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Should we be in a recession already?

Should we be in a recession already?

We have been optimistic about the prospects for equities this year despite fears of recession. And even though investors have listed a deeply inverted U.S. Treasury yield curve, a sharp drop in the oil price, falling consumer demand, credit tightening and declining M2 money supply as reasons to justify expectations of a recession, the outcome is not guaranteed.

Meanwhile, equities are climbing the wall of worry. Since the beginning of the year, the S&P500 is up 9.65 per cent, Nasdaq composite is up 24.06 per cent, the Nasdaq 100 is up 30.79 per cent and the MSCI ACWI, which captures large and mid caps across 23 developed markets is up 13.58 (AUD) per cent / 7.68 per cent (USD).

My reasons for optimism back in November were both historical and fundamental. Looking back 100 years, we discovered terrible years – such as that experienced in 2022 – tend to be isolated. Bad years, it seems don’t like to be preceded or followed by bad years. We also discovered that particularly poor years – declines of more than 20 per cent – are more likely to be followed by a positive year. And more fundamentally we saw evidence global central banks were engaging in net quantitative easing (QE) again.

Shifting to the present, and the gains since the beginning of the year may have priced-in some of our optimism. It may be worth reflecting on whether or not our bullish posture should be maintained. And since March, fears of recession have gained a foothold although those fears are somewhat less acute now than when they first emerged.

Given the slumping credit demand and tightening lending standards in the U.S., which typically precede or accompany a recession, one wonders why we aren’t in a recession yet. We should be.

But as we have noted here at the blog in recent weeks, U.S. reporting season did not resemble a recession. The much-feared contraction in earnings of circa nine per cent simply failed to materialise, and at the time of writing, earnings for the second quarter of CY23 fell just 1.5 per cent year-on-year.

What is curious is the obviously bearish sentiment failing to correlate with the performance of the equity market. Are equity investors unreasonably optimistic, or are the pessimists missing something?

One observation is that recessions vary in flavour. The recessions associated with the global financial crisis (GFC) and the COVID-19 Pandemic were unusual in that both real and nominal economic growth went negative. This is atypical. In the 1970s and the 1980s nominal economic growth remained largely positive during relatively deep recessions.  Again, in 1990 and 2001 when the U.S. economy was in recession, nominal GDP growth hovered around 2-2.5 per cent.

Why is any of this relevant?

To most of us, recession relates to declines in real economic indicators such as employment or output. Nominal economic growth however also takes into account prices. When inflation is high, as it is now compared to the decades prior to the pandemic, it offers companies with pricing power some protection against steep falls in earnings. This is because revenue and profits are nominal variables. In other words, vanilla-flavoured recessions – the type being predicted currently – are associated with positive nominal GDP growth. 

Global Macroeconomic research house Alpine Macro note that strong pricing power associated with higher inflation, and therefore higher nominal growth, was the reason earnings per share EPS drawdowns were milder during the 1970s and 1980s recessions. EPS drawdowns have been much deeper since the 1990s, when inflation is lower. The recessions of 1990 and 2001, when inflation was lower, saw EPS contractions of 40 and 50 per cent respectively.

So today, even though a recession is entirely possible, the higher level of inflation and margin expansion (plenty of companies have reported record gross margins recently), may mean earnings growth remains robust, or at least better than what some investors fear.

Think of it this way; nominal GDP, according to Alpine Macro, is 6.9 per cent. The GDP deflator (inflation adjustment) is 5.3 per cent. That means real GDP is about 1.6 per cent.  Therefore, if inflation falls by another 150 basis points by the end of the year and a mild recession takes real GDP growth to zero, nominal GDP would still be just under four per cent.

And keep in mind our oft-repeated argument that even anemic positive economic growth combined with disinflation (which is not deflation) has historically been the backdrop for solid gains in innovative growth stocks. Perhaps the stock market has already got it right, and the pessimists need to recalibrate.

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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7 Comments

  1. Aust Bond 10y – 2y = -10.3 basis points. When this turns positive we may be in recession

  2. ONLY PEOPLE WHO DON’T FOLLOW OVERSEAS NEWS DO NOT REALISE THE DIRTY TRICKS THAT AMERICA PLAYS. WAS
    THE WAR IN UKRAINE BEGAN AS A RESULT OF A CERTAIN PRESIDENT HAVING A POPULARITY READING OF 26%.
    TO IMPROVE HIS STANDING HE IMMEDIATELY VISITED SEVERAL COUNTRIES INFORMING THEIR LEADERS THAT UKRAINE WAS GOING TO JOIN NATO.
    THE SECOND BENEFIT TO USA BECAME A REDUCTION IN THE SIGNIFICANCE OF THEIR ENORMOUS OVERSEAS DEBT BY CREATING INFLATION WORLDWIDE.
    THE THIRD BENEFIT LIES IN THE FACT THAT THE US ARMS MANUFACTURERS, WHO PRODUCE 30% OF ALL ARMS GAIN IMMEDIATE SALES TO SUPPLY UKRAINE FROM MANY PLACES AND THEIR OWN GOVERNMENT.

  3. Hi,
    We are in a recession now.
    Businesses struggling to stay afloat.
    The govt docent know it because they are 3 months behind on stats.
    Not worth being in business now because the risk is greater than the reward.

    • There’s certainly mounting evidence in Australia to support your observation. The ANZ-Roy Morgan Consumer Confidence index has now spent 13 consecutive weeks below the 80 mar, which is considered a warning of trouble ahead. It last occurred prior to the 1991 “recession we had to have”. In April, Comm Bank cited declining discretionary consumer spending on household goods, down -5.7% over the year to March. To put that in context, it was the weakest annual growth in 19 months.

      Unemployment has ticked up, with jobs down -4,300 versus economist expectations for an increase of 25,000. While the unemployment rate increased from 3.5% to 3.7%, the 400,000 immigrants arriving in the next twelve months will see the rate rise further. This will occur amid potentially persistent inflation (energy costs are expected to rise by 25% next month), weakening consumer spending amid the rise in mortgages moving from low fixed rates to much higher variable rates, and the 25% fall in building approvals which will crimp the incomes of tradies who are part of an industry that is the third largest employer in the country.

      • Alexandros Dermatis
        :

        Dear Roger,

        Why do I get the feeling that the RBA’s recent multiple increases of the cash rate are not as near as an effective tool (such as in the past) in bringing down inflation to an acceptable range? Does the RBA monetary model provide an effecrtive contigency for global supply shortages from extraordinary events such as Covid-19? Lots of moving parts at the moment thats for sure

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