CAPITAL IDEAS: The recession everyone was expecting already happened; now it’s getting better (but barely)

CAPITAL IDEAS: The recession everyone was expecting already happened; now it’s getting better (but barely)

There was a recent flood of freshly released economic data for investors to sift through: inflation, labor costs, consumer spending, home prices, an interest rate hike by the Federal Reserve, Gross Domestic Product (GDP) for the second quarter (Q2) of 2023, and about one-third of the S&P 500 companies reported earnings.

I’m not going to drag you through all of those. I’ll sum it up for you: For 19 months, I have heard from many that a recession is right around the corner. None of this recent data feels recessionary (except for corporate earnings, but I suspect those are on the mend).

That is not to say a recession won’t occur eventually. I don’t see how any economy could ever avoid a future recession. Recessions in the U.S. happen and have for hundreds of years. But still, I don’t believe there were ever so many people so wrong simultaneously about the next recession being imminent.

I’m not saying that I don’t make mistakes; I certainly do. But it is interesting that so many people were on the wrong side of the trade. And now it is interesting that the winds are shifting regarding economic sentiment: Many pundits are now calling for rosy times ahead.

Economic data that tracks what is happening currently is called “coincident” data. Coincident data has been solid or improving for the last year, so that is nothing new. Perhaps the aggregate of that coincident data over the previous year has soothed the spirits of nervous investors.

However, the “leading” indicators have been sour. Given the negative direction of the leading indicators, you would imagine the pundits would remain downbeat. Yet many have shifted from their “the sky is falling” narrative. So what has been the most significant change to have influenced thinking? Stock prices.

U.S. equity markets have been on a tear for nine months. Apparently, that is long enough to turn predictors of a recession into the most soothing of soothsayers. Are investors becoming too complacent? Not yet, but it is hard to fight the Fed’s headwind—watch out!

Despite a year-plus of concerns, the U.S. economy grew at a 2.4 percent annualized rate in the second quarter of 2023. That was faster than the 2 percent growth rate of the first quarter and the fourth consecutive quarter of growth since the first half of 2022.

I agree that the odds of a recession starting in 2023 are receding (pun intended). However, with interest rates at a 22-year high, recession risk will remain uncomfortably high for 2024.

If not for the delayed government spending from the American Rescue Plan Act and the Inflation Reduction Act, I would sell stocks in preparation for a recession. There is still something like $350 billion of ARPA dollars that remain unspent. And while a good amount of the $891 billion IRA has been allocated, much of that has yet to be spent. The Committee for a Responsible Federal Budget has a “Track the COVID Money” widget.

However, it only shows breakdowns of the committed/disbursed amounts, not what was spent. Spending numbers are not specific in that tool and must be parsed out. However, the amount that still needs to find its way into the economy is significant, no matter the rounding errors.

Before the COVID-19 era of fiscal stimulus, half a trillion dollars of stimulus felt like a lot. And guess what? It still is. ARPA money must be expended by 2026, so more of that will hit the economy in 2024. It took about five months for the Treasury to announce a timeline for IRA implementation; I doubt with all my heart and brain that it will be spent up this year, and much of that spending will occur in 2024 and beyond.

There seems to be enough stimulus remaining in the pipeline to stave off a recession until after the 2024 election. There is an emphasis on “possibly”—those higher interest rates are a killer.

And the recent U.S. credit rating downgrade by Fitch from AAA to AA+ may erode the risk appetite of investors. Still, I suspect the stock market should hold up for the rest of the year, and any pullback could be an opportunity to get cash to work.

Scott Little of Berkshire Money Management shared practical knowledge on his LinkedIn page. July 2023 marked the fifth straight month of gains for the S&P 500, marking a year-to-date increase well into the double digits. For the 21 previous times this occurred, the average return through the remainder of the year was 4.8 percent, with a 95 percent win rate.

The Nasdaq also has a positive average return over that period. After the monster rally stocks have enjoyed, a 4.8 percent return probably doesn’t sound exciting. But it should.

First, it is an annualized rate of 11.52 percent, and that is tremendous. But more importantly, given all the recession chatter, nothing is necessarily ominous on the horizon for stock prices. The economy is getting better, even if barely so.

If you are a bull, you can cherry-pick your favorite gangbusters econ reports to support your case. If you’re a bear, there is more than enough weak data to hang your hat on.

Ultimately, all this information is aggregated, interpreted, and filtered through the lens of an investor trying to generate a return in the markets. Since corporate earnings are the mother’s milk of investment success, all this information must be directed toward an expectation of profits.

More than two-thirds of the companies in the S&P 500 have reported earnings for the second quarter of 2023. The blended (reported and expected) year-over-year earnings decline is -7.3 percent at the time of this writing.

If that number holds, it will be the largest earnings decline since the COVID-19 shutdowns in the second quarter of 2020 (-31.6 percent). And it will be the third consecutive quarter in which earnings have declined year-over-year.

Think about that.

GDP declined in Q1 and Q2 of 2022.

In Q3 of 2022, the S&P 500 broke below 3,600 points.

Corporate earnings declined in Q4 of 2022 and Q1 and Q2 of 2023.

The National Bureau of Economic Research (NBER) has yet to “officially” declare a recession for this cycle, so people continue to expect a recession. Others are turning more upbeat and now hinting that the Fed will either engineer a soft landing or even no landing.

I say to heck with the NBER; the U.S. economy has suffered a recession. And now it is getting better. But barely—at least measured by corporate profits.

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For 2024, Wall Street analysts are projecting earnings growth of 12.6 percent. An earnings growth rate of 12.6 percent is not “barely” improving; that is fantastic. But I don’t trust analyst expectations. At the start of 2022, the average of 23 analysts from the biggest, most well-known banks and investment firms had a year-end 2023 price target of 4,080 for the S&P 500.

The index is now 500 points above that. It could drop 500 points by year end, but it is not as if those analysts were expecting the stock market to rocket up and come back down—they were wrong. Analysts are generally bad at their jobs; I can’t rely on an expected earnings growth rate of 12.6 percent.

The economy went through a recession, and it is getting better. Throughout 2024, however, the Federal Reserve’s monetary policy and the continued COVID-19 fiscal stimulus will battle it out to determine if the economy can escape a recession next year.

Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources.

Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. (Source)

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