Stocks sold off yesterday capping off the day in an ugly late session drop in the wake of ECB rate hike announcements. Traders were unwilling to support the markets at key technical levels ahead of today’s critical inflation number.
Trouble in the bubble? Do you want to know what question I get most often these days from clients and colleagues? Sure, you do. You may not be surprised to hear that the dreaded “r-word” dominates the list. That r-word, if you haven’t already guessed, is recession. I am sure you have your thoughts on the matter as well. Let’s forget about the stock markets for a moment and focus on the economy. To get a technical recession we need two consecutive quarters of negative GDP growth. In case you missed it, we got 1 in the bag already. In the first quarter of this year US GDP fell by -1.5% according to the most recent release by the Bureau of Economic Analysis. Economics 101 to follow.
The most basic equation for GDP is C + I + G + NX, where C = consumption, I = corporate investment/spending, G = government consumption, and NX = net exports. The Government can spend all it wants, whenever it wants, so let’s leave G out of the discussion for now. Most often we focus on Consumption (C) and Investment (I), because the two aggregates make up some 90% of the economy. Lesson over.
In the first quarter, personal consumption, which accounts for around 70% of GDP, climbed by 3.1% after climbing by +2.5%, +2.0%, +12.0%, and +11.4% in the prior, consecutive 4 quarters. So, while Q1 registered a slight uptick, the longer-term trend is still decreasing. Considering all that nasty Fed threatening, runaway inflation, and lack of government stimulus money, you are probably not surprised that consumers may be tightening the purse strings a bit. Do you want to guess which category of PCE fell the most? If you guessed Gasoline and Other Energy Goods you are correct. It makes sense given the sharp rise in gas prices that began to ramp up in earnest during Q1.
Investment (I), which makes up around 22% of GDP was up modestly in Q1 (+0.5%), but after growing by +36.7% and +12.4% in the prior two consecutive quarters, the small gain could be viewed as a slowdown in growth. This too may not surprise you given higher yields and inflationary pressures. Companies, principally borrow investment-destined capital in the bond market, and higher yields mean that companies’ cost of capital increased throughout the quarter. Further, as discussed here in this note often, last quarter’s earnings were rife with reports of cost inflation. When companies are faced with rising costs, they raise prices to consumers AND cut spending in order to keep Wall Street happy by maintaining margins.
Though we don’t typically focus on Net Exports (NX) because, by now, it is a given the US is a net importer, which means we buy more foreign goods than we sell domestic goods to foreign nations. Because dollars are, on net, flowing out of the US, it is a drag on GDP. Why is it important to bring this up now? Well, there has been this issue with the US Dollar recently – it has been going up in value because the US economy is relatively stronger than its trade partners and interest rates are rising in the US at a quicker pace as well. The stronger US Dollar means that domestic goods are more expensive to foreign buyers. This ultimately leads to lower exports, which is negative to GDP, because they lead to lower inflows of foreign capital.
That leaves us with the question of “what will happen in Q2,” you know, the quarter that we will wrap up in a few weeks? Well, the general consensus is that Q2 GDP growth will come in at +3.1%. If it does, that means that we have avoided a recession, for now. A timelier estimate of inflation can be found in the Atlanta Fed’s GDPNow estimate which calculates expected GDP using real quantitative methods. Its latest estimate shows a mere +0.9% growth for the quarter. A less optimistic view, for sure, but still avoiding a recession.
All of this said, it would seem that inflation is clearly the key factor in determining the path of economic growth for consumers and companies. If we look at the same general consensus expectations, we see that economists are expecting CPI to remain high for Q2 (+8.0%), but to recede to +7.5% and +6.3% in Q3 and Q4 respectively. If these numbers play out, there is a chance for the US to avoid a recession. Want to know what the “experts” think? Bloomberg polls around 50 well-known firms to come up with a Recession Probability forecast, and that number stands at 31.5%. That is not too bad, but it is important to recognize that the probability has been rising -- it started the year off at 15%. Before it alarms you, you should know that the same metric topped off at 35.0% in 2019, the year prior to the pandemic.
YESTERDAY’S MARKETS
Stocks sold off yesterday in response to the ECB rate hike announcement. Later in the session, the selling accelerated as stock index’s failed to hold key technical levels. The S&P500 fell by -2.38%, the Dow Jones Industrial Average slid by -2.94%, the Nasdaq Composite Index traded lower by -2.75%, and the Russell 2000 Index sold off by -2.12%. Bonds fell and 10-year Treasury Note yields gained +2 basis points to 3.04%. Cryptos slipped by -0.11% and Bitcoin declined by -0.66%.
NXT UP