U.S. Gross Domestic Product (GDP) contracted in the first two quarters of this year, so according to the conventional definition of a recession (two consecutive quarters of negative GDP growth) the U.S. economy is in a recession. However, there is much debate about whether this time is different and what officially defines a recession. Regardless of how we label it, the U.S. economy has definitely slowed and faces further challenges. So, what are investors to do during these very uncertain economic times?
First, let’s evaluate the current situation. In the first quarter of 2022, U.S. GDP decreased -1.6%, followed by a -0.6% contraction in the second quarter. At first glance, this would seem to clearly indicate that the U.S. economy is in a recession. However, these quarters came after an enormous 6.9% expansion in the final quarter of 2021. That growth was largely driven by an unsustainable rapid increase in inventories, which subsequently caused a significant drag on GDP growth in the first half of this year.
Contributions to GDP Growth
The reason why the change in inventories isn’t too unsettling is because it is the smallest component of GDP, and over time it has no cumulative effect on GDP growth. However, inventories are notoriously volatile, so at times they can have an outsized impact on GDP. In this case, retailers had a surplus of inventory to work through as they poorly anticipated the rebalancing in consumer purchases—such as the shift back to spending on services from goods, as the economy normalizes post-COVID.
To gain a clearer understanding of the economy, let’s focus on the two largest and most important subcomponents of GDP—personal consumption (i.e., consumer spending) and business fixed investment (nonresidential & residential), which is sometimes referred to as core GDP. As seen below, core GDP hasn’t contracted this year, but growth did flatline in the second quarter.
Real Core GDP Growth
The sudden drop off in core GDP growth is due to weakening in both its subcomponents. Consumer spending grew in Q2, but more slowly than in prior quarters, and business fixed investment decreased due to a large pullback in residential construction, which is likely to continue contracting. The market for new houses has just started to soften, but it has done so rapidly. Spiking mortgage rates have made houses, which have also experienced significant price appreciation, to become unaffordable to many would-be homebuyers. As a result, the supply of new houses has surged, and homebuilders have responded by cutting prices. Going forward, homebuilders are likely to remain cautious until mortgage rates and recession fears abate.
Meanwhile, persistently high inflation continues to pressure consumer spending. If inflation remains high, consumers will not be able to continue increasing spending on an inflation-adjusted basis. Their wages are growing, but not fast enough to keep up with rising prices.
Ironically, the Federal Reserve (Fed) is concerned about the pace of wage gains as it helps sustain high inflation. However, if the labor market weakens, personal consumption will come under even more pressure. At present though, that is a secondary concern to the Fed as they focus on bringing down inflation. The Fed hopes to accomplish this by weakening demand (i.e., consumption & investment) through higher interest rates. This approach leads many investors to wonder how the Fed can bring inflation down to their target without forcing the economy into a recession—if it isn’t already in one.
Much of the current financial press coverage is focused on debating whether the U.S. economy is already in a recession or not. On one hand, the conventional recession definition of two consecutive quarters of negative GDP growth has been met. However, the National Bureau of Economic Research (NBER)—a private, nonpartisan network of 1,700 economists, which is widely accepted as the arbiter of U.S. business cycle dating—does not espouse the conventional recession definition. Instead, they evaluate a broader set of monthly measures (spanning production, income, employment, and sales data) for a “significant decline in economic activity that is spread across the economy and that lasts more than a few months.” While the conventional recession definition typically aligns with the NBER’s recession dates, it hasn’t always. For instance, the NBER doesn’t consider the U.S. as having experienced a recession in 1947, despite two consecutive quarters of contraction that year. However, the NBER identified a recession in 2001, despite not having two consecutive quarters of contraction that year.
So far, the NBER has not announced the start of a recession, but in the past they have taken four to 21 months to declare the start or end of a recession, so they may soon. However, we believe it’s unlikely that they will identify the start of 2022 as the beginning of a recession since most economic measures continued to expand during the first half of this year, as depicted below.
Monthly Change in NBER’s Recession Indicators
Regardless, from an investment perspective, it’s not important whether the U.S. already entered a recession but rather what will happen going forward. What we know with certainty is that the core drivers of GDP have stalled, making the economy more susceptible to faltering amid continued pressures from inflation and tightening monetary policy.
With so much economic uncertainty, what should investors do? Some may feel inclined to try to sidestep further losses by getting out of the market. However, market timing is fraught with risks. For instance, so far in Q3 markets have rebounded sharply. On the flip side, if markets selloff again, it will likely be in response to further deterioration in the economic environment, which would present even more reasons not to be in the market. In other words, market timing poses two challenges—not only identifying the top but also the bottom.
Instead of trying to predict how the market will behave in the short-term or positioning for one possible scenario, we believe it’s wiser to:
- evaluate risks in light of current valuations and your investment horizon,
- prepare for a range of potential outcomes by diversifying across assets with varying sensitivities to growth and inflation, and
- look for opportunities to increase resiliency or return potential.
Recently, we have seen opportunities to take advantage of sharp drawdowns in riskier market segments. We have also captured some gains in pockets that have surged alongside inflation by repositioning into assets that are more defensive in nature—all while maintaining broad diversification.
As always, it’s unclear what the future holds, and that is why we believe it’s wise to prepare ahead of time by having a financial plan, aligning your investments accordingly, and tracking your progress as you stick to the plan through the inevitable ups and downs of the market.
At Ronald Blue Trust, we strive to understand our clients’ goals and implement a personalized investment strategy to achieve those goals. If you need assistance and would like to talk to a Ronald Blue Trust advisor, please contact us at 800.987.2987 or email [email protected]