We're not in a recession...yet
But high inflation and Fed tightening are taking us closer.
The U.S. economy has declined for the second consecutive quarter, as the highest inflation in 41 years and a series of large interest rate hikes by the Federal Reserve combined to slow a broad swath of economic activity. Personal spending on services was solid and exports were inexplicably strong, despite dollar strength. But personal spending on goods fell for the third time in the past four quarters, housing plunged by the most since the start of the pandemic, corporate spending on equipment and structures declined sharply, the pace of inventory restocking plummeted by more than half from the first quarter, and government spending dropped for the third consecutive quarter.
The Commerce Department reported yesterday that GDP surprisingly declined 0.9% in the second quarter, compared with a drop of 1.6% in the first quarter and an increase of 6.9% in the fourth quarter of 2021. The most recent Bloomberg consensus estimate for the second quarter was for growth of 0.4%, while the Blue Chip consensus estimate was 1.1%, the Atlanta Fed’s GDPNow model was forecasting a 1.2% decline and our estimate here at Federated Hermes was for a gain of 0.8%. Yesterday’s miss lowers our full-year GDP estimate from 1.7% to 1.4%.
But the economy is not in a recession just yet The common rule of thumb is that two consecutive quarters of negative GDP constitutes a recession. But the National Bureau of Economic Research, the official arbiter of dating recessions, typically requires 12-18 months of data before they make such a judgement. It determines whether the economy is in a sustained downturn by measuring employment, industrial production, real personal income (less government transfer payments), manufacturing activity, and wholesale and retail sales. To be sure, these metrics are deteriorating, but they are not yet in full-blown recessionary territory.
Yield-curve spreads going south Bond investors point to the spread between 2- and 10-year Treasury yields as an early-warning recession indicator. The 2-year yield is now at 2.90% and the 10-year at 2.65%, a 25 basis-point inversion that suggests growing recession risk.
Likewise, the spread relationship between the fed funds rate and the benchmark 10-year Treasury yield is another strong recession predictor. Over its last four policy-setting meetings, the Fed has raised rates a total of 2.25%—putting it now 40 basis points below the 10-year. If the Fed hikes rates by another half- or three-quarters of a point at its next meeting on Sept. 21 as we expect and Treasury yields continue to grind lower due to decelerating economic growth (the 10-year sat at 3.50% in mid-June), the yield curve could also invert. That would similarly imply a risk of recession.
Watch private domestic final sales This metric is an excellent indicator of the economy’s underlying fundamental strength because it excludes volatile net trade, inventory liquidation or restocking, and government spending. It was breakeven in the second quarter, compared with a downwardly revised gain of 3% in the first quarter and 2.6% in the fourth quarter of 2021. Certainly, the second quarter could be revised down into negative territory in coming months, and our current forecast for third-quarter GDP is for a decline of 0.2%. If so, we could very well be on a glide path into recession in the second half of this year.
Fed hiked rates aggressively on Wednesday For the second consecutive meeting, the Fed hiked rates by three-quarters of a point. We expect three more data-dependent rate hikes at the remaining Federal Open Market Committee meetings this year, putting it somewhere between 3-4% by year-end. As a result, the Fed’s monetary policy symposium at Jackson Hole, Wyo., in late August is particularly important. Chair Jerome Powell will likely parse the trajectory of July inflation trends during his keynote speech and may telegraph a potential downshift in the pace of future hikes.
Inflation is still a big problem This morning, we learned that the Personal Consumption Expenditure inflation index soared to a fresh 40-year high of 6.8% year-over-year (y/y). That’s consistent with the Consumer Price Index’s 41-year high of 9.1% y/y in June and the wholesale Producer Price Index’s gain of 11.3% y/y gain in June (just missing a record 10-year high of 11.5% in March).
From these elevated levels, policymaker’s ability to use rate hikes to knock the inflation dragon back down to its long-run target of 2-3% may be measured in years rather than months. Interest rates are still far from neutral, in our view, and the market’s expectation of a quick Fed pivot from aggressive rate hikes to rate cuts by mid-2023 may be overly optimistic.
Fade the equity rally As a result, the S&P 500 has soared nearly 9% this month, marking its best performance in a single month since November 2020. Since mid-June, it has surged by more than 13% to an overbought 4,122. Growth stocks have outperformed value stocks by more than 7% over the past six weeks, erasing nearly half of their 15% underperformance during the first half of 2022. We expect stocks to relinquish these gains over the next few months, which is why we cut our equity overweight back to neutral this week, increasing our cash allocation to 9%.
Details on the second-quarter GDP report:
- Personal consumption, which comprises 71% of GDP, rose by a weaker-than-expected 1% in the second quarter, accounting for 0.70 percentage points of the overall gain in GDP, versus consensus expectations for a 1.2% increase. This compares with a 1.8% first-quarter gain and a 2.5% increase in last year’s fourth quarter. Spending on services grew by 4.1% in the second quarter, as post-pandemic “revenge travel” is all the rage. But spending on goods fell for the second consecutive quarter by 4.4%.
- Housing plummeted 14% in the second quarter, reducing growth by 0.71 percentage points, versus modest gains of 0.4% in the first quarter and 2.2% in the fourth quarter of 2021. This is the largest decline since the start of the pandemic, as mortgage rates have doubled to 6%, prices are at a record high and affordability has plunged to the worst level since 2006.
- Net trade was by far the biggest contributor this quarter, adding 1.43 points to GDP. Exports soared 18% in the second quarter, adding 1.92 points, versus a 4.8% first-quarter decline, despite the relative strength in the dollar against the yen, pound and euro rendering our exports much more expensive. But imports rose for the eighth consecutive quarter, rising 3.1% in the second quarter, which subtracted 0.49 points, compared with an 18.9% first-quarter increase, as the U.S. demand for foreign goods slowed along with the economy.
- Inventories rose for the third consecutive quarter by $81.6 billion in the second quarter on a chained-dollar basis, down from $188.5 billion in the first quarter. But this much slower sequential pace of inventory restocking subtracted 2.01 points.
- Corporate nonresidential capital spending slipped 0.1% in the second quarter, subtracting one basis point from GDP, versus a 10% first-quarter gain. Structures declined for the fifth consecutive quarter, falling 11.7%, subtracting 32 basis points. Equipment spending fell 2.7%, stripping 16 basis points. Intellectual property spending grew 9.2%, adding 47 basis points.
- Government spending declined for the third consecutive quarter and for sixth time in the past eight, falling 1.9% in the second quarter, subtracting 0.33 points, compared with a 2.9% first-quarter decline. Federal spending declined for the fifth consecutive quarter by 3.2%, subtracting 0.20 points. State and local spending slipped 1.2%, subtracting 13 basis points.