Fading Risks of a Recession

The North American equity markets continued to trade in a “Goldilocks” fashion during the month of July driven by economic data that supported “soft to no landing” narratives. The headline inflation rate in the US dropped to +3.0% (expected +3.1%) from +4.0% and in Canada fell to +2.8% (expected +3.0%) from +3.4%. The labour market stayed strong with unemployment rates in the US and Canada at +3.6% and +5.4%, respectively. Declining inflation and strong labour markets were consistent with improving consumer confidence readings on both sides of the border. The Conference Board’s Consumer Confidence Index for the US has been on the upside for past two consecutive months and the Nanos Economic Mood Index in Canada has been on a rise this year.

Resilient economic data put together with better-than-expected improvement in inflation numbers strengthened the case that perhaps the inflation problem can be solved without having to incur severe economic damage in the form of rising unemployment and GDP contraction. The annualized US GDP numbers for the second quarter were at +2.4%, ahead of expected +1.8%, and indicated acceleration from the +2.0% observed during the first quarter. The Canada GDP, on the other hand, showed deceleration during the second quarter (estimated at +1.2% annualized) after having registered annualized growth of +3.1% during 2023’s first quarter. In absence of any further deterioration, the Canada GDP appears on track to register annualized expected growth of ~+1.7%-1.8% for the year 2023. The Bank of Canada again started increasing interest rates with a +25 basis-points hike and the US Federal Reserve also delivered a +25 basis-points hike, citing persistently high core inflation numbers. Both the central banks indicated that future hikes will be contingent on the incoming data, keeping the flexibility on policy rates trajectory.

The above backdrop implies that the market should start to put more stock in the economic datapoints over the central banks’ language, given their emphasis on dependency on future datapoints. Therefore, indicators suggesting lower inflation and continued economic growth should be received favorably by the markets and vice versa. The growth in Canada appears to have slowed over the past couple of months and in the US appears to have picked up again after contracting for some time. The US ISM Manufacturing and Services PMIs (Purchasing Managers’ Index) – Business New Orders Indices, have both shown improvement in the recent past (See Figure 1). The ‘New Orders’ component typically leads the headline index suggesting improvement in the manufacturing activity ahead. A reading of above 50 indicates the activity is expected to expand and a reading of below 50 indicates the activity is expected to contract.

Figure 1: ISM Manufacturing and Services – Business New Orders Index

Source: Bloomberg

Given that the experienced economic slowdown is not as severe as one would have expected after a steep increase in interest rates and a deep inversion of the yield curve, the question now on investors mind is – does this means that the recession is cancelled, or has it not yet arrived because of the time lag in monetary policy action and its impact on economy? The authority on determining and declaring recessionary periods, NBER (National Bureau of Economic Research), looks at a variety of factors before declaring any period as a recessionary period. The most important factor is ‘significant decline in economic activity that is spread across the economy and lasts more than a few months’. Typically, it is safe to say that economy is in a recession if two consecutive quarters of negative GDP growth is observed.

In practice, the NBER typically classifies any period as a recession long after it has passed, therefore, indicators that suggest economy might be in a state of contraction/expansion are the only reliable inputs for investors to position themselves. Given that the most recent leading indicators suggest manufacturing sector might be turning around while services sector continues to hum along, the expectations of fading recession risks are not far-fetched, in our opinion. That said, we also think it is early to entirely dismiss the probability of the lagged effect of monetary tightening beginning to show on economic growth. Looking ahead, we stay cautiously optimistic with eyes on what the balance of incoming economic data is telling us.