The question on many investors’ minds this year has been, “Is a recession coming?” Most economists and market watchers seem to agree the answer to that question is, “Yes.” There is less certainty, though, about when the recession might come and how long and severe it might be.

Watchers of the U.S. Federal Reserve have not been able to discern how the central bank might act in the months ahead. Fed Chair Jerome Powell and other members of the Federal Open Market Committee that sets rates have indicated they are willing to continue implementing 75-basis-point hikes to tame inflation, but in other communications they have suggested they would be perfectly willing not to be that aggressive in order to avoid impeding the economy.

Negative wealth effect could help tame inflation

Beyond rate hikes, another factor that could bring inflation down is a decline in the wealth effect. In positive economic environments, when the stock market and house prices are rising, and consumers feel optimistic, they are willing to spend more and the rise in demand can bring an increase in prices. Many of those conditions are now negative, and the loss of wealth could reduce consumer demand and begin to curb inflation.

The U.S. stock market, as measured by the S&P 500, was down 20% for the first six months of 2022, its worst first half of a year in 50 years.1 Investors in cryptocurrencies also saw major losses, as the market capitalization of crypto globally declined from $2.8 trillion in November 2021 to less than $900 billion, as of June 29, 2022.2

Housing prices still rose in April, the most recent month for which data is available, but the increase was not as high as it had been in previous months, a possible indication that housing prices could be cooling off.3 The public’s perception of the state of the economy and their financial circumstances, as measured by the University of Michigan Consumer Sentiment Index, fell to its lowest level on record.4

All these factors could lead people to spend less, and there are already some minimal indications that inflation might be cooling off a bit. In May, the prices for core personal consumption expenditures, which excludes food and energy, rose 4.7% from where they were a year ago, an increase that was slightly less than economists were expecting.5 Headline inflation, though, which includes volatile energy and food prices, did rise 0.6%, as that measure of price hikes held close to its highest level since 1982.

The good news for those fearing an imminent recession came from the Institute of Supply Management’s Purchasing Managers’ Index, which was down to 53% in June, a drop from 56.1% in May.6 That reading indicates the manufacturing sector grew in June, with the overall economy posting its twenty-fifth consecutive month of growth after contracting at the height of the pandemic in April and May of 2020. The ISM’s Price Index did increase for the twenty-fifth consecutive month, but it did so at a slower rate than it had in May.

Recession could be Fed’s tool for combatting inflation

After Fed Chair Powell’s testimony before Congress on June 22, in which he addressed questions from Massachusetts Senator Elizabeth Warren, Louis Ricci, the Head Trader for Emles Advisors, offered some perspective on what the Fed’s course of action for the rest of the year might be. He told Yahoo Finance recently,7 “Powell has stressed that he thinks tighter monetary policy will be an effective tool against inflation and has said he thinks the economy is well-positioned to handle higher rates. However, he also told [Senator] Warren that higher rates won’t do much to lower soaring food and gasoline costs. He noted that the war in Ukraine and Covid-linked shutdowns in China are adding to inflation pressures and added that the problem is not unique to the U.S. but is affecting many global economies.”

According to Ricci, the biggest question is whether the Fed is willing to risk a recession. As he observed to Yahoo Finance, “The most hawkish traders are saying we need a recession in order to get demand for crude etc. down – and if the Fed is intent on targeting headline inflation, this may be their only option. However, if Powell really wants to avoid a recession, and focuses on core CPI and what is directly under his control, markets may see relief sooner than expected.”

Emles doesn’t share the bears’ view

An advance estimate of the Gross Domestic Product (GDP) for the United States in the second quarter of 2022 will be released by the Bureau of Economic Affairs on July 28. Some economists are lowering expectations for what those GDP numbers will be.

Lisa Shalett, the chief investment officer for Morgan Stanley Wealth Management told Bloomberg TV on June 25 that she thinks many Wall Street analysts are acting like “deer in the headlights” because they have not yet revised down their earnings expectations for companies in light of the earnings hit weaker GDP growth could bring.8

That is the bear case – a view Emles doesn’t share. We do not believe that the Fed is truly willing to push the economy toward recession and instead may be determined to convince everyone it is willing to do so only to get the financial markets to calm down. The Fed’s leaders recognize that what is happening with supply chains is beyond their control, and there is little they can do to counter that disruption.

Even though inflation has been high and is having a widespread impact, especially for consumers in lower income brackets, the “hammered by inflation” news headlines may still be somewhat sensationalistic. Household balance sheets are strong. While household wealth did decline in the first quarter (the latest period for which results are available), that dip stemmed largely from the decline in stock prices. Collectively, U.S. household balance sheets are $32.5 trillion higher than they were before the pandemic, and that fact could support strong consumer spending even in the midst of high inflation.9

We do not share the view that corporate earnings will have to decline. We are seeing companies miss projections on unit sales, but beat their own guidance and analyst estimates on revenues. Part of the reason for that is that inflation is helping companies to increase their sales in dollar terms.

Still, inflation, because companies also have higher expenses, is causing a number of firms to miss their profit-margin estimates, but many are still offering positive guidance on their earnings. In our view, the markets have been driven too much by fear over the past few months. Not enough analysts and investors appear to be spending the time to determine which companies are doing a good job of protecting their margins in this environment, and which ones aren’t. Instead, all companies are being painted with the same brush.

Some sectors, such as consumer discretionary and homebuilding, have already priced in a severe recession. The S&P Homebuilders Select Industry Index, for example, is now trading at 7.6 times next year’s earnings.10 Even in the darkest days of the Great Financial Crisis of 2008-2009, that index never traded below 12x.

We believe that as soon as the Fed signals it is willing to pause its rate hikes or when there is evidence that the economy can emerge from a slowdown, stock multiples will greatly expand because we do think stocks have already priced in low expectations for economic growth. Stock prices factor expectations for the economy so far ahead of time that, if the Q2 GDP numbers show any indications that the recession has already started, its end could be in sight. As long as the downturn is not too long or severe, the stock market, as a forward-pricing mechanism, could lead us out of it.

Tags: Inflation, Interest rates, Recession