Economic Outlook

Inflation Up, GDP Down

• Two consecutive negative quarters for GDP
• Inflation hits another new high at 9.1%
• Federal reserve boosts rates another 0.75%, signals slight change in posture
• Markets post a positive month in a difficult year

Real GDP registered a negative number for a second consecutive quarter—a common “rule of thumb” indicator of recession. Many analysts have disputed the notion that the economy is currently in recession, citing areas of continuing strength such as employment and consumer spending. It would not be a profitable investment of time or ink to further dispute here whether the US is already in recession—our economy is decelerating, and that deceleration is becoming more pronounced with each successive economic release.

Real GDP contracted by 0.9% in the second quarter of 2022, according to the initial estimate, after contracting 1.6% in the first quarter. GDP and many of the other economic measures most commonly cited are backward-looking. They report on events that have already occurred. Leading economic indicators tend to get less attention, but also tend to be more indicative of where the economy is heading. Leading indicators include such measures as new building permits, new orders for manufacturing, and initial jobless claims. The Conference Board’s index of leading economic indicators declined for a fourth consecutive month in June and was down 1.8% for the first half of 2022.

Industrial production contracted in June, after posting an almost negligible gain in May. New orders and employment are contracting, even as other measures of output continue to expand. Personal income is increasing, but at a slower rate than inflation, so household purchasing power has declined. We are spending more to acquire less. Average hourly earnings increased 5.1% YOY in June. Wages have been rising at a slower pace in recent months. Personal consumption increased 1.0% in the second quarter, the smallest increase since the height of the pandemic. Spending on goods was negative, and spending on services was up 4.1%, annualized. Services comprise the greater part of the US economy, and spending on goods was pulled forward during the pandemic.

Prices are increasing at the fastest pace in decades. The Federal Reserve is sharply raising interest rates.  In a perfect world, policymakers could bring prices under control by tempering demand without triggering a recession. In our world, that outcome is not impossible, but very difficult to orchestrate in a very large and complex economy where policymakers have a limited toolbox.

The primary factors that shaped the economy over the past two years are evolving, but not going away.  Supply chains appear to be gradually healing, and many businesses are diversifying their sources and channels for tangible goods. Ships at anchor off the California coast have declined 80% since January, but truckers and railroads are still struggling to keep up with the increased throughput. The war in Ukraine continues to negatively impact energy costs, grain, and fertilizer markets. In back-to-back reports, we learned that Russia and Ukraine had entered into a grain export agreement and then that one of Ukraine’s key ports had been attacked. More broadly, the world economy has stepped back from decades of progress in the direction of globalization. With all its faults, globalization reduced barriers to trade, lowered the cost of tangible goods, and tamped down inflation over most of the past several decades. If there is another trade regime that will succeed it, it has yet to take shape.

Some positives could emerge from the present challenges. Persistent energy inflation has increased focus on renewables with an attendant focus on the hard economics of our choices in this area.  Diversification of our supply chain is long overdue, with perhaps decreased dependence on trading partners who may not wish us every success.

Overall employment increased by 372,000 in June—a slower pace than in recent months, but still positive. Unemployment was unchanged at a low 3.6%. Employment remains the strongest element in a weakening economy, however, employment is also a lagging indicator that is often one of the last to register a change in direction. Employers still report difficulties filling open positions, but there are also early indications of a cooling in the labor market. The pace of wage increases has slowed, and initial jobless claims, while still low, have been steadily increasing since April.

A growing number of baby boomers are hitting retirement age every day in America, and the generation behind them is notably smaller in size. COVID accelerated retirement for many boomers who had, up until the pandemic, been extending their working lives beyond the normal retirement age. As a result, some of the tightness we are experiencing in the labor market is demographic and therefore less responsive to the economic cycle. 

Inflation has been providing us with the screaming headlines in this economy, and, yes, it is the worst we have seen in 40 years. The CPI “all items” index increased 9.1% YOY in June. “Core” CPI (less food and energy) was up 5.9% YOY and has actually decelerated over the last three months. The energy index rose 41.6% over last year. Energy remains the linchpin of this inflation cycle. 

Inflation will remain the priority over economic growth for policymakers for the foreseeable future.  However, there is some evidence that higher rates and tighter money are already impacting some prices. Many commodities are trading well below their recent highs. Copper is down 20% YOY, steel is down 27.75%, and iron ore is down 38.48% YOY. Lumber is less than half its recent high in March, and many agricultural commodities are down as well. Energy is key, however, since it is a component in virtually everything we buy. While many energy prices are down from their most recent highs, they remain well above the prices we paid pre-pandemic.

The Federal Open Market Committee (FOMC) met on July 26 and 27^th and raised their target for short-term rates by 0.75%. The upper end of that target is now 2.50%. Short-term rates were essentially at zero as recently as February. The FOMC will not meet again until September 20^th, so they will have two months of additional data before they consider another rate increase. The Chairman’s comments following the meeting made it clear that the Fed is now entering a different phase of this tightening cycle. They appear to be past the “shock and awe” phase of monetary tightening and more focused on incoming data. They now believe that short-term rates are “neutral”—neither stimulative nor restrictive.  If the next two months of data confirm a slowing of the economy, and especially if they show any slowdown in the rate of inflation, the Fed may adopt a slower rate of increases beginning in September.  However, they certainly appear prepared to continue the process of monetary tightening in the Fall.  Although their rate increases have been swift and dramatic, interest rates remain well below the rate of inflation. Therefore, “real” rates are still negative. If we assume that rates need to get close to the current rate of inflation before prices stabilize, then the Fed has a very long way to go. If, however, the economy continues to slow and prices level off, the remaining rate increases for 2022 may be moderate compared to what we’ve seen so far. Markets are already pricing some change in Fed policy by early next year.

The sharp increases are impacting those parts of the economy that are rate sensitive. Housing starts were down 11.9% in May and down another 2% in June. Single-family starts were down 8.1% in June; multifamily is holding up better. Existing home sales are off 14.2% compared to 2021. Clearly, the rising cost of borrowing is impacting the housing sector. The current national average for a 30-year mortgage is 5.3%, up from 2.8% one year ago.

Markets posted a counter-trend rally in July with the S&P 500 rising just over 9% for the month. Tech and growth stocks, which had been especially hard hit in the first half of the year, led the rally. The S&P 500 is still down 13% year-to-date. Parts of the bond market also fared better—the yield on the 10-year Treasury note fell from 2.88 to 2.67% during the month. Bond prices rise when yields fall. The bond market seems to be telegraphing an expectation that the Federal Reserve will be obliged to stop raising rates, or even reverse course, sooner than its own statements would suggest. 

It is possible that these positive moves will prove to be little more than a bear market rally. Only time will tell. Corporate earnings have generally been positive but are also being served up with an abundance of warnings from business leaders about the uncertainties associated with inflation, the supply chain, and a consumer increasingly squeezed by inflation. Overall earnings for the S&P 500 were up over 10%, however, if you strip out profits from the oil companies, the gain is much more modest.  Travel & Leisure industries benefited from demand that accumulated during COVID. Whether that demand survives the summer remains to be seen. The current price-earnings ratio for the S&P 500 is 20.78; well below its recent peak, but also well above the long-term average of 16. So, stocks are cheaper than they have been in recent times, but not truly cheap in absolute terms. 

Earnings, like so many other measures, are backward-looking. If some of the effects of higher rates and slower growth are still working their way through corporate earnings, there may be more downside before the bulls run again. However, markets also try to anticipate economic developments well in advance, and if inflation starts to respond to this more restrictive environment in the second half of the year, we may get through the worst of the current adjustments in that same time frame. That’s a lot of “ifs.” As Chair Powell pointed out last Wednesday, predicting economic developments six months out is uncertain in normal times—and these aren’t normal times.