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What's the story behind all the talk about inflation and a recession?
Headlines abound with news about inflation and a possible recession, which can make even the most steadfast investor feel a little uncertain. And the numbers so far for 2022 don't tell a great story.
After stellar economic growth in 2021, the US economy declined 1.4% in the first quarter of 2022[1]. This was the first contraction of the economy since the beginning of the economic recovery during the pandemic in 2020. The S&P 500 is down 12.9%[2] for the year through April 2022, and is off to its third-worst start in history. Bonds using the Bloomberg US Aggregate Bond Index are also down -9.5%[3].
This performance is largely due to record high inflation, with all eyes focused on the Federal Reserve (Fed). Investors are concerned that the Fed may not be able to tame inflation without causing economic damage. This concern is causing many investors to worry that a major recession is right around the corner.
While it’s true that the potential for a recession is greater, it is far from a foregone conclusion. Here we'll share some of the reasons why the risk of a recession, while possible, remains low in 2022. But first, what exactly is a recession?
Defining a Recession
Given the increasing worries of an impending recession, let’s start by defining it. The most widely accepted definition of a recession is: two consecutive quarters of negative economic growth as measured by gross domestic product (GDP). Using this definition, the recent 1.4% drop in economic growth alone does not meet the definition of a recession, but certainly points to the possibility.
Looking beyond the headline numbers, the story is mixed. For the quarter, the U.S. was hurt by a sharp drop in exports due to supply chain disruptions and decreased government spending. Yet at the same time, consumer and business spending increased.
It’s clear that economic growth is slowing as the post-pandemic stimulus fades; however, underlying growth trends, as evidenced by continued consumer spending and business investments, show the economic engine has yet to run out of steam[4].
Additionally, there are several other reasons the U.S. economic outlook may be brighter than some suspect.
Four Reasons for Optimism About the Market
1. Consumers remain financially healthy.
Consumers have accumulated more than $2 trillion in excess savings during the pandemic[5]. In addition, the household debt service ratio, which is the percent of after-tax income used to make payments on mortgages and other debt, remains at a 40-year low[6]. High savings and low debt servicing costs support continued consumer spending, which drives 70% of US economic growth.
2. Inflation is taking a smaller bite out of consumer spending today relative to history.
It’s true that higher gas and grocery prices leave less for consumers to spend on other items. The current trend in energy prices is estimated to deliver a $200 billion hit to consumption for the year[7].
However, while the hit is meaningful, it pales in comparison to $2 trillion US consumers have collected in excess savings.
Finally, thanks to more fuel-efficient vehicles, spending on gasoline has declined 60% as a share of a consumer’s total wallet during the past four decades.
3. The job market remains resilient.
To that final point, corporate profit margins remain resilient and suggest companies have been able to successfully navigate inflation pressures. Since World War II, after-tax profit margins have consistently peaked several quarters before the beginning of a recession.
Today, despite higher costs for labor and goods, after-tax profit margins are at record highs not seen since the 1950s[9]. With profit margins still healthy, businesses are unlikely to immediately cut costs, which is a common precursor to a recession.
4. Consumer Sentiment and Stock Returns Don’t Align
High Inflation, the war in Ukraine, rising mortgage rates and falling portfolio values have all impacted consumer sentiment. This is a measure that tracks how consumers view both their own financial situation and the general state of the economy. However, history shows how consumers feel about the economy does not necessarily correlate with future stock returns, as seen in the chart below.
Interestingly, when consumer confidence bottoms, it tends to precede stellar equity returns, while peaks in sentiment don't see as much upside[10].
What's this really mean? Investors using how consumers feel about the economy to make large changes in their portfolios might be taking a risky investment strategy.
What to Keep in Mind During Times of Inflation About Recessions
Recessions are the inevitable end to all economic cycles. There are clear signs the economy is starting to slow after a decade of record growth, but slowing is not stalling. The data points to an economic outlook may be brighter than how consumers feel—and what news outlets are reporting.
For investors, having a plan that can withstand a wide range of environments—including an eventual contraction—is far more important than worrying about inflation and predicting the start and end of the next recession.
Is you find you still feel worried about what's happening, don't hesitate to seek guidance! Working with a financial planner who can walk you through the various aspects of your financial life beyond just the fluctuations in your portfolio can provide a little perspective.
SOURCES
[1] US Bureau of Economic Analysis. [2] Source FactSet. Year to Date returns as of 4/29/2022 [3] Source FactSet. Year to Date returns as of 4/29/2022 [4] https://www.bea.gov/news/2022/gross-domestic-product-first-quarter-2022-advance-estimate [5]JPMorgan Guide to the Market. Q2 2022 [6] JPMorgan Guide to the Market. Q2 2022 [7] Morgan Stanley Wealth Management. 3 Reasons for Optimism About the U.S. Economy [8] https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/market-insights/weekly-market-recap-us.pdf [9] https://privatebank.jpmorgan.com/gl/en/insights/investing/tmt/a-recession-in-the-near-term-is-possible-but-not-probable-heres-why [10] JPMorgan Guide to the Markets. Q2’2022
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