Demand side in focus
While we have been talking about supply constraints for the last few months, the focus is now shifting to the demand side of the equation as pent-up demand starts to cool and central bank tightening begins to take a toll.
The markets will continue to toggle between inflation and recession fears for the next few weeks, as a quick resolution remains unlikely. Inflation is likely to persist at high levels in the US and UK/Eurozone, while macro data will continue to weaken as higher interest rates start to take a toll on sentiment as well as activity. What we are more worried about is the rising risk of policy error as the Fed tries to do the balancing act while trying to catch the inflation train from the back.
The doom and gloom
A slew of misses in Fed surveys sparked caution on the US economy to begin with. But to be fair, survey data has been divergent and can be misleading depending on the way the survey questions are constructed.
The University of Michigan survey for June dropped to a record low of 50.2 from 58.4 and both the expectations index (46.8 from 55.2) and the current conditions (55.4 from 63.3) plunged. Meanwhile, consumer confidence from the Conference Board has held up. The University of Michigan arguably focuses more on the inflation/cost of living dynamics, which is hitting the consumer now especially due to the increase in gasoline prices. As the chart below shows, inflation expectations in the University of Michigan survey have closely tracked retail gasoline prices, possibly because of the way the survey questionnaire is constructed. But the Conference Board survey phrases questions more on the job market and household incomes which haven’t taken a big hit so far.
Still, real activity data has now started to turn dismal, including retail sales, housing and manufacturing output, suggesting there is reason for caution. A decline in retail sales has sent a warning on demand destruction, while weakening housing demand due to higher borrowing costs is setting the stage for a property market meltdown.
Does that mean a recession is coming?
A technical recession means two consecutive quarters of negative GDP growth. With US Q1 GDP at -1.5% and Atlanta Fed GDPNow pointing to a flat Q2, this means that the possibility of a technical recession is high.
However, the National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months. These include real personal income less transfers, nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production.”
Data on these counts has remained solid so far. Nonfarm payroll growth has slowed to 390k in May from levels of 500k+ seen in the months to January, but it still signals strong labor demand and a robust job market. Real income and spending has been rising with the Fed’s preferred core PCE measure up 6.3% y/y in April, beating estimates. There is no doubt that the US economic momentum will slow down, but it doesn’t appear to be crashing. The demand shift from goods to services will continue to aid growth in job, income and spending levels. However, the pressure on cost of living suggest households are running down savings and borrowing more to finance it. The consumer sentiment may turn in H2 as recession concerns pick up further, suggesting a lower contribution to overall growth from consumer spending in the second half.
Heading for an earnings recession
With interest rates rising, markets have been generally lowering the valuation placed in equities. But with recession concerns building, earnings prospects are getting hammered as well. We had most companies guiding for increasing cost pressures in Q1, and with supply and wage pressures rising, we are bracing for an earnings disappointment from mid-July. Factset estimates that earnings growth for the S&P 500 will fall to 4.3% in Q2, which will be the lowest earnings growth reported since Q4 2020 (3.8%).
Recessions usually have the largest drag on cyclical stocks and sectors such as energy, and industrials and technology hardware. While the tight supply situation on the energy side may prevent them from being hit in a significant way this time, we cannot rule out caution on these sectors.
Defensives such as consumer staples, utilities and healthcare usually outperform. With inflation having been more important than other macro concerns in H1, bonds haven’t been a great hedge for a portfolio either. We may be looking at the narrative turning in H2 as lower commodity prices help to cool inflation and central banks begin to focus on the growth side of the story. This could make fixed income products relevant again in a portfolio to provide diversification benefits, but this will depend on whether inflation is in retrenchment.
But key to remember is that a long-term investor would likely make maximum profits in his portfolio from positions taken in a bear market. As equity markets fall further, dollar-cost averaging appears to be the best strategy to accumulate those quality (consistent cash flows, reliable profit streams, and manageable debt levels) growth stocks that will be the long-run bearers for your portfolio.