By Ellen Hazen, CFA®, Chief Market Strategist

July 29, 2022

July Takeaways:

• The economy slowed, most recently confirmed by a second consecutive quarter of negative GDP growth
• Corporate earnings reflected both economic slowing and margin compression, with S&P500 companies reporting an average of 10.6% revenue growth (down from +13.1% last quarter), and only 3.3% earnings growth, due to higher labor and materials input costs
• Commodities prices weakened across the board, while growth stocks began to outperform value stocks again, after underperforming value stocks in the first half of the year. Both are also consistent with a slowing economy
• The yield curve inverted early in July, with the spread between the 2-year and the 10-year widening to as much as negative 25 basis points. Historically such an inversion has presaged a recession, albeit with a lag
• A high inflation reading of 9.1% on the Consumer Price Index (CPI) undergirded the Federal Reserve’s (Fed) decision to continue tightening monetary policy, including an increase the Federal Funds rate by an additional 75 basis points and a continuation of its balance sheet runoff

What We Are Watching for in August:

• Inflation readings, including the CPI on August 10 and the Personal Consumer Expenditure Index on August 26. A decline in core and/or headline inflation could give the Fed cover to pause monetary tightening in September
• July jobs data, which will be released August 5, will provide additional information on the strength of the US consumer
• Retail companies will report their July quarters, giving us an additional window into consumer spending dynamic

It has become somewhat of a parlor game among professional investors to discuss whether or not the US economy is, or will soon be, in a recession. One complicating factor is defining what a recession actually is. A common definition is two consecutive quarters of negative quarter-over-quarter GDP growth. Quarter-over-quarter GDP growth was negative in both Q1 2022 (-1.6%) and Q2 2022 (-0.9%), so by this definition, the US is in a recession. There are a couple caveats, though. One is that a significant portion of the Q1 negative print was due to a reduction in net exports, while the negative Q2 print was primarily a reduction in inventories – should those “count” when assessing whether the economy is in a recession, for investment purposes? Many investors instead choose to follow the formal National Bureau of Economic Research (NBER) definition, which is a significant decline in economic activity that is spread across the economy and lasts more than a few months.

They pay particular attention to net personal income less transfers (such as the pandemic stimulus checks) and employment, so it may be that the NBER will not characterize today’s environment as recessionary. A strong labor market is generally uncharacteristic of a recession.

Regardless of the definition (“you say tomayto, I say tomahto”), the reason we as investors care about whether the economy is in recession is because of the impact on corporate earnings and securities prices. In order to ascertain what the impact might be, we focus carefully on the US consumer. Because consumer spending comprises two-thirds of US GDP, our view on GDP growth and the overall health of the economy hinges on our view of the consumer.

The US consumer is in fairly healthy shape by many measures. The broad unemployment rate has been near a record low, at 3.6% for each of the last two months. Jobs are plentiful, and nominal wages are rising. (True, the unemployment rate may be somewhat artificially depressed because the labor force participation rate – which is the denominator in the unemployment rate calculation – has decreased, with 45-54 and 55+ age cohorts still shy of pre-COVID participation rates. Even so, consumer sentiment surveys reflect a belief that jobs are “plentiful.”)

Around the edges, the evidence is piling up that the consumer is weakening. “Excess” household savings – savings above the pre-COVID trendline – has declined, from about $2.4 trillion in March to about $2.2 trillion now, according to The Macro Research Board.

The consumer also continues to spend on credit cards at a much higher growth rate than debit cards, with the most recent readings showing credit card spending growing just over 15%, while debit card spending is growing less than 2%. Debit cards are often used when the user has the funds in the bank, while credit cards are often used to carry a borrowing balance. During COVID, consumer spending shifted more toward debit cards, particularly after the stimulus checks were sent, but this has reversed over the past year with credit growing much more quickly.

Another concerning data point is that average consumer deposit balances at banks have declined, according to major banks. In June 2022, JPMorgan Chase & Co. noted that average bank balances had been declining across all income cohorts.

Adding to these stresses, in recent weeks we have observed a number of consumer-oriented companies report that consumer spending is rapidly shifting: Target Corp. significantly missed April quarter earnings estimates because the consumer pivoted sharply away from more discretionary, higher-ticket (and more profitable) goods like electronics and appliances and toward basic goods like food and household supplies, while Walmart announced just this week that the negative impact of inflation is impairing its customers’ ability to afford general merchandise items as well.

Finally, no discussion of the consumer would be complete without examining autos and housing. Both are items that are frequently financed, thus are effectively more expensive in a higher interest rate environment. Auto sales have declined on a seasonally adjusted year-over-year basis in recent months, although that may be in part attributable to shortages. In June, housing sales were lower than June of every year since 2016, and numerous other housing measures are showing signs of softening.

Despite the very strong labor market, as Fed Chair Jerome Powell repeatedly cited in this week’s press conference, consumer spending is slowing. The investment implications of this are fairly straightforward. Pro-cyclical areas, such as consumer discretionary, industrials, and materials often underperform in a slowing economy. Conversely, more stable areas, such as healthcare, utilities, and real estate tend to outperform. The implications for growth and value stocks are not as clear-cut. In a rising interest rate environment, growth stocks tend to underperform, as much of their value is far in the future, hence discounted at a higher rate. On the other hand, in a slowing economy, growth becomes scarcer, and investors are more willing to pay for growth stocks. We’ve seen both of these dynamics play out over 2022 thus far, with rising interest rates and high starting valuations causing growth stocks to underperform in the first half, while growth stocks have strengthened as economic slowing becomes more apparent.

Within fixed income, a slowing economy justifies a tilt toward higher quality and away from lower quality. We have continued to reduce exposure to lower quality areas such as high yield while increasing exposure to Treasury securities.

Whether the consumer will weaken sufficiently to cause a full-blown recession in the US is hotly debated amongst our team. As long as the labor market remains as strong as it has been, it is difficult to envision a deep recession. At the same time, evidence of incremental consumer weakness continues to accumulate. Should the labor market begin to weaken, we would become increasingly concerned about the probability of recession.

Disclosures