity, risk tolerance, time horizon, and income planning. If goals and objectives have not changed since last year, there is no reason to make large adjustments to investment allocations. However, whenever circumstances that pertain to goals and objectives change, whether in bear markets or bull markets, allocation changes should be made.

Financial markets are inherently volatile and the future is unknowable. In the second half of the year, markets can go down, go up, or stay flat. Our tactical strategies are currently positioned with these three possible outcomes in mind.

 


References

Federal Reserve Bank of Atlanta. (2022, July 13). GDP Now. Retrieved from Federal Reserve Bank of Atlanta: https://www.atlantafed.org/cqer/research/gdpnow

Hilsenrath, J. (2022, July 4). The Wall Street Journal. Retrieved from If the U.S. is in a recession, It’s a very strange one: https://www.wsj.com/articles/recession-economy-unemployment-jobs-11656947596

National Bureau of Economic Research. (2022, July 13). Business Cycle Dating. Retrieved from NBER – National Bureu of Economic Research: https://www.nber.org/research/business-cycle-dating

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