Recession 2022 Odds!

Today I want to discuss the complicated and dreaded topic of the possibility of a looming recession and what some market indicators would be.

The topic of a looming recession has been thrown out every year since the last recession, in many different forms and fashions. It\’s no surprise that it is again in the headlines as a topic of discussion.

But how seriously should we take these recession warnings?

First, let\’s define what it is.

According to Merriam-Webster, a recession is \”the act or action of receding.\” But in terms of an economy, it simply means two consecutive periods (each period or quarter is three months) where economic activity drops.

This fear-inducing word might make you think of stagnant or declining wages, layoffs, unemployment, reduced economic activity, and foreclosures.

When looking at the official onset of a recession, we turn to NBER, which shows the business cycle. According to the National Bureau of Economic Research (NBER), \”The NBER\’s definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.

We treat the three criteria—depth, diffusion, and duration—as somewhat interchangeable in our interpretation of this definition. While each standard needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another.

For example, in the case of the February 2020 peak in economic activity, the committee concluded that the subsequent drop in activity had been so great and so widely diffused throughout the economy that, even if it proved to be quite brief, the downturn should be classified as a recession.\”

They also state, \”The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production.\”

In layman\’s terms, the drop in economic activity is according to real GDP or gross domestic product, income, employment, manufacturing, and retail sales according to the Balance.

The NBER retroactively looks at economic activity, so a recession won\’t be announced until there are two quarters with the data confirming it.

Therefore, you won\’t know that you\’re officially in a recession until around six months later, although you will feel the effects sooner.

The Last Recession

Looking back briefly at the last recession, According to The Balance, \”The U.S. economy contracted 5% in the first quarter of 2020, then contracted a record 31.4% in the second quarter. The economy grew 33.4% in the third quarter, but it was not enough to make up for earlier losses. In the fourth quarter, it grew just 4%.\”

These two quarters would point to a recession, but in this specific case it was a government-induced recession due to the stay-at-home orders, non-essential business shut-downs, and resulting negative effect on GDP.

According to Forbes, \”The business cycle describes the way an economy alternates between periods of expansion and recessions. As an economic expansion begins, the economy sees healthy, sustainable growth. Over time, lenders make it easier and less expensive to borrow money, encouraging consumers and businesses to load up on debt. Irrational exuberance starts to overtake asset prices.\”

Forbes also mentions, \”As the economic expansion ages, asset values rise more rapidly and debt loads become larger. At a certain point in the cycle, one of the phenomena from the list above derails economic expansion. The shock bursts asset bubbles, crashes the stock market, and makes those large debt loads too expensive to maintain. As a result, growth contracts and the economy enters recession.\”

Sound a little too familiar? We have enjoyed a long period with cheap money and spurring extended economic growth, which has led to euphoric-esq asset valuations across the board.

Forbes explains the predictions related to a coming recession which included an inverted yield curve, declines in consumer confidence, decline in the Leading Economic Index (LEI), sudden stock market declines, and rising unemployment. We will cover each of these five aspects shortly.

General

I think it\’s essential to get an idea of the general reference points related to the economic cycle before jumping into the specific data.

According to Goldman Sachs, \”Traditional market indicators of recession risk are sending conflicting messages. Models based on the slope of the yield curve imply recession odds of 20-35% over the next year, above the 15% unconditional historical odds of a recession in any four-quarter period.\”

More specifically, Jan Hatzius of Goldman Sachs stated, \”Hatzius, for his part, argues that the risk of a recession over the next one to two years has increased as the Fed is set to deliver contractionary shocks to an economy that was already likely to disappoint even before the growth-negative geopolitical conflict began.\”

According to an Insider article, \”As the Federal Reserve prepares to kick off a series of interest rate hikes Wednesday, its current policy roadmap will steer the US into stagflation and a major recession, according to former US Secretary of the Treasury, Larry Summers.\”

The article also mentions, \”Summers, who is currently the President Emeritus of Harvard University and previously led President Barack Obama\’s National Economic Council, noted that a recession often follows conditions of high inflation and low unemployment.\”

In an MSN article referencing David Rosenberg of Rosenberg Research & Associates, Inc., \”is convinced that the Fed will beat inflation so hard that the U.S. economy will slide into recession as early as this summer.\” He also states, \”Relative to overall inflation, housing is overvalued by 35%, and 27% relative to wages. Home prices relative to residential rents are 25% overvalued by the standards of the past. A single-family home now absorbs more than eight years of Americans\’ personal income, which is almost 50% higher than the average going back to 1968. In a normal market it takes five years of income to buy a single-family home. Housing, like equities, a long-duration asset and benefitting from years of accommodative monetary policy, is again ensnared in a mess of a price bubble. The price-to-income multiple is just about where it was in 2006 and 2007.\”

He further recommends, \”As we head into the recession, you want to have a cash reserve. The notion that cash is trash gets trashed. Cash will provide you with resources to buy assets that are deflating and will deflate further.\”

It is also mentioned, \”We\’re already in a recession when it comes to real wages. Real average weekly earnings have been negative now for five months in a row, and six of the past seven. There\’s over a 90% correlation between real spending and real incomes, and just a lag of a few months that separate the two…That would put a recession starting sometime this summer — as early as June and as late as August. It\’s going to be either a second-quarter or early third-quarter event.\”

Now all of these positions vary from cautiously bearish to full-on bearish based on the direction we are headed economically. Nonetheless, it\’s crucial to look at different opinions related to the data.

Inverted Bond-Yield Curve

The bond-yield inverse compares short-term bond returns to long-term returns. There is fear of the short-term and increased related risk than the long-term with an inverse between the two. This points to the volatility of the short-term.

The Corporate Finance Institute referenced that \”…the Treasury yield curve inverted in the 18 months preceding the last seven financial crises in the U.S.\”

According to Barron\’s, they referred to 8 to 19 months following the yield curve inverting.

If you look at the Federal Reserve Bank of St. Louis, we are chasing down the yield between the 10-Year Treasury and 2-Year with just 17 basis points before it\’s in negative territory. The last time this occurred was August of 2019, and before that, it was December of 2005. The recession did not officially start until December 2007.

Consumer Confidence

When looking at consumer confidence according to OECD data, it currently sits at 98.5. This represents that future sentiment on aspects like the economy, unemployment, and savings are showing slightly higher pessimism by consumers than the index average of 100.

Looking at the second data set by The Conference Board, Consumer Confidence is hovering above the 100 at 110.5, but it continues to decline. Both surveys show an overall decline in consumer sentiment, indicating that consumers may become more cautious with spending and become pessimistic toward a self-fulfilling prophecy.

The Leading Economic Index

According to The Conference Board statistics on LEI, the most recent reported data shows that \”The Conference Board Leading Economic Index® (LEI) for the U.S. increased by 0.3 percent in February to 119.9 (2016 = 100), following a 0.5 percent decrease in January and a 0.8 percent increase in December.\” The Leading Economic Index® tells us the average weekly hours, manufacturing, and initial claims for unemployment insurance, manufacturers\’ new orders, consumer goods, and materials ISM® Index of New Orders. They further communicate that this does not fully factor in the impact of the Russian-Ukraine invasion, which most likely will negatively affect LEI.

Real Gross Domestic Product or (Real GDP)

Although not outlined by Forbes, GDP is also an important indicator of future economic activity, although a lag indicator. When looking at data in real-time, you will also want to track GDP, as outlined by the IHS Markit data.

The Conference Board shows the correlation of LEI to GDP, which tracks closely.

\”IHS Markit\’s index of Monthly US GDP (MGDP) is a monthly indicator of real aggregate output that is conceptually consistent with real Gross Domestic Product (GDP) in the National Income and Product Accounts.\”

According to the IHS Markit data, we saw a monthly GDP decrease in February, July, and November last year. Now, these were individual months, so looking at this one indicator, it\’s essential to look at the trends concerning consecutive drops in GDP.

Stock Market Volatility

It\’s no secret that the stock market has been quite volatile going into the new year. The Dow Jones Industrial Average is off its January 4th high of 36,799.65 to a low of 32,632.64 on March 8th of over 11%. As for the S&P 500, January 3rd had a high of 4,796.56 and hit a low of 4,170.70 on March 8th–over 13%. Both have since shown some signs of a return in momentum, but only time will tell.

Unemployment

The mixed message we currently have is around jobs and unemployment.

According to the Bureau of Labor Statistics, the U.S. added 678,000 jobs in February while the unemployment rate decreased to 3.8%. We have a tight labor force that has been even more impacted by people not returning to work after the government stimulus and concerns around their health and those who returned to work only to join the great resignation.

Summary

Beyond these five indicators of the inverted yield curve, consumer confidence declines, the Leading Economic Index (LEI), sudden stock market declines, and rising unemployment, it\’s important to look holistically at the market and whether there is greater upside reward or low risk.

This has been a longer blog, but I wanted to provide some data on what indicators to watch and where we are.

Currently, we see excessive debt on both the consumer and business side of the equation, a so-called everything bubble. In contrast, asset prices have surged to unprecedented levels, sharply raising fuel costs and causing the increase in the cost of everyday living, and a runaway inflation sitting at 7.8% year-over-year, as of last week\’s report, which is no longer being deemed transitory. We also see how the Fed is counteracting this by raising interest rates, which they did this week at 25 basis points.

According to the Federal Reserve Bank of St. Louis, personal savings rates were 8.3% in February 2020, peaked at 33.8% in April 2020, and declined to 6.4%, below the February 2020 figure. This rate may sound especially low now, but it\’s 3X that of July 2005\’s when it hit 2.1%. Time will only tell how far the Fed will go to shore up inflation and at what cost it will slow growth and reverse course.

In the meantime, it\’s essential to look at the data and take a position that includes some buffer for contingencies if things don\’t go the way you anticipate.

Have a question? Our team would love to help! Send us an email.

Additional Resources Referenced

Personal Saving Rate (PSAVERT) | FRED | St. Louis Fed

When Is the Next Recession Coming? Here\’s How to Time It | Barron\’s

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity (T10Y2Y) | FRED

Forecasters see growing chance of a recession as Fed hikes rates this year to fight inflation

US Consumer Confidence

The Conference Board LEI for the United States

US Conference Board Leading Economic Index vs. GDP | MacroMicro

The Employment Situation – February 2022