ENTERING A RECESSION? There is much debate about whether the U.S. economy is in a recession. According to the U.S. Bureau of Economic Analysis (BEA) advanced estimate, the U.S. economy has contracted for two consecutive quarters (see chart). GDP declined by -1.6% in the first quarter followed by a -0.9% decline in the second quarter ending June 30th.
The second quarter decline reflected a slowdown in capital expenditures. Major retailers (Walmart, Target, etc.) and automobile dealerships trimmed inventory, and manufacturers held back on system upgrades. A slowdown in government spending in non-defense items and housing sales (notably broker commissions for residential transactions) also contributed to the decline. A surge in exports, including industrial supplies and materials, was offset by higher imports related to a boom in travel related services. And there lies the crux of the recession debate.
Despite the slowdown in capital expenditures, personal consumption levels held up, although mostly because of higher costs for food, accommodation and health care. Strong employment data also seems to counter the recession line of reasoning – it is hard to argue the economy is slowing when the unemployment rate is at 50-year lows. That said, the labour market is often a lagging indicator.
An apparent decline in government spending in the headline numbers had more to do with accounting semantics than transformative political thinking. For example, slight decreases in non-defense spending were offset by increased spending on defense, which effectively, created a wash. The headline number also took into account a one-off spike in revenue generated by the sale of 30% of the crude oil held within the U.S. strategic petroleum reserve (SPR). The intent was to increase the supply of domestic energy to cool inflation at the gas pump. While admirable, at some point those reserves will have to be replenished (i.e., re-purchased in the open market).
Finally, the decrease in nonresidential fixed investments (i.e., factories) was almost entirely offset by increased costs related to intellectual property. Just goes to show how valuable patents, trademarks, and copyrights are relative to other fixed assets on corporate balance sheets. If nothing else, it supports our thesis that the U.S. economy is being propelled more by technological innovation than manufacturing.
Headline inflation for the July year-over-year period remained hot at 8.58%. Core inflation (i.e., less food and energy) for the July year-over-year period came in in at 5.3%. Although these numbers remain well above central bank targets, the takeaway among market participants was that inflation has now peaked and is beginning a downward trajectory.
We also were pleasantly surprised that topline consumer prices did not budge at all from June to July. Although, when you remove food and energy from the calculation, core inflation rose 0.3% from June through July 2022.
The other concern is that most of the decline is related to lower energy costs. Gasoline prices dropped nearly 8% in July, which is a positive, but the July 2022 number is still well above levels from a year ago (+32.9% year-over-year). Moreover, gasoline prices could once again spike at any moment given the uncertainty created by the Russian invasion of Ukraine.
According to the BEA, “current-dollar personal income increased USD $353.8 billion in the second quarter, compared with an increase of USD $247.2 billion in the first quarter.” The increase primarily reflected an upswing in private wages and salaries, personal income from small businesses (reflecting both non-farm and farm income), personal income from the sale of assets, and rental income.
Disposable personal income surged 6.6% (USD $291.4 billion) in the second quarter, compared with a decline of 1.3% (-USD $58.8 billion) in the first quarter. After accounting for inflation, real disposable personal income decreased -0.5% in the second quarter, which was significantly better than the -7.8% decline in the first quarter. Personal savings declined slightly to USD $968.4 billion in the second quarter, compared with $1.02 trillion in the first quarter. These numbers reflect a decline in the personal saving rate, likely the result of increased costs of food, accommodation and fuel, to 5.2% of income in the second quarter versus 5.6% in the first quarter.
Given the U.S. Federal Reserve’s (FED) dual mandate of price stability and maximum employment, we watch the jobs market closely. The stronger than expected non-farm payroll number in July gives the FED a lot of latitude to hike rates in their quest to quell inflation.
However, we may be seeing the beginning of weakness in the labour market. The four week average for jobless claims rose to 248,000 up from 231,000 in June. Continuing claims, which run a week behind the headline number, totaled 1.42 million, up 48,000 from the prior week and 83,000 from the beginning of July.
Jobless claims have been on the upswing since February as the economy begins to cool. The trend is noteworthy but hardly conclusive as unfilled vacancies remain well above 8 million. Still the July jobless number was the highest since November 2021.
The U.S. trade deficit at the end of the second quarter, retreated from its record high USD $107.7 billion March number. Hopefully that reflects a return to a more normal environment. However, we cannot discount the more than USD $20 billion in exports of defense systems to support Ukraine’s war effort.
Exports rose USD $4.3 billion while imports declined by USD $1 billion at the end of June. However, the goods deficit with China rose USD $4.7 billion to just shy of USD $37 billion at the end of March. Imports on auto vehicles, parts and engines declined USD $2.7 billion while capital goods increased nearly USD $1 billion.
Notes the BEA, “Even with the June decline in the deficit, it is still 33.4% higher than a year ago as domestic supply has failed to keep up with strong demand. That has fueled an inflation rate running at its highest level since the early 1980s.”
IF IT LOOKS LIKE A RECESSION AND QUACKS LIKE A RECESSION…
Statistically the U.S. economy looks and quacks like a recession. Notable factors include two quarters of negative growth, above-trend inflation, plus secular turmoil (war in Ukraine’s impact on oil and food) and a hawkish U.S. Federal Reserve (Fed).
However, in this case the slowdown was deliberate. It was orchestrated by central banks with the intent to slow economic activity enough to dampen inflation without sending the economy into a deep recession. The recent flattening inflation numbers coupled with a strong labour market suggests the Fed is on the right track, and time will tell if it succeeds.
The White House is certainly influencing the Fed’s actions. After the latest negative U.S. GDP numbers, the Biden Administration highlighted strength in the jobs market in their effort to allay recession fears. The U.S. Administration posited that, while the economy has contracted from the torrid 6.7% expansionary pace in the last quarter of 2021, it was based on a well thought-out strategy to deal with high inflation and supply chain disruptions. Unlike Biden’s approval ratings, Democrats believe that, despite two quarters of GDP contraction, the U.S. economy is robust.
Applying economics 101, the White House attempted to downplay the data by explaining that two consecutive quarters of economic contraction does not, in and of itself, constitute a recession. The administration went on to clarify that the National Bureau of Economic Research (NBER), as the official recession arbiter, weighs a number of statistics over a period of months, before making an ex-ante determination about a recession. That’s critical positioning given that midterm elections are around the corner and the Democrats must deal with a Republican platform that will almost certainly play the recession card.
Politics aside, we can apply a generally accepted principal that a recession must be broadly based, causing persistent weakness in the economy. So far, that’s not the case. The current softness appears to be sector specific caused by bloated inventories, labour shortages and a strong U.S. dollar. In many ways, it is a reflection of an economy shifting into a lower gear after a frenzied recovery.
Further, although it will negatively impact profit margins and go-forward revenue expectations, a slowing economy will have a positive impact on inflation – a point that was driven home by corporate executives during second quarter analyst calls. Still, the thrust of public companies’ second quarter commentaries related more to the lack of visibility rather than predictions of apocalyptic revenue shortfalls.
What we did not hear was any serious discussion about shrinking profit margins, which would clearly be impacted if companies were unable to pass along price increases. In a worst case scenario, we could envision lower earnings and multiple contraction over the next two quarters, which would seriously impact equity markets. That’s why so many analysts view the recent bounce in stock prices as a bear market rally that will quickly fade, resulting in a re-test of the June lows.
Allow us to posit an alternative trajectory. The playbook being used by analysts focuses on a return to the 1970s-to-early-1980s inflation bubble that culminated in stagflation. However, the 1970s era was not caused by a pandemic, and it generally caught corporate management by surprise. Why would inflation be expected during the early 1970s, given a post-world war II economy that had enjoyed nearly 20 years of uninterrupted low inflation and growth? When inflation bumped higher in the early 1970s, most executives believed that it would be an inconsequential blip that would quickly abate.
In the current environment, we do not believe management expects inflation to be short-lived. Unlike the 1970s, when management was late to the game in passing along price increases, corporations in the current environment have been quick to protect their margins with price adjustments. In fact, one could argue that the reason inflation jumped so quickly was a desire by companies to get ahead of the curve. For the most part, companies have been able to pass along price increases with little blowback, as consumers are flush with cash from government support programs and lower personal spending during COVID lockdowns.
If that assessment proves correct, it would infer that inflation has peaked and central banks can rein in their aggressive actions. Profit margins should remain healthy and earnings would, at a minimum, remain stable. Remember, the bearish sentiment that currently exists is backstopped by expectations of continuing lower revenue, earnings and ensuing multiple equity price contractions.
If the next two quarters show signs of earnings stability and solid margins, that would lead to multiple expansion of equity prices. In that scenario, the current market rally would continue to a point where sentiment begins to shift from bearish to bullish. If multiples return to pre-COVID levels (i.e. price to earnings multiples of 22 to 25 times) that would propel the S&P 500 index to the 5,000 level. Make no mistake, that surge could come faster than anyone expects. That is our current view although, in fairness, you must understand that we are out on a limb here.
If we were to remove our rose colour glasses, we would point out that the recession/inflation debate is premised on warning signs… nothing more! It may get worse, but we are sticking with the position that the Fed will initiate a 50 bps or 75 bps rate hike at their September meeting after which, we expect the Fed to pause and assess the performance of the economy.
HOW MILLENNIALS ARE IMPACTING THE LABOUR MARKET
While recently watching a streaming comedy/drama, I was struck by one character (a Millennial) who confronted his superior to demand a change in the corporate culture. When his superior questioned why the employee felt his righteous anger was appropriate, the subordinate responded that he was entitled to speak up because of the sacrifices he made to support the company. Since when did work become a ‘sacrifice’?
Similar concepts of entitlement seem to permeate the Millennial demographic cohort. This is important from a macroeconomic perspective because Millennials now make up more than 50% of the U.S. labour force. That is not to dismiss the work ethic of Millennials, which is highly valued among the corporate elite. But it does point to a changing paradigm that is having a marked impact on employment standards.
Speak to any engineer and they will tell you that even the most robust materials can fail when subjected to the right amount of force and load. The same thing can happen to any organization when people and teams get overextended in a world of 24/7 technology.
When companies demand that employees do more than they can do well, it’s a lose-lose proposition for both company and individual. The blowback comes in the form of costly dysfunctions – plummeting performance, turnover, absenteeism and presenteeism (attendance in body, but not in mind), and burnout.
Millennials recognize this dysfunction, which has lead them to expect and demand more flexibility from their jobs than previous generations. Recent innovations such as the work-from-home and now hybrid work models have been embraced by Millennials as being better aligned with their deep-seated ethos to embrace a healthy work-life balance. In fact, more than 80% of Millennials say that, before accepting a position, they seriously consider how the position’s inherent ‘sacrifices’ will impact their work-life balance.
Millennials are torn between competing requirements to lead a successful and fulfilling life at work, at home, with family, and friends. In the current robust labour environment, employees have more power, forcing employers to endorse strategies that balance the time spent in the work environment and home life. By doing so, the employer takes on a burden that previously was managed by the employee.
Not all employers can accommodate. Take the service sector (i.e., restaurants, travel, hotels, entertainment and leisure,) where a hybrid solution is not possible. Not being able to adapt to Millennial requirements diminishes the quality of job satisfaction and employee productivity. We see the impact in airport chaos, limited menus at restaurants and generally poor service, all because of labour shortages.
For sectors that can adapt, human resources are seeking ways to integrate work-life balance without impinging productivity. That includes strategies that provide flexibility for Millennials that enables them to thrive outside of work. But such accommodations come at a cost, as employers must make investments that include hybrid solutions and targeted benefits (i.e., in house child care, family-related benefits, pet insurance, etc.) if they are to retain productive employees.
Technology plays an important role with systems that have both simplified working from home and, in many ways, have resulted in increased productivity. According to a recent Gallup poll, employees across various industries who spent 60-80% of their time working remotely had the highest rates of engagement and productivity – a fact not lost among innovative companies. Amazon and United Health Group, for example, have been ranked among the top ten companies offering remote work.
The rise of software solutions from Zoom and Microsoft (Teams) have allowed employees to work remotely while engaging with their colleagues, which supports Millennials’ desire for social contact. Constant collaboration and constructive feedback have also been shown to boost job satisfaction.
Millennials also have a strong desire to give back by focusing their energies on creating positive change. In that sense, Millennials prefer to work for companies that align with their own internal values and provide purpose through corporate wellness initiatives. Colgate-Palmolive and Patagonia are frontrunners in offering employee opportunities to support philanthropic efforts.
Millennials also want holistic wellness initiatives. On-site fitness, stress management, wearable devices, mental health support, and healthy food options are becoming entrenched in some corporate cultures. Millennials are more tech-savvy than previous generations so offering innovative health technologies (i.e., digital access to their health practitioner) help create a substantially higher level of engagement in these wellness programs.
Companies that develop programs to address what’s important to Millennials (flexibility, family, health and sense of purpose) will reap the benefits this demographic has to offer. The ideal work-life balance for Millennials empowers them to contribute effectively to their organization, while having the resources and flexibility to care for themselves and deal with life’s demands outside of work.
The Macroeconomic Implications
From an investment perspective, it is important to understand the long-term implications this demographic will have on the labour market. We anticipate continued labour shortages across sectors of the economy that cannot, or will not, adapt. Labour shortages will result in service disruptions, chaos and diminished profit margins.
Companies that can and do adapt will benefit from productivity improvements engrained in the Millennial work ethic. Look for big-tech names to lead the earnings parade with stable and in some cases, improved profit margins.
Service industries will struggle. Frustrated consumers will, in time, seek alternatives to airline chaos; rising food costs and limited menus will weaken restaurant demand. These and other headwinds will stunt profit margins and impact earnings. In general, we anticipate a seismic demarcation among sectors of the economy that will remain long after a return to normal. We suspect investment strategies that focus on sector rotation will benefit from demographic changes within the labour market.
WHY WE FOCUS ON THE U.S. ECONOMY
When we talk about the economy, we usually focus on the U.S. Obviously, the U.S. economy is most significant because of its size. It is the world’s largest economy representing 20% of global output making it the most influential in terms of its impact on other nations. Most notable, from our perspective, is how conditions in the U.S. impact Canada’s policies, and we felt it useful to look at what makes the U.S. economy the juggernaut that it is.
According to the International Monetary Fund (IMF), the U.S. economy generates the sixth highest per capita GDP, which boils down to the productive capacity of individual employees. Features include a highly developed and technologically-advanced service sector, which accounts for about 80% of U.S. GDP. The U.S. economy is dominated by service-oriented companies in areas such as technology, financial services, healthcare and retail.
The largest U.S. corporations are global in nature and 20% of the Fortune 500 Global corporations are based in the U.S. So important is their global footprint, that foreign currency translation (i.e., strong U.S. dollar) can and, as recent earnings number demonstrate, do negatively impact profits.
While we recognize that the service sector is the main driver of economic activity, the U.S. maintains a healthy manufacturing base representing roughly 15% of output, second only to China. In the broadest sense, the U.S. is the leader in higher-value manufacturing of automobiles, aerospace, machinery, telecommunications and chemicals. Completing U.S. GDP inputs is agriculture, which represents about 2% of output. Despite that miniscule number, the U.S. is the largest exporter of agriculture products thanks to its vast acres of usable land, advanced farming technology and generous government subsidies.
According to Focus Economics: “The U.S. economy maintains its powerhouse status through a combination of characteristics. The country has access to abundant natural resources and a sophisticated physical infrastructure. It also has a large, well-educated and productive workforce. Moreover, the physical and human capital is fully leveraged in a free-market and business-oriented environment. The government and the people of the United States both contribute to this unique economic environment. The government provides political stability, a functional legal system, and a regulatory structure that allow the economy to flourish. The general population, including a diversity of immigrants, brings a solid work ethic, as well as a sense of entrepreneurship and risk taking to the mix. Economic growth in the United States is constantly being driven forward by ongoing innovation, research and development as well as capital investment.”
Despite these positive characteristics, this economic powerhouse is not without its own unique set of risks. We note the 2008 – 2009 Great Recession as a case in point. The combination of low interest rates, widespread mortgage lending, excessive risk taking in the financial sector, high consumer indebtedness and lax government regulation set in motion the 2008 collapse that bankrupted several major banks and caused a period of contraction that lasted into 2009. It was, by all accounts, the worst downturn since the Great Depression of 1929. Fortunately, the ability of the U.S. government to print money allowed it to provide USD $700 billion in aid to mitigate a total collapse. Another USD $831 billion stimulus package was passed to be spent over the ensuing 10 years to anchor the economic recovery. Not many economies have such capacity.
Since 2009, economic growth in the United States has been uneven. That the U.S. has been able to maintain an upward trajectory is due in no small part to ex-ante expansionary monetary policies, including the unorthodox practice of central bank purchases of government debt (i.e., quantitative easing) that expanded the money supply and kept interest rates at the lower end of their band.
Interestingly, despite strength in the labour market, many question the overall health of the U.S. economy, perhaps for good reason. According to Focus Economics, the federal government’s role in micromanaging growth has caused “deteriorating infrastructure, wage stagnation, rising income inequality, elevated pension and medical costs, as well as large current account and government budget deficits.”
The end of World War II marked the beginning of a golden era for the U.S. economy. Economic activity and productivity surged on the back of the ensuing Baby Boomer generation. The middle class prospered and from 1940 to 1970 the economy grew at an average rate of 4% annually. Around 1970, we began to see a structural shift in which the primary base of the U.S. economy transformed from industrial and manufacturing to services. Then came the law of big numbers that lead to slower growth from a much larger base. A series of unfortunate events including the 1973 oil crisis, the collapse of the Breton Woods System and increased global competition, precipitated changes that mutated into a period of stagnating growth and inflation that became known as “stagflation.”
The 1980s gave rise to supply side economics, as promoted by famed economist Milton Freidman. President Ronald Reagan embraced lower taxes, tighter money supply, reduced government spending, and deregulation throughout many sectors of the economy. While the supply side theorem, which became known as “Reaganomics,” spurred higher growth and increased productivity, it also caused government debt to spiral upward, mostly from increased defense spending.
There is much debate about whether the benefits of increased defense spending of this era, which was credited with ending the cold war, outweighed the longterm damage caused by ever increasing deficits grounded in supply side thinking.
The U.S. was the leader in pushing for global integration supported by a rise of new technology. The adoption of productivity-enhancing IT in the workplace and the surge of high-tech companies helped fuel an economic boom in the 1990s. The period between 1993 and 2001 marked the longest sustained expansion in U.S. economic history, and powered a steep rise in employment, income and consumer demand.
Moreover, strong growth and low unemployment in the 1990s was remarkable, given that it was supported by the private sector. During the 1990s, the federal government reigned in expenses and actually achieved a surplus for four years between 1998 and 2001. The fiscal improvement was made possible in part by tax increases introduced by President Bill Clinton, but also thanks to the booming economy and surging stock market. The stock market was propelled by a surge in internet startups that later became known as the “dot-com bubble”, which generated vast sums of unanticipated revenue for the government from capital gains taxes and rising salaries. However, the overvaluation of dot-com stocks eventually became apparent and the bubble burst in 2000.
After the turn of the century we witnessed a sharp decline in economic activity as the dot-com bubble burst. The terrorist attacks on September 11th, 2001, and several corporate scandals put a further damper on economic activity and business confidence. The Fed, under Alan Greenspan, stepped in to counteract the struggling economy by introducing low interest rates. This move would later be considered a major factor in causing the massive housing market bubble that burst and precipitated the great recession that began in 2008.
Balance of payments
Over the past several decades, the U.S. current account balance has been heavily influenced by international trade flows, with the ongoing trade deficit resulting in a consistent current account deficit. That said, there is much debate on whether the current account deficit is real.
The current account deficit is the difference between the value of the goods and services purchased by the United States relative to the value of goods and services being sold to foreigners. How these components are valued draws into question their legitimacy. I recall comments at a symposium in New Orleans in the late 1990s, where one speaker addressed that question. He cited one example in terms of how exported feature films sent overseas for distribution were valued. At one point films were valued as plastic, with their export value calculated as cents per pound. Software fell into a similar category, which by any measure, vastly underestimated its real value. The fact that so many tech companies held sizeable foreign reserves supports that position.
To that point, earnings on U.S. assets and investments owned abroad play a very small part in the current account, and a surplus in this category is not nearly enough to offset the large trade deficit. The U.S. current account deficit has widened progressively since the 1990s and reached an all-time record and global high of 5.8% of GDP in 2006. The deficit has since narrowed due in part to increased domestic oil production.
Notes Focus Economics; “The current account deficit is mirrored by a capital account surplus. The net amount of capital inflows received in the United States from abroad makes it possible to finance the current account deficit. Foreigners continue to invest in U.S. assets and companies, and so the net international investment position of the United States has grown over time. The United States is by far the top recipient of foreign direct investment (FDI). About 80% of FDI in the United States comes from a set of just nine industrialized countries, including the UK, Japan and the Netherlands as the top sources. The U.S. manufacturing sector draws about 40% of FDI.”
The U.S. government has experienced significant swings in economic activity. Deep contractions that lead to short-lived troughs followed by sharp upswings that turn into irrational exuberance. The U.S. advantage is the enormous economic firepower that can be unleashed by the government through monetary policy and fiscal initiatives.
Government stimulus and broad based tax cuts short-circuited the 2008-2009 great recession preventing the U.S. economy from falling into the abyss. Not all countries have that luxury. On the monetary side, the Federal Reserve can tackle economic weakness with traditional and, sometimes, unconventional policies.
Despite these interventions, the United States is generally considered the home of free market economic policies – a the “great free market experiment”. In reality, the U.S. government exercises a significant amount of regulation over economic, commercial and financial activities. Note the stepped-up oversight in the financial sector following the great recession. The Dodd-Frank Act, passed in 2010, represents the most comprehensive reform of financial markets regulation since the Great Depression.
The U.S. government tends to spend more money than it takes in, and has, with rare exceptions, incurred fiscal deficits during the past several decades. That these fiscal deficits had only a muted impact on economic activity, is one of the benefits of being the caretaker of the world’s reserve currency.
The U.S. predilection for deficit spending is the result of entitlement programs that are mandated by existing laws. Case in point are entitlement programs like Social Security and Medicaid. Mandatory spending represents about 60% of total government spending. The remainder is referred to as discretionary spending, and is determined by the annual federal budget. About half of the discretionary budget is spent on the military and defense, with the other half spent on government programs and public services.
Nearly 50% of tax obtained by the U.S. government comes from income taxes on individuals, with an additional 10% coming from income taxes on businesses and corporations. Another 35% of collections come from payroll and social security taxes. Excise taxes charged on goods such as liquor, tobacco and gasoline bring in a smaller amount, less than 5%. Tax revenues equaled about 18% of GDP on average between 1970 and 2010. Total tax revenues as a percentage of GDP were about 18% in 2015.
The U.S. Congress has established a dual mandate for the Federal Reserve, which requires the central bank to promote maximum employment and price stability. The Federal Open Market Committee (FOMC) is the Fed’s monetary policymaking body. The FOMC meets about eight times a year to discuss the outlook for the economy and to debate different policy options. The federal funds rate, the main interest rate managed by the Fed, is the rate which deposit banks charge each other to trade funds overnight in order to maintain reserve balance requirements. The federal funds rate is one of the most important in the U.S. economy because it influences all other short term interest rates.
In recent years, the Fed has been very active. Interest rates were initially supposed to be kept low only until the unemployment rate dropped to 6.5% or inflation surpassed 2.5%. However, this specific forward guidance was revamped in March 2014 giving way to the “follow-the-data” mantra. In an additional response to counter the effects of the recession, in December 2012, the Fed announced an unconventional policy known as “quantitative easing”. This policy involves the purchase of vast sums of financial assets in an attempt to increase the money supply and hold down long-term interest rates. It has been a key initiative in the Fed’s response to Covid lockdowns.
 CPI data was released by the U.S. Bureau of Labour Statistics on August 10th, 2022.
Richard Croft, Chairman & CIO