Lots of talk out there, especially in the mass media and our politicians, about recession and if we are headed for one this year. That’s not an easy question to answer, but I understand why it’s being asked. We have high inflation, ongoing supply chain issues and a tight labor market with rising wages. But, as is often the case, the story needs to be researched to better understand the underlying conditions that can lead to some of these conditions, and whether those conditions could lead to recession. In today’s Financially Speaking I want to look more closely at these issues and try to make some sense out of the concerns about a recession this year. As always, the team at Barron Financial Group are only a phone call or email away if you have further questions or prefer a personal discussion.
What is a Recession?
To best define a recession, we need to explore the basic measure used, Gross Domestic Product (GDP). Our standard GDP measurement comes out quarterly as a series of monthly estimates starting the first month after quarter-end. The first estimate is the early or “advanced” estimate, the second is generally thought of as reasonably close and the third and final estimate is considered very close to the real value. GDP estimates are percentage amounts that show the amount of growth of the economy over the previous quarter, but that amount is then annualized to represent the potential growth for an entire year. For example, the U.S. GDP report for the first quarter of 2022 was shown as -1.5% as of the second estimate. That -1.5% represents what would have happened if the economy performed similarly over an entire year, a.k.a. annualized. Recession, as commonly defined, results when two consecutive quarters show negative GDP growth. GDP from the fourth quarter of 2021 was listed as 6.9%, again annualized. So, the first quarter of 2022 was negative, and a second negative quarter would then result in the U.S. being in recession. Fortunately, the Atlanta Federal Reserve Bank has a GDP estimating tool that is showing the second quarter 2022 GDP estimate at +1.3%. Not a great GDP estimate by any means, but far from a second consecutive negative quarter.
Issues Driving Recession
For starters, please know that we do not believe we are headed for a recession this year, or even early next year. We feel a recession may be coming, but we believe it would be until later in 2023 or even 2024. Now to move on to our explanation of why we feel this way. Earlier in this report I mentioned the issues of high inflation, ongoing supply chain issues and a tight labor market with rising wages. Let’s look at these and try to consider if they are truly driving us toward recession. Starting with inflation, I’ve mentioned in previous writings that the pandemic, and government response to the pandemic, has caused the M2 money supply to increase by 40% over the last two years. This compared to a historic norm for M2 growth of about 6% per year. That amount of cash entering the economy has been a major driver of inflation. It’s just too much money chasing too few goods. But the Federal reserve is working to increase interest rates and has just begun the process of “Quantitative Tightening”, which is intended to reduce the Federal Reserve balance sheet, and through the change in bank reserves also reduce the M2 money supply. Although there is no guarantee these efforts will work, we believe this is a good start to reducing inflation over the next several months. Inflation estimates won’t be out until later in June, so we don’t have new data available yet.
The supply chain issues have been a combination of the pandemic and the dramatic demand increase due to the recovery in employment and in part to government stimulus and unemployment payments. The combination resulted in rising demand, which can best be illustrated by the fact that in the 26 months since February 2020 (the start of the pandemic), retail sales are up 28.8%. This compared to the previous 26 months where retail sales increased by 6.7%. This increased demand, along with reduced supply due to the pandemic and labor issues, represents the magic recipe for inflation, too much demand and too little supply. The good news here is that one great measure I’ve found for the supply chain is the Supply Chain Pressure Index, a measure put out by the Federal Reserve Bank of New York. The normal measure for the index, meaning no positive or negative pressure, is zero. The peak reading came in December 2021 at +4.38, a high level of pressure associated with the supply chain. It has since dropped to +2.90, still well above the zero level, but much improved. We believe this suggests that the supply chain is improving and as we get beyond the pandemic and our labor issues subside, the supply chain will continue to improve.
Finally, we have the tight labor market and rising wages to deal with. While it is true that rising wages can reduce corporate earnings, which can lead to recession, we feel there are other important considerations. First, the U.S. labor market has a bit over one million fewer employees than we had in February 2020. Second, we have twice as many available jobs as we have unemployed people to take them. This is an underlying driver of the tight labor market…we simply don’t have enough people to take the open jobs. And this condition is also responsible for much of the rising wages. Because as a potential employee negotiates with an employer, and the employer worries that the job won’t be taken due to the low amount of unemployed, that potential employee has the leverage to demand a higher wage. And this is happening with not only new potential employees, but also with employees changing jobs. The May employment report came in stronger than expected at +390,000 employed. The unemployment rate stayed the same at 3.6%, only slightly higher than the pre-pandemic low of 3.5%. As important, the unemployment rate has been the same 3.6% for three months in a row, suggesting that employment remains strong enough to ease the tight labor market over time. We believe that about half of the one million fewer employed people will re-enter the labor market over the rest of this year, which will ultimately reduce the labor strain. We also believe as the Federal Reserve raises interest rates employers will reduce open positions and the strain of too many open jobs will reduce. There is some evidence of this already happening as the 3-month moving average of monthly employment gains is lower than the 6-month moving average by about 19%.
Wrapping Up
The simple truth is that there are a number of moving parts associated with how the economy proceeds. There is no way to know for sure if we end up going into recession in the next year. One risk we feel happens often is that people tend to assume that whatever is happening today will continue to happen or get worse. So, if inflation is 8.3% now, it will stay that way or get worse. We feel this is a mistake because nothing ever stays the same and what direction it will go is entirely dependent on the data. Thus, we feel it is our responsibility to understand the workings of the economy and make our best assessment of what the economic progress might look like. Our view is that what we feel are the most important issues are in the process of improving and that will likely continue and result in our not entering recession for at least the next year. Could we be wrong? Of course. But we feel the economic data is on our side and time will tell if we’ve read the tea leaves correctly. Lastly, as difficult as it can be, try not to let the mass media, or our wonderful politicians, sway your thinking on the economy. Each has a different underlying agenda to help gain clicks or votes. The data they portray is often not accurate, or out of context. We will do our best to keep you informed along the way.
All the best,
Jim