For months, I’ve suggested the only way for the US economy to avoid a recession is for analysts, economists and, importantly, the White House, to redefine the word.
By definition, Q1’s contractionary GDP print raised the odds of a US recession. You need two consecutive quarters of negative growth using the BEA’s preferred methodology, and absent a reason to unequivocally rule out a negative print in a subsequent quarter, one negative print materially increases the chances of a downturn.
In that context, Fed officials and sundry Biden appointees are playing with fire by refusing to countenance the idea that the economy is already in a recession. The risk is amplified immeasurably by last year’s “transitory” inflation debacle. Both the administration and the Fed are running a rather large trust deficit thanks to an inflation problem that refused to abate consistent with predictions.
When the US economy logged a quarterly contraction, the best strategy would’ve been to get out ahead of the situation by explaining to voters that although a recession is possible, it’d be a technicality of sorts. Initially, the public would be skeptical, but there was ample time to refine the narrative and set expectations.
Now, it’s too late for that. A popular real-time tracker that employs the BEA’s methodology is squarely in contraction territory (figure below) and there are only three weeks to go before the advance estimate on Q2 growth is due.
Although the Fed and the White House missed the opportunity, you should expect analysts, economists and everyone with a name or a platform to start explaining why a recession isn’t a recession anymore. Bill Ackman, who relentlessly chided the Fed for being slow to act in May, went down this road in a series of social media posts.
Ackman’s remarks (below) are a template. In the weeks ahead, you’ll be subjected to a similar story from other people you’ve heard of, and plenty you haven’t too.
My purpose here isn’t to weigh the merits of Ackman’s assessment. Only to present it as a preview of what’s coming. At the least, it’s a decent take on last week’s STIR stop-outs and positioning purge into thin, pre-holiday trading. I’d remind readers that rates are prone to false optics — sometimes, the signal from STIRS and bonds is a Fata Morgana. While that may be the case this time too, some of the decline in yields and terminal pricing is indicative of rising recession odds. And with that, I’ll leave you to peruse Ackman’s message to the public.
Over the past two weeks, rates have declined dramatically purportedly due to fears of a recession. Friday’s move was particularly stunning for the scale of the move and for the degree of intraday volatility. I put forth here a theory of what is going on.
On the risk of a recession: A recession is defined as a two-quarter decline in real, as opposed to nominal, GDP. In a highly inflationary economy, it is more difficult for nominal spending and growth to exceed inflation. In order therefore for today’s economy to grow on a real basis, nominal GDP growth must be >8.6% which is a difficult hurdle to exceed. It has been 40 years since we have experienced inflation at current levels and as a result, market participants are used to a world with 4-5% nominal GDP growth and 2% inflation.
With inflation at 2%, nominal GDP growth need only decline from 4-5% to less than 2-3% for two quarters in a row for real GDP to be negative and for the economy to be deemed to be in a recession. Two quarters of negative GDP growth does not however seem to be a reasonable definition during a period with high inflation, particularly when inflation has spiked to nearly 9%. Nominal spending growth of 8% for the last two quarters would technically put us in a recession but this does not make sense fundamentally. The economy is continuing to grow rapidly on a nominal basis. Consumers are spending substantially more this year than last. There are about two times as many job openings than people looking for work. The unemployment rate is at a 50-year low. Wages are rising substantially and it is hard to find workers. Q2 revenues and earnings growth should be strong for most businesses, with earnings misses and margin declines for some companies which have limited pricing power. Consumers have approximately $2.5 trillion of excess savings. While there is a mix shift underway from goods to services, overall demand is extremely strong. We have a supply, not a demand problem. This does not seem like a set up for a true economic recession regardless of the favored definition.
So why have rates declined so dramatically, particularly short rates when the Fed has become increasingly strident about the need for aggressive tightening to bring inflation back down to 2%? The answer I believe is largely due to some misunderstanding about what a recession is, but more importantly technical factors that are driving volatility and the downward move in rates.
Market participants speculating in the fixed income market, particularly hedge funds, often use enormous amounts of leverage because it is available and it allows one to make windfall profits if you get the trade right. The bet that rates would rise became one of the more crowded trades in history going into June 15. As speculators covered their shorts on the Fed news, rates began to decline causing substantial mark-to-market losses particularly for levered participants, who were forced or chose to cover.
With more data points emerging indicative of a slowing economy, the recession narrative took hold causing a further decline in rates, contributing to more losses, and short covering going into the quarter-end when exposures are required to be disclosed in investor reports and financial statements. Extremely limited liquidity going into the July 4th holiday compounded the move and the volatility and pain for levered market participants, as traders looked to, and in many cases, were forced to, exit, or didn’t wish to hold open positions over the long weekend.
So what happens from here? Powell has committed to do ‘whatever it takes’ to quell inflation even if doing so causes an increase in unemployment and a recession. Inflation is not coming down soon. Housing and rental costs, energy, agriculture and food are supply-constrained and higher prices are unlikely to abate for the foreseeable future. Wages are continuing to rise as immigration has been limited, many have exited the workforce and the balance of power has gone from companies to their labor forces. Companies are raising prices because they must in order to cover their costs and because they can. The wage price spiral is underway.
While demand is moderating due to sticker shock and inflation as well as rising rates, overall demand remains strong. Inflation has become embedded and is a daily experience, in headline news and a dinner table topic for all. I Savings bonds pay 9.62%!
In order to stop the inflationary spiral, the Fed will need to rapidly raise rates to 4-5% by next year, which hopefully will be enough to snuff inflation. The mild and transitory inflation being priced by the market as of Friday is a fiction. Rates are going up a lot soon.
The sooner the Fed quells inflation, the better for longer-term bonds and long-term financial assets like equities. Don’t be misled by short-term, technically driven market movements. Stocks of high quality businesses with long-term growth and pricing power look cheap.
Don’t forget that the stock market measures nominal business value. Inflation is hurting business and consumer confidence and slowing growth. Killing off inflation will save the economy in the longer-term at the expense of some short-term pain. Let’s hope the Fed gets it right.
And yes, we put our money where our mouth is. I have often wondered why investors who share their views are often criticized for holding investments on which they will profit if the views they share turn out to be correct. We are 100%+ long high-quality growth businesses with pricing power, and own hedges on which we will profit if rates rise. Our positioning, as always, matches our thinking and stated views.
We’ve been told there’s a ton of leverage in the system — and unwinding it, necessary as that may be, is likely to have unforeseen consequences. I expect something pretty major will break before we get to Ackman’s 4%-5% on rates.
“The answer I believe is largely due to some misunderstanding about what a recession is”
The boldest type of claim to make about anything in financial markets is that the market got it wrong. Not that this never happens, but because often time is more likely to prove that person wrong.
Also, I feel like I’m missing something as I most likely do not understand economics as much as Ackman, but how is real GDP distorted due to high inflation? Doesn’t the fact that real GDP is an inflation-adjusted measure already take into account whatever the level of inflation is? Am I missing something?
Appreciate some clarity from smarter minds.
It’s not that real GDP is distorted by high inflation, but rather real GDP growth will be negative (by definition) if inflation is higher than nominal growth. With negative real growth in two consecutive quarters we enter a recession (again, by definition).
You’re right that real GDP takes inflation into account. Perhaps the disconnect is that you interpret Ackman’s point as “inflation is altering how the economy grows and distorting measures of economic growth such that real growth is artificially lower”, which would require a lot more explanation by Ackman.
His point is a little simpler: “while real growth will be negative, economic dynamism remains strong, so entering a technical recession won’t be causing economic distress any time soon.”
I see this as an attempt by Ackman to explain why his losses on paper (he bet on higher rates) are widening and is telling investors to be patient with his strategy. He explains the decrease in rates as not necessarily a sign of imminent economic distress (hence his point about a technical recession not being that bad) but rather a short squeeze caused by our entering the technical recession. In other words: “the Fed will keep tightening, and the obvious trade is still alive”.
I guess I fail to understand why negative real GDP growth can be “explained away” by high inflation, or how this combination results in a technical recession but which somehow isn’t comparable to a normal recession.
To me, the logic sounds similar to a company saying: “Our profits went down, but that’s only because our costs increased more than our revenues.” Of course no company would say this as an excuse (rather more as an explanation).
It is more accurate to say a company might announce that European sales are down in dollar terms, because of the strong dollar, but European sales are actually up in local currency. Hence, European sales ARE growing, they just are down when translated into dollars. I think Ackman is just saying that in the day of lazy analysis, be careful for flawed logic.