As a rule of thumb, contraction in Gross Domestic Product (GDP) for two consecutive quarters is considered a recession. Officially, the NBER (National Bureau of Economic Research) is the authority that decides on dating business cycles. For NBER, apart from a mere contraction in GDP - a host of other parameters such as real income, employment, industrial production, and retail sales etc. are also factored in to determine if a period can be officially classified as a recession.
The above premise is necessary to appreciate the complicated environment currently faced by investors. The US GDP contracted for two consecutive quarters (-1.6% during the first quarter and -0.9% during the second quarter) meeting the technical definition of recession. However, the other conditions such as employment levels, retails sales etc., are too high to come to a such a conclusion. On the other hand, Canadian economy fared relatively better with 0.3% expansion in May as per Statistics Canada. During the second quarter earnings season so far, companies have fared better-than-expected in general but the forward guidance from Walmart, Target and Best Buy suggests consumers are beginning to hold back on purchases and inventories are rising.
Overall, the trajectory of economic data is indicating that economic activity is slowing down. We had argued in our previous updates that a little moderation in economic activity and levelling off or softening of inflation data are the necessary conditions for markets to react constructively as this would indicate Central Banks’ policy actions are yielding results and things are heading in the right direction. In the US, the headline inflation at +9.1% for the month of June (reported in July) was ahead of market expectations of +8.8% and +8.6% for the month of May. In Canada, the headline inflation at +8.1% was lower than market expectations of +8.4% and ahead of +7.7% for the month of May. Nevertheless, the equity markets in July traded on expectations that inflation has peaked and will begin to show signs of moderation in the coming months.
During the press conference after the FOMC (Federal Open Market Committee) meeting on July 27th, the US Fed Chair, Jerome Powell, mentioned that policy rates at about 2.5% (after the 75-basis points hike) are now at a level what the committee broadly considers as a ‘neutral rate’. Earlier, the Bank of Canada had raised policy rates by a full percentage point to 2.5%. A neutral rate is the policy rate that is neither too stimulative nor too restrictive for the economy. Expectations of peak inflation and the interpretation of Jerome Powell’s comments as the bulk of rate hikes are now behind us and the pace of future rate hikes might slow down if future economic data co-operates led to a positive reaction in the markets in July.
The recent market cheer is justified if future reports confirm that peak inflation is achieved as investors can begin to put the scare of runaway inflation behind them. That said, it would only be half the battle won as bringing inflation back to 2% target would become the next goal post. While central banks recognize that future rates hikes are going to be restrictive for the economy, as long as unemployment remains at historic lows, we believe the risk of a wage price spiral will keep central banks on a hiking path. With estimated about two job openings for every unemployed looking for work and labor force participation not increasing as expected, the risk remains elevated. In addition, the war in Ukraine, and the ongoing Covid-19 lockdowns in China adding to inflationary pressures from the supply side indicate it does not yet look like a cake walk from here. In other words, to break the back of inflation central banks might have no choice but to increase unemployment and reduce demand by inducing a recession.
The yield curves on both sides of the border have inverted (see chart 1) and historically inverted yield curves have been a harbinger of recession (see chart 2). This implies the resilience of corporate earnings could be put to a test in the coming quarters. Though the markets have already priced in a lot of bad news, the outlook suggests there are several reasons to stay cautious in the near-term. Long-term investors with risk appetite to withstand near-term volatility can go bargain hunting as many quality assets are now trading at cheap prices. However, investors with shorter time horizon and/or lower risk appetite would be well served by staying invested defensively until darker clouds clear the horizon.
Chart 1: Yields Curves: Beginning of the year and now
Chart 2: US Recession and yield spread between 2-year and 10-year treasury note
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