Seems Like Old Times
There are those saying that a recession is imminent and there are those saying that the economy is booming. Both are wrong. Whenever you hear gloom-and-doom or euphoric commentary, beware. We're currently experiencing a phenomenon that most investors and most money managers have not experienced before.
The last time inflation and interest rates were rising in the same manner was at least 40 years ago. The latest market commentary reminds me of the Neil Simon classic movie, "Seems Like Old Times." In the movie version, Chevy Chase plays a writer who finds himself in the wrong place at the wrong time and needs his ex-wife's help, played by Goldie Hawn. During the course of the movie, he becomes convinced he's still in love with with his ex-wife and that she's still in love with him, despite the fact that she's married and has moved on. In the end, she realizes she loves her current husband, played by Charles Grodin, and needs to let go of her former husband. That's similar to where we are now in the current economic cycle - it sure seems like old times, or does it?
The Recession Is Imminent Crowd. This group of prognosticators / economists are shouting from the mountain top that a recession is due any day now. Among many in this group are the perennial Bears that always seem to find something wrong, even with good economic numbers. The flaws in this gloom-and-doom commentary are that some of the key elements of a recession are not yet evident in the economic data. For example, this yesterday's report on 1st quarter GDP is being reported as the first quarter of negative GDP since the 3rd quarter of 2020.
As Lee Corso would say, "Not so fast my friend!" It is true that the quarter-over-quarter growth declined 1.4% from the 4th quarter to the 1st quarter. However, GDP itself was not negative. The definition of a recession is "two consecutive quarters of negative GDP." The actual change in GDP a value of $24.3 trillion for the 1st quarter compared to $24.0 trillion in the 4th quarter, for total percentage change of +1.6% - positive GDP. The market is focused on the fact that the amount of quarter-over-quarter GDP growth in the 1st quarter was down when compared to the amount of growth of the 4th quarter. It's important to note that over the last 20 years, the quarterly GDP percent growth has been 1.0%, lower than the 1st quarter of this year. History also shows that the 1st quarter of GDP is usually the worst or 2nd to worst quarter of the year. In the last 20 years, 13 times 1st quarter GDP was worst or next worst of the 4 quarters for the year. Of those 13 occurrences, only twice did the bad Q1 print lead to negative GDP for the year. If we examine this quarter's GDP number, the components which dragged down growth were rising imports, slow pace of rising inventories, and fewer government purchases. These issues are expected to be temporary.
What is harder for the "imminent" crowd to comprehend are the other positives in economic data. While growth may not be as robust, Housing Starts, Employment, Wages, and Financial Stress still suggest no imminent recession. Year-over-year, Housing Starts are up 3.9%, the Unemployment Rate is still low at 3.6%, Wages are growing at 5.6% year-over-year (albeit, below inflation), and the Fed's Financial Stress Index is -1.43.
A reading below zero means we really don't have much stress in the financial system. Just before the 2008 Financial Crisis, the Fed's Financial Stress Index rose from a healthy -0.70 on July 13th, 2007 to +1.14 one month later. Similarly, just prior to the pandemic, the Fed's Financial Stress Index rose from -0.60 on January 17th, 2020 to +0.84 by February 28th, 2020. We began the current market selloff on January 4th of this year and the highest the Stress Index has reached is -0.25 (still below zero). Right now, with the data we have available, recession does not appear to be at the doorstep.
The Economy is Rosy Crowd. While there are several areas of the economy that do not look like typical recessions, there are some soft patches. The crowd that wants to promote how great things are clearly have blinders on. We just pointed out the GDP growth for the 1st quarter was +1.6%, but that's not robust. On top of that, inflation and interest rates are rising and looking more and more recessionary.
An analysis of the last 13 periods where inflation began to move higher reveals that the current cycle is on par with other extremes. The most relevant example is the period between 1976 and 1980. During that period, inflation increased 9.6% year-over-year and interest rates increased 460 basis points on the 10-year Treasury. So far, this current cycle has seen inflation rise 8.5% and interest rates increase 205 basis points. On average, over the 13 cycles going back to 1949, the average increase in inflation has been 5.3% and 76 basis points increase in interest rates. What is notable, however, is that in slightly more than half of the cycles, the rise did not lead directly to a recession. Also notable, is that a rise in inflation did not always accompany a rise in interest rates. Yet, we have to acknowledge that the current cycle resembles the latter half of the '70s which did lead to a recession. And, as we previously noted, wage growth is not keeping pace with inflation increases. In addition, the current rise in inflation and interest rates are from near all-time lows, so we could see inflation and interest rates rise for some time before the U.S. consumer is weary.
What Should Investors Do? While this current market Seems Like Old Times, it also doesn't. Real Consumer Spending, which is adjusted for the effects of inflation, released yesterday shows a relatively healthy consumer. Prior to the pandemic Real Consumer Spending averaged +2.7% and this morning's number for the 1st quarter was +2.7%. The consumer, which comprises 2/3 of GDP, is the more important economic barometer to monitor versus some other data. Some good news was released this morning on the consumer - both Personal Income and Personal Spending for March were higher than expected and higher month-over-month.
Our Wealth Protection Signal can offer some guidance, as well. Leading up to the 2008 Financial Crisis, the panic or fear element of the Signal (TED Spread) spiked from 43 to 103 in a matter of 4 days. Similarly, in 2020, the Ted Spread spiked from 40 to 111 in just 5 days. So far, we're not seeing that kind of movement this year. The highest the TED Spread has reached is 56 (March 17th) and has not tripled in just a few days like 2007 or 2020. For now, it's wait, watch, and see. Investors who react to rising interest rates or yield curve inversion too quickly typically miss a rising equity market. In 2007, equity markets increased 21% after the yield curve inverted. In 2019, equity markets increased 19% after yield curve inversion. Making rash investment decisions can cost investors and listening to extremists can hurt overall investment returns.