Timely Financial News

Recession worries? Here’s a Message From Our Chief Investment Officer.

BY Spectrum Wealth Management | Apr 29, 2022

On Thursday, the Bureau of Economic Analysis reported that real GDP fell by -1.4% (annualized rate) in the first quarter of 2022, well below the forecast of +1%. The decline was the first negative reading since the second quarter of 2020.  One of the major concerns dogging the market this year has been that, in its effort to fight inflation, the Fed will induce a recession and, as a result, the surprise drop in GDP may make it seem like a recession is now inevitable.

Are we in a recession?

The easy answer is no. A recession is defined as two consecutive quarters of economic contraction, which is not the current case. However, because the data is backward-looking, we will not know the answer until the second-quarter data is available. Even though the economy shrank in the first quarter, that does not mean that a recession is inevitable. There have been many previous occasions when the U.S. has had a standalone negative quarter (a negative quarter that was preceded by and followed by positive quarters and thus did not result in a recession). Since 1947, there have been 43 quarters when the U.S. had negative real GDP growth; of those 43, 17 (or just under 40%) were standalone. So, it is entirely possible that we could avoid a second negative quarter and a recession.

Unfortunately, this does not necessarily mean that there is smooth sailing ahead. For instance, there was a “standalone” contraction in the first quarter of 1974 as real GDP was down -by 3.4% and then gained 1.0% in the second quarter. However, the economy slipped into a recession in the third quarter of 1974, and the S&P finished the year down nearly 30%.

On the other hand, more recently, there was a standalone contraction in the first quarter of 2014 when real GDP declined by 1.4%. GDP rebounded for the rest of the year, gaining 5.2% in Q2, 4.7% in Q3, and 1.8% in Q4, and the S&P 500 finished the year up more than 11%.

Over the 17 single-quarter contractions since 1947, the S&P 500 has posted an average one-year forward return (from the beginning of the quarter) of about 1% (with a similar median return), with nine observations being positive and eight being negative. There is an extremely wide dispersion in the returns as some of these single-quarter contractions were truly standalone events, like 2014, while others occurred either shortly before or shortly after major recessions.

The critical point here is that we should be concerned about the possibility of the economy and the market worsening; however, as we saw in 2014, we have experienced a single quarter of negative growth without a steep drawdown.

Corporate Earnings Remain Strong

Since the beginning of April, 220 of the companies that comprise the S&P 500 have reported earnings. Of those 220 companies, 182 (or nearly 83% have beaten their consensus estimates). While the economy slowed in real terms over the quarter, the companies in the S&P 500 have generally seen their profits grow faster than analysts projected, which is not what we would expect to see during a recession. While broad economic growth is undoubtedly important for the market, there is a more direct link to corporate profits. 

However, this also begs the question: how could so many companies beat earnings during a period when the economy contracted? At least part of this may be explained by inflation. The -1.4% Q1 GDP figure is expressed in real terms (after considering inflation); in nominal terms (excluding inflation), GDP grew by 6.5% in Q1, but growth was negative after adjusting for the historically high inflation. Corporate earnings, on the other hand, are expressed in nominal terms. Analysts may adjust their earnings forecasts based on inflation, but there is no explicit adjustment on firms’ financial statements.

More importantly, several factors outside of domestic demand for goods and services negatively impacted GDP. 

One of the major items weighing on Q1 GDP was trade.

Another reason for the disparity between corporate earnings and GDP was increased inventories and reduced exports, resulting in a negative trade balance that weighed on GDP. The quote below is an excerpt from a Reuters article:

Front-loading by businesses fearful of shortages because of the Russia-Ukraine war contributed to a surge in imports. Exports tumbled, leading to a sharp widening of the trade deficit, which chopped 3.20 percentage points from GDP growth, the most since the third quarter of 2020. Trade has now been a drag on growth for seven straight quarters.

Government spending decreased for the second quarter in a row, contributing to the GDP decline.

However, consumer spending, which accounts for the bulk of U.S. economic activity, increased by 2.7% compared to 2.5% in the fourth quarter. This is also potentially supportive of the idea that the economy’s core remains strong overall but was hampered by some temporary factors, like the buildup in inventories.

What does this mean for the market going forward?

A shrinking economy is not a positive environment for equities. Some of the worst bear markets on record took place during deep economic recessions. However, from a short-term perspective, there could be a silver lining.

The recent hawkish stance from the Fed, which has contributed to the weakness in the equity market, has largely been in response to inflation and an overheating economy. In addition to the weak GDP number, quarter-over-quarter core PCE (PCE is the Fed’s preferred inflation gauge) was released on Thursday (April 28) and came in lower than projected (5.2% vs. 5.5%). It is possible that the slower growth and lower-than-expected core inflation could cause the Fed to consider slowing its pace of quantitative tightening, thereby easing some of the concerns that have been weighing on the market. In addition to the signs of underlying strength obscured by the headline GDP number, the potential for a softer stance from the Fed could partially explain why we saw the S&P gain nearly 2.5% in Wednesday’s (April 27) trading.