The Uneven Path Forward

After a strong start to 2023, equity markets moved lower in mid-March amid banking stress with the failures of Silicon Valley and Signature banks, coupled with the eventual arranged sale of Credit Suisse to UBS Group. However, the corresponding decline in interest rates (with yield on the two-year falling from 5.04 percent to 3.7 percent), spurred by decreasing fears of additional rate hikes by the Federal Reserve (Fed), provided a tailwind for a narrow group of mostly tech stocks as we moved through the first half of Q2 2023. As we approached the quarter’s end, the rally broadened to include other industries and sectors as the Fed paused its aggressive rate hike campaign at its June 14 meeting. In essence, it appears previously pessimistic investors are applauding a U.S. economy that appears to have weathered the brunt of Fed rate hikes that have helped pull inflation lower without causing a full-bore U.S. economic recession. The newfound optimism was reflected in the American Association of Individual Investors (AAII) sentiment survey. After spending 74 straight weeks below the long-term average of 37 percent of respondents reporting bullish views on the direction of the market during the next six months, the survey saw a surge in optimism during first week of June. The upbeat outlook helped propel broader equity markets higher, despite interest rates rising back toward pre-banking-crisis highs.  

It appears as if re-energized investors have returned to the old favorites, they abandoned in 2022 with hopes of better future outcomes (something we believe is unlikely).

The technology-heavy Nasdaq Composite Index led the market advance with a 13.05 percent return for the quarter, thus pushing its year-to-date return to an astounding 33 percent gain. Many of the largest companies in the Nasdaq are also heavily weighted in the S&P 500 index, which posted a strong 8.74 percent return during the period and is now up nearly 17 percent year to date. While the advance broadened toward the end of the quarter to include more stocks, the reality remains that the largest names have done the heavy lifting. Consider that the top 50 market capitalization-weighted names in the S&P 500 are up 27.6 percent year to date versus an equally weighted S&P 500, which is up a “meager” 7.02 percent. 

Breaking the same index into sectors underscores the narrowness of the rally, with nearly all of the year-to-date returns primarily in three of the 11 sectors that make up the S&P 500: technology up 43 percent, communication services up 36 percent and consumer discretionary up 33 percent. The performance marks a sharp reversal of 2022, when the Nasdaq was the worst performing of the major U.S. indices and the three sectors were in the performance cellar. It appears as if re-energized investors have returned to the old favorites, they abandoned in 2022 with hopes of better future outcomes (something we believe is unlikely).  

Indeed, while the expected arrival of a recession seems to be continually pushed out into the future, we still believe an overall contraction of the U.S. economy remains likely. Additionally, we believe the parts of the market that have seen the strongest performance of late remain expensive relative to other domestic equities, which have already seen their forecasted earnings revised downward. These earnings revisions, in our view, should help cushion any further impact of earnings declines. Consider that the S&P 500 trades at 20 times forward 12-month earnings, while the 50 largest names by market cap trade at nearly 24 times. Contrast this with the S&P Mid-Cap 400 stock index, which is trading at a below-average 14.4 times already reduced forward 12-month earnings expectations. Similarly, the S&P 600 Small Cap index trades at a below-average 14 times forward 12-month earnings, despite earnings expectations already having been reduced by 16 percent.  

While we continue to believe a recession will act as a wet blanket on equity returns in the second half of 2023 and into early 2024, the silver linings remain that 1) we believe it will be mild, 2) the aforementioned parts of the market remain cheap, and 3) a basket of high-quality U.S. investment-grade bonds, which yielded 4.81 percent at quarter end, offers real value and a likely hedge against potential future equity market weakness.  

Inflation continues to falter and is a “shelter” problem  

While the Fed’s 15-month rate hike campaign that has driven short rates to above 5 percent has not yet pushed the overall U.S. economy into a recession, it has pulled inflation lower (albeit we believe that the U.S. economy’s return to normal following COVID has done much of the heavy lifting). The May Consumer Price Index (CPI) report showed all-in U.S. inflation at 4 percent year over year, down from the 5 percent level at the beginning of the quarter and well off the June 2022 peak of 9.1 percent. Simply put, as spending has shifted from goods to services as the economy reopened post-COVID, inflation pressures have followed. The May report showed goods inflation back to a normal 2 percent (down from 12.3 percent year over year in February 2022), while services inflation checked in at a still elevated 6.6 percent.  

However, it’s important to recall that shelter prices (home prices) make up 59 percent of services inflation and enter the CPI calculation with a more than 12-month lag. We again note that U.S. home prices peaked last June and have been flat to slightly down since. Put differently, shelter prices still reflect the state of the housing market prior to its price peak in June, and the next few months will see that calculus change. The results will be downward pressure on CPI in the coming months.  

For example, services inflation is running at 6.6 percent year over year, but when shelter is removed from the equation, the rate drops to 4.2 percent year over year and the trajectory points lower. The six-month annualized pace is up a more “normal” 2.3 percent, while the past four months have seen this number flatline. While many, including some members of the Fed, acknowledge the distorting impact of lagging shelter prices, the retort that often follows is that core inflation, which excludes volatile food and energy prices, remains elevated and “sticky” at 5.3 percent year over year, which is off its September 2022 peak of 6.6 percent. Once again, though, we note that this has a lot to do with shelter, which makes up 43 percent of the core inflation reading. Applying the same math here shows that core inflation excluding shelter is up a more modest 3.4 percent year over year and during the past nine months is up an annualized rate of 2.8 percent.  

Pulling the above-mentioned pieces together, we’d note that if you run the calculation using only current price indicators (i.e., goods, services and commodities), and exclude lagging shelter, the headline prices are up just 2.1 percent year over year. Simply put, over the past year inflation above 2 percent has been a “shelter” problem in aggregate. This is set to fall as the elevated readings recorded in June 2022 roll off from the year-over-year calculation. And while it appears that home prices have stabilized recently, it’s important to note that inflation is a year-over-year calculation and that still high interest rates and lack of affordability are likely to keep a cap on home price appreciation into the future.  

This is not to suggest there still aren’t other hot spots for inflation to rear its ugly head, but when taken in totality, we believe inflation is moderating. To this point, our discussion has focused on year-over-year inflation readings and the impact we expect from the elevated numbers of June 2022 rolling off the 12-month calculation. However, another way to measure inflation is based on month-over-month readings that exclude outliers when evaluating the overall picture. The Federal Reserve Bank of Cleveland calculates this monthly rate in its 16 Percent Trimmed Mean CPI report. The good news found in the report is that over the past few months that reading is moving back toward its historical range with two of the last three readings coming in at a historically normal rate of 2.8 percent annualized, which is down sharply from the 5 to 9 percent range of the prior 18 months.  

A multi-speed but slowing U.S. economy 

The U.S. economy continues to be kept out of a recession by the services side of the economy, which continues to benefit from consumers who are still flush with cash and who have spent much of the past 15 months shifting their spending habits back toward service-sector consumption from goods.  

During the past eight months, the Institute for Supply Managements (ISM) Manufacturing Index has languished in contractionary territory (below 50), with the June report checking in at 46, the lowest level since May 2020 and before that May 2009 when the U.S. economy was climbing out of the Great Recession of December 2007 to June 2009. Think of this index as representing the goods side of the U.S. economy. This weakness is further highlighted by the fact that manufacturing production in the U.S. has been negative on year-over-year basis for the last three months, a condition that has happened roughly 11 other times since 1960. In all but three of those occasions the country has been in or was headed toward a recession; the exceptions were 1967, when industrial production turned negative for one brief month; again in 2015–16 during the “mini” industrial recession; and again in 2019 during the trade war. While 2019 ultimately gave way to a recession, we consider that to be caused by COVID. The reality is that in the last two instances, the service sector kept the U.S. economy afloat much as it is doing today. The difference between then and now, however, is that in the last two instances the Fed was not raising rates aggressively as it tried to remove liquidity from the U.S. economy to stem inflation.  

While services have remained strong, they have shown signs of weakening. During the quarter the ISM Services index moved toward contraction with readings of 51.9 and 50.3 in April and May, only to pop back to a stronger 53.9 in June. We continue to believe the delayed impact of previous Fed rate hikes and quantitative tightening, coupled with tightened bank lending, will eventually push the services sector and overall economy into a recession. Further, while the federal debt ceiling debate was resolved during the second quarter with limited drama, we believe the resolution marked the beginning of future debt debates and tightening fiscal policy that will bring down fiscal spending. Consider that not only has our debt risen dramatically, but so, too, have interest costs, something that we believe will result in more money going to pay interest costs and fewer dollars for government programs.  

The result of all these Fed actions has been a contraction of the U.S. M2 money supply (or liquidity in the economy) by 4 percent over the past year, which is only the fourth time since 1900 in which the money supply has contracted on a year-over-year basis. The other three times were 1921, 1930–33 and 1958, with the connection between them being that each were concurrent or led to a recession.  

We should reinforce what we believe is the silver lining of this growth slowdown—the end of any simmering inflationary pressures. Each of the aforementioned ISM indices also has price sub-component measurements that have a historical correlation with future inflation, and each continues to point to inflation pushing back toward 2 percent. The manufacturing prices paid was at 92.1 in June of 2021 and 87.1 as recently as March 2022. This number today resides at a disinflationary reading of 41.3. Similarly, services peaked at an all-time high of 84.5 at the end of 2021 and 83.2 in April 2022. In June 2023 this measure checked in at historically normal reading of 54.1. When we combine these two in a manner that reflects the U.S. economy, the current reading suggests that inflation is likely to further push toward the Fed’s 2 percent target in the coming quarters.  

The last but most important inflation indicator for the Fed

Most importantly, members of the Fed worry that wages remain elevated, which could result in inflation moving higher going forward.

Every inflation number mentioned to this point, apart from shelter, provides a picture of inflation in its current state. As we have noted, the good news is that it is subsiding, and we believe most Fed members see the same thing; however, they want to make sure price pressures are fully extinguished to prevent any remaining embers from reigniting. Most importantly, members of the Fed worry that wages remain elevated, which could result in inflation moving higher going forward. As we’ve noted in the past, the Fed is afraid of a repeat of the period of sustained high inflation that occurred from 1966–1982, a period that they characterize as driven by a wage-price spiral in which rising wages were used to pay ever-rising prices and resulted in sticky inflation embedded in the economy. A return to the dynamic of the 1970s and early ’80s is the paramount concern and why they are intently focused on the tight labor market, which they view as the final front in the battle against rising prices.  

As the above chart reveals, wage increases for non-supervisory and production workers started 1966 at 3.9 percent and continued to rise for the next 16 years to a peak of 9.4 percent by early 1981, even as the U.S. economy experienced three recessions. Since then, over the past three recessions (not including COVID), wage increases peaked in the range of 4–4.3 percent annualized. This peak is not arbitrary. Rather, it is the result of the Fed raising rates each time wage growth approached 4 percent on a year-over-year basis. The Fed views the 4 percent level as significant because it the sum of the historical average 2 percent growth in worker productivity (worker output per hour) and the 2 percent in annual wage increases the Fed believes the economy can absorb without sparking an economically damaging rise in inflation.  

This is why the Fed remains concerned about a tight labor market and wants to see the employment picture weaken. Put simply, if demand for workers is greater than supply, then companies will be forced to pay higher wages to attract and retain workers. The higher wages could then be used to pay ever-rising prices, and the risk of inflation becoming embedded in the economy would grow.  

The good news is that wage increases have declined from a peak of 7 percent recorded in March 2022. The bad news is that by this measure they remain at 4.7 percent year over year, as labor demand has remained strong. This strong demand is coming against declining labor market supply. While the Fed paused rate hikes in June, it is likely to continue tightening, albeit at a more measured pace, until members of the Fed see job demand decline and/or wage growth subside to well below 4 percent.  

Certainly, we have seen workers return, but it appears the easy lifting has been done.

The one avenue we see leading to a potential soft landing is if equilibrium between supply and demand were regained through a return of workers who bowed out of the workforce during COVID and have sat on the sidelines ever since. Consider that the current labor force participation rate today is 62.6 percent—down from its pre-COVID level of 63.3 percent. If participation were to return to 63.3 percent, it would translate to an additional 2 million people reentering the labor market. This influx could fill open positions and keep wage pressures at bay, which would likely keep the Fed from raising rates and perhaps keep the U.S. economy out of a recession.  

Certainly, we have seen workers return, but it appears the easy lifting has been done. The largest cohort of workers (those aged 25–54) have returned, and the participation rate for the group is now 83.5 percent—above the pre-COVID high of 83.1 in late 2019 and early 2020 and now at the highest level since the end of May 2002. Only one time in history has the participation rate for this group been above 84 percent—during the strong job market from 1996–2001. The bulk of the roughly 2 million workers who have not returned to the workforce comes from the pool of individuals 55 years and older. In this group, the participation rate is currently at 38.3 percent compared to 40.5 percent pre-COVID. Will these workers come back, or are they permanently retired?  

There is certainly a potential for these individuals to come off the sidelines as well as room for others to rejoin the ranks of workers. However, the imbalance of available workers and open positions is reaching levels that haven’t been seen in years, all against a backdrop of an aging society. Productivity gains (such as those anticipated from the much-hyped advancements in artificial intelligence) can help, but the reality is that even if we avoid a recession in the coming quarters, one is still likely in the near future given the current realities of low labor market slack.  

Have we already had a recession? 

The past three years have been anything but normal as far as the economy goes. Beginning with the shuttering of the economy and the loss of 16 million jobs and continuing to the subsequent reopening that saw consumer spending shift dramatically from services to goods and now back to services, nearly everything about the past three-plus years has been almost unheard of. Add in the historic fiscal and monetary stimulus unleashed at the beginning of the global pandemic and now the rapid draining of that excess liquidity, and it all ends up in an unprecedented level of economic upheaval.  

The reality is that economic forecasting is never easy, but it’s certainly been even more complicated over the past few years as new variables have entered the fray. We have been on the forefront of the concept of rolling recessions due to the asynchronous closing and reopening of the economy and continue to believe that this phenomenon will dampen the impact of any potential recession.  

These rolling recessions have forced us to consider the question of whether we will look back one day and find out whether the U.S. has already had a recession or perhaps is in one now. While economists analyze the U.S. economy in many ways, the reality is that the various measures generally feed into the calculation of one number, gross domestic product (GDP). And this is where over the past few quarters we have witnessed economic growth that leads many to use the phrase “slowing but resilient” when describing the U.S. economy. Consider that GDP growth registered at 3.2 percent in Q3 2022 quarter over quarter on a seasonally adjusted annual rate, and Q4 2022 GDP came in at 2.6 percent, followed by 2.0 percent in the first quarter of 2023. Contrast that with the negative 1.6 percent GDP growth in Q1 2022 and the 0.6 percent decline in Q2 2022, and you get a sense of how volatile and contradictory growth data has been.  

However, there is another overall measure of economic growth calculated by the Bureau of Economic Analysis that economists use: gross domestic income (GDI), which measures U.S. economic activity based on incomes. In theory, GDI should equal GDP. Over intermediate to longer periods of time these two tend to equal out, albeit with some deviations in between. Over the past few quarters these deviations have been historically large.  

While GDP over the last two quarters has shown an annualized growth of 2.3 percent, GDI has actually been negative in both quarters at an annualized pace of negative 2.6 percent. Simply put, going back to 1947, every time GDI has been negative for two quarters at the magnitude seen during the last two quarters, the economy has had a recession. The current divergence between GDP and GDI marks the largest quarterly gap between the two measures since the data was first recorded in late 1947. This is likely due to the difficulty of measuring a rapidly evolving and COVID-influenced U.S. economy in real time.  

Given the size of the discrepancy between the two, it may be enlightening to average each reading. Doing so based on the annualized rate from the two most recent quarters yields a growth rate of -0.14 percent, which marks the second two-quarter decline in the current business cycle (with the other being the two quarters ended June 30, 2022). For historical context, going back to 1947, every other time the GDI and GDP average has been negative (12 occurrences), the economy has been in recession. Any other way you slice this data the narrative remains the same.  

The one retort many give to this commentary is that the labor market has remained strong. For the most part, we agree and note that perhaps companies are attempting to hoard labor since it has been so hard to find. However, recall the de-synchronized cycle we’ve seen and the reality that the jobs market is a lagging indicator and is often the last to succumb. We also note that different measures of the labor market that generally even out over intermediate to longer time periods have likewise given different answers to overall strength last year. The establishment or Nonfarm Payroll report from the Bureau of Labor Statistics (BLS), which gets most of the financial media’s attention, has shown a consistently strong labor market. However, the Household report, also from the BLS, has often painted a different picture over the past 15 months. For example, the Nonfarm Payroll showed job gains of 2.8 million between March 2022 and November 2022, while the Household report showed just 199,000 total added during that time period—a discrepancy of more than 2.6 million.  

We also note that initial and continuing jobless claims have ticked higher since September of last year. While the narrative is that these are not large increases, we believe a look at history suggests that prior to recession they don’t appear all that large. Indeed, when measured from their lows of the economic cycle to the recession start date, the four-week rolling average of initial jobless claims in the past seven recessions have risen between 15 and 43 percent, with the five recessions between the highs and lows of the range averaging around 20 percent. It’s worth noting that from the low of this post-COVID cycle set the week of Sept 23, 2022, initial jobless claims have risen by 33 percent, more than all but the recession of 2001, when the four-week average rose by 43 percent before a recession was declared. Similarly, those filing for continuing claims peaked at 44 percent in April 2023 and remain 33 percent higher than at its Sept. 9, 2023, low, which eclipses all prior seven bottom to recession start date occurrences.  

The bottom line 

The recession discussion in the previous paragraphs provides not only context of our rolling recessions concept but also raises the question of exactly what a recession is and when will we know if we are in or have been in one. This is also important from a market perspective since the market has historically bottomed during eight of the past nine recessions (the one exception being 2001, when it bottomed in October 2002, after the recession ended in November 2001). We believe the late bottoming may have been influenced by the Iraq war at the time.  

We note the historical relationship between market bottoms and recessions because there appears to be an ongoing fear that once a recession is declared, the markets are likely to make new lows. Perhaps—but maybe we have already had a recession, and maybe the low of the market reached in early October corresponded with a recession. Maybe the current situation is reminiscent of the period from 1966 to 1982: When inflation peaked, the market bottomed (the difference being that back then, it took recessions to put a stop to rising CPI).  

The good news remains that there are cheaper parts of the market that we believe are positioned for intermediate-term strength. Contemplate that if the recession is mild, it is reasonable to believe the economic and market impact could also be muted. Further consider that during the duration of five of the last 11 recessions the market posted positive returns during the recession and that in 10 of the last 11 recessions the market was positive one year after the recession ended, with an average return of 20 percent. Lastly, investment-grade bonds today yield close to 5 percent, a level that we believe provides real return opportunities as inflation heads lower and a likely hedge against potential equity downside. Stick to your plan, stay invested, and this time will pass—just like all the others.  

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here. 

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