The R Word

Stock market declines are nearing bear market levels. Does that mean we’re headed for recession? It depends where you look.

The market selloff this year has understandably caused significant consternation among market participants and the populous overall. Stock price declines often precede recessions, and that’s why equity returns are included in the Conference Board’s index of Leading Economic Indicators. On the other hand, equity drops don’t necessarily cause recessions, and this selloff has been driven entirely by valuation compression. Consensus analyst estimates of forward 12-month revenues and earnings have climbed steadily higher to start the year. If a recession is on the horizon, you can’t see it here.

The price the market is willing to pay for those earnings, though, has fallen from a historically elevated level of 21x to a more reasonable 17x this year. It could be because investors don’t have confidence in consensus outlooks for growth. Or it could simply be that valuations are reverting to pre-COVID levels now that the pandemic is largely in the rearview mirror.

At the same time, interest rate spreads are signaling concern in the fixed income markets. The 2s10s curve inverted earlier this year, a signal that has reliably preceded recessions (albeit by varying intervals) over the last 40 years.

The difference between rates on High Yield bonds and U.S. Treasuries has jumped more than 2% this year. Historically, spiking credit spreads have coincided with weakening expectations for economic activity. Often, recessions follow.

The bearish action in risk appetite is reflective of deteriorating consumer sentiment. The University of Michigan’s Consumer Sentiment survey is the lowest it’s been since 2011 and at a level you generally only see during recessions.

People simply aren’t happy, and inflation is largely to blame.

To deal with rising prices, Federal Reserve leadership is set on tightening monetary policy for the remainder of this year. The consensus view for voting members seems to be for 50 basis point hikes at each FOMC meeting until interest rates reach neutral. In addition, balance sheet runoff is set to begin next month. The Fed has a history of tightening financial conditions until something breaks, yet most officials are confident they can cool inflation and push it towards their 2% annual target without causing an economic downturn, engineering a ‘soft landing’ similar to what was achieved in the mid-1990s. They point to continued strength of the labor market as justification for their optimism. Unemployment is still near all-time low levels at 3.6%, and jobless claims aren’t increasing either, which tends to happen before the U-3 rate starts to rise. We’ve never seen a recession that didn’t include job losses.

The National Bureau of Economic Research is the official arbiter of recessions in the United States, but two consecutive quarterly declines in Gross Domestic Product is the general rule of thumb for those of us who aren’t PhD-trained economists. After the first estimate of first quarter GDP came in below zero, we’re halfway there. Negative GDP prints are never good, but there’s reason to believe this one isn’t quite as bad as it looks. Net exports alone were a 3.20% drag on the quarter. Meanwhile, the Personal Consumption and Fixed Investment components of the number were still pretty good. For now, having a job and being on the receiving end of elevated wage growth, coupled with pent up savings from pandemic-era stimulus payments, still outweighs the negative impacts of weak sentiment and high inflation.

Recessionary winds are blowing. Markets are selling off, people are unhappy, the yield curve inverted, credit spreads are widening and GDP growth is negative. But traditional hallmarks of a recession are still absent. The labor market is strong, earnings estimates are rising, and consumers are still spending money. Something’s got to give.

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