Keystone Financial Group
David R. Guttery
RFC, RFS, CAM
Answer: Probably, But the Details Are Complex and Fascinating
You have probably been hearing a lot about the state of the economy in the mass business media, and along with that, a lot of conjecture over whether we are in a recession or not. The recession topic similarly has dominated the conversations I have had with my clients for several months.
The National Bureau of Economic Research is the only organization that is tasked with determining if we are, in fact, in a recession. Frankly, it will be several months before we hear an official ruling from the organization, but for the time being, we can certainly evaluate the economic metrics that will factor into that determination. At a very high level, in my opinion, yes, we are in the beginning stages of a recession, and furthermore, as I have discussed in the past, I believe this recession could be long in duration but shallow in frequency.
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Are we in a recession?
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What Is a Recession?
Many people have the impression that a recession is nothing more than two consecutive quarters of negative growth in gross domestic product. Is this an accurate definition of what it means to be in recession? No, not really.
It is a good, high-level, layman’s definition of what it would mean to be in recession. I say that because if you find two or more consecutive negative growth quarters, then you generally have all of the other components that are required to meet the definition of being in recession.
This is a very odd time. Many firsts are impacting both the markets and the economy, and there are other things taking place that we haven’t seen in 50 years. When trying to answer the question “are we in a recession?”, we have to consider these oddities.
On one hand, it is difficult to have a recession when jobs are being created, and both the manufacturing and services sides of the economy continue to expand. However, rampant inflation, wages that are not keeping up with inflation, and economic deceleration are certain characteristics of a recession, and we have all of these present right now.
This shows that observing two negative quarters of gross domestic product growth does not fully define what a recession is. The definition of being in recession includes many other factors. When viewed holistically, I do believe that the current trajectory of the economy will indeed meet the definition of recession, but again, it will be the National Bureau of economic research that makes that determination, and that will likely not happen for several more months.
Quantitative Tightening Actions Show the Complexity of the Current Economy
With regard to “firsts” and “oddities”, it is certainly very strange to observe the Federal Reserve in an aggressive quantitative tightening posture while the economy contracts. We have observed negative economic growth over the last six months, as evidenced by recent GDP readings. Yet the Federal Reserve is quantitatively tightening, which is normally what they would do when the economy is expanding too quickly.
Statistics from June showed that the CPI increased by 9.1% over the previous 12 months. In light of this, it is certainly odd that a precious metal like gold would be down 13% since March while this was unfolding.
Aren’t gold, silver, and other precious metals supposed to be stores of value during periods of high inflation?
Clearly, that isn’t working well today, and this is due in part to the Federal Reserve’s aggressive posture and the strength of the United States dollar.
The U.S. Dollar Nears All-Time Highs
As you can see in this chart, the Bloomberg dollar spot index suggests that the dollar is nearing an all-time relative high against the global basket of currencies. What is most striking, though, is how quickly the dollar has strengthened.
Anything denominated in the strengthening currency will likely go down in value. So, yes, we do have inflation at a level not seen since 1980, and at the same time, we see a precious metal like gold, which has historically been a safe haven against inflation, also moving down as a function of significant dollar strength.
For the first time in 20 years, the dollar and the euro are at parity. Remember, currency pairings are relative. The weakness in the euro is adding to the strength of the dollar when you consider the two in tandem. The actions of the Federal Reserve are inherently strengthening the dollar. The eurozone economy is being adversely impacted by the effects of the war in Ukraine, particularly with regard to energy and food, and Brexit also continues to impact the eurozone.
Did Money Printing Exacerbate Inflation?
Why is the Federal Reserve taking such an aggressive posture? The members of the board are desperately trying to rein in the money that was printed over a 30-month period before it becomes incendiary and touches off a period of stagflation.
Why did they print so much money? The printing took place to fund unprecedented spending promulgated by Congress in a response to the unprecedented shutdown of the American economy and the loss of so many American jobs and businesses.
For the first time in 50 years, treasury securities and equities are positively correlated.
Normally, when the market is volatile, we’re able to turn to things such as treasury securities for buoyancy and take advantage of negative correlation. This means that treasuries are likely to move in a positive direction while the market is moving in a negative direction.
But we don’t have that today, because the Federal Reserve’s attempts to unwind its balance sheet are creating significant price distortion and, as a result, prices of treasuries are declining and yields are rising. Again, this is very unusual and is something that we have not seen since 1972.
This is just a handful of the firsts we are seeing, and this is making it virtually impossible to rely on anecdotal evidence and historical models to gain insight into what may happen next. So, when we’re wrestling with the definition of a recession, we simply cannot rely solely on a high-level layman’s definition of two negative growth quarters of gross domestic product. We must look more deeply at the components of what is taking place and view them all holistically.
Determining the State of the Economy: Look at the Details
What are the economic components that should be monitored when trying to gauge the trajectory of the economy? Well, first, let’s take a look at our capacity to spend.
We know that all nonfarm payrolls rose by 5.1% over the most recent 12-month period, according to the Bureau of Labor and Statistics. I mentioned earlier that headline inflation was 9.1% over the same period. Other things like food, fuel, shelter, and health care have risen by much faster rates than headline inflation.
Therefore, our capacity to purchase these things is going backward and doing so by an increasingly wider margin each month. And keep in mind that gross domestic product is 70% consumption.
Over the last several weeks, I have absorbed the thoughts of many economists, many of whom suggest that roughly two-thirds of American households are living paycheck to paycheck. Throughout the year, we have read many opinions that suggest Americans are saving very little of their income. I believe that could be true because it doesn’t appear that we have much left to save.
On top of that, we are also hearing that savings may have been depleted.
As just one example of this, a metric from the St. Louis bank branch of the Federal Reserve suggests that the average American household is in more credit card debt right now than at any other point in the last 20 years.
To me, it appears that our capacity to spend has gone backward for a very long time, and the majority of what we do have to spend is being spent on durable things that we must have, like food, fuel, healthcare, and shelter — and that this is happening to the point where we may have depleted what savings we had, meaning the average household is turning to credit cards to make ends meet.
So next year, when inflation is still likely to be high and wages may still struggle to keep up with inflation, you must now add the debt service to this equation. I’m not sure how you connect these dots and come up with an expanding economy.
From a macroeconomic standpoint, we see that the ISM Manufacturing index does remain above the expansion line of 50, but look at the trend of the last 12 monthly readings. We are clearly moving in a discernibly negative direction.
The same is true of the ISM Services index.
We can look at other metrics like housing, durable goods, and industrial production, to confirm these trends.
Housing is also a concern. I would suggest that nothing the Federal Reserve is doing right now will impact the cost of gasoline or food. In fact, Jerome Powell, the chairman of the Federal Reserve, recently admitted that the Fed has no power over these two durable yet pervasive areas of inflation. I would counter, however, that future actions of the Federal Reserve will actually add to housing inflation.
Through quantitative tightening, we see treasury prices declining and yields rising. Mortgages are clearly tied to those yields that are rising. As a result, mortgage rates have more than doubled from where they were just in mid-February.
The Goldman Sachs housing affordability index is at a level that we have not seen in a very long time. As mortgage rates have increased, increasing numbers of families have been priced out of the housing market. This means that rental income is rising. Think about it. If I am a landlord, and the thing that I have is growing in demand, then why wouldn’t I raise rents?
This is bad news: food, fuel, and shelter — three durable things that we must have and that we will consume regardless of the state of the economy — are increasing at a rate that is higher than that of headline inflation.
Indeed, these were the three largest contributors to the CPI reading in June. The Federal Reserve, by its own admission, can’t touch two of them, and they’re making the third one worse with each new policy action.
Finally, according to the University of Michigan, consumer sentiment is at an all-time record low.
Confident people spend money. People that aren’t confident typically don’t spend money on things that aren’t necessary, and as a result, the velocity of money is usually lower. That’s exactly what we observe today.
Are we in a recession? We will learn the official answer over the coming months, but for now, looking at the data that will go into that analysis, I am comfortable in suggesting that indeed we are in the beginning phases of a recession that could last for a long time.
We will actually produce two videos and articles this month as we tackle this subject. Our next article will discuss investment strategies that people should consider when navigating this recession.
*David R. Guttery, RFC, RFS, CAM, is a financial advisor and has been in practice for 31 years. He is the president of Keystone Financial Group in Trussville, Ala. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided here is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.