US recession: Why traders should handle the news with care
By Tim Vollans
05:56, 2 August 2022
Last Thursday (28 July) we learnt that the US is officially in a recession. But lots of talking heads want to tell us it’s not really a recession. Meanwhile, stock markets are pumping as if this recession will force an imminent return to the ‘easy money’ low-rate policies that the Fed so recently abandoned.
The S&P 500 (US500) is up more than 5% from Tuesday’s low (at time of publication), while the Nasdaq (US100) has been even more impressive, gaining 7% over the same period. Just a strong bear market rally or a sign that times are changing, and sentiment is picking up?
What is your sentiment on US100?
S&P 500 (US500) stock index price chart
So what’s going on and what does it mean for traders?
There’s loads of noise, moving parts and disconnects among all this market mayhem, so let’s break things down to make sense of it all before getting carried away.
First, the recession that isn’t. According to the technical (or widely accepted) definition, the US economy entered recession last week after two consecutive quarters of negative GDP growth.
There’s going to be a load of tedious debate about this (probably lasting months). We can leave it to the academics and politicians to argue about the correct definition. The data provides ammo for pretty much every argument you can make.
Academia aside, the US economy looks like it did just fine in the first half of the year. Employment was still growing, and a key measure of overall consumer demand in the economy (final sales to domestic purchasers) rose by 2% in Q2.
At the same time wages are increasing by much higher amounts than they have previously. The US employment cost index (ECI) increased by 5.7% compared to Q2 2021. While it’s true that wages aren’t keeping pace with headline inflation at 9.1%, wage growth is definitely accelerating to try and keep pace with rising prices.
In the pre-Covid regime, pay was rising at a pretty stable rate of between two and three per-cent. That’s not the case anymore…
Source: US Bureau of Labor Statistics
So, people are still spending, employment is increasing, and wages are rising… Funny looking recession you’ve got there…
No Recession, No Fed Pivot?
There are definitely signs of a slowdown but it’s almost impossible to reconcile the technical definition with reality. There are recessions and RECESSIONS. And if this isn’t a big, bold, capital letters recession, who’s to say the next quarter won’t see the economy resume growth, albeit at a slow pace?
If that happens and inflation hasn’t significantly slowed, would perceptions change?
Put another way, is the recent rally due to the market front-running the Fed pivot? And, is it too early to anticipate that?
Nasdaq 100 (US100) stock index price chart
We’ll see a parade of Fed speakers seeking to clarify their message on this. Minneapolis Fed President Neel Kashkari was first out of the blocks and gave his thoughts to the New York Times at the end of last week.
He said that he was “surprised by markets’ interpretation” when asked about the pricing of rate cuts for next year. Emphasising the point further he added:
“The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”
And just in case anyone at the back wasn’t paying attention, Kashkari declared that the bar to clear for lower rates is “very, very high”
The Minneapolis Fed Chief appeared on ‘Face The Nation’ on Sunday night to reiterate his position:
“Whether we are technically in a recession or not doesn’t change my analysis, I’m focused on the inflation data. I’m focused on wage data. And so far, inflation continues to surprise us to the upside. Wages continue to grow. So far, the labor market is very, very strong.”
Don't fight the Fed
“Don’t fight the Fed” is a timeless cliché passed down from older generations of traders and investors to the new breed. Perhaps that message has been lost after a decade plus of markets being spoiled by a central bank that’s quickly responded to slowdowns by cutting interest rates. It’s a fascinating dynamic.
Sir John Templeton famously said that the four most dangerous words in the English language are “it’s different this time”.
Even accepted wisdom needs context though. If you’re comparing the Fed response function to the past decade of low inflation, then why wouldn’t it be different when inflation’s at 9.1% in the US?
If you’re comparing it to the 1970’s and the era of high inflation, why wouldn’t the Fed response be the same, or at least similar?
What Do Consumers Think Will Happen to Inflation?
One of the more important questions to answer, and one that the New York Fed is on top of with its Survey of Consumer Expectations. Basically, it asks 1,300 people their views on inflation over different time horizons. This is the result:
For now, longer-term inflation expectations are what central bankers would call “well-anchored”. The public believes that this period of high inflation will pass. Within the next three years, inflation will reduce significantly. Within the next five years, inflation will return to the 2-3% range
Which is all well and good as long as they don’t change their minds.
Ahead of the June meeting, the preliminary results of the University of Michigan survey showed longer term inflation expectations accelerating to 3.3%. This is partly what prompted the Federal Reserve to hike by a larger than expected 75bps. The final reading was later revised down to 3.1%, while the latest survey saw expectations drop to 2.8%.
The Fed has already shown their hand once. If longer-term inflation expectations begin to tick higher again, it would be no surprise to see them increase the aggression and drive those expectations back down with even higher interest rates.
One big driver could be energy… Brent crude price chart
Almost everyone notices inflation in their household energy bills and when they’re filling up the car, and despite all of the recession chatter, oil prices remain surprisingly resilient.
If the energy complex (oil, natural gas, and refined fuels such as gasoline, diesel and jet fuel) strengthen, this could cause inflation expectations to push higher and prompt more hikes from central banks.
If that happens, there’s not much margin for error in the tech-heavy Nasdaq 100 (US100). The index is down 22% from all-time-highs…
And up by 95% from the March 2020 lows. Pre-Covid, the Nasdaq traded at a high of 9,755. Two and a half years later, it’s trading just shy of 13,000. If rate hike expectations shift higher again, it’s not hard to imagine another drop in US tech stocks. A higher risk-free rate isn’t usually good news for company valuations.
What is the risk free rate? |
Will that be the case now, or has peak inflation psychology set in?
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