The technical definition of a recession has been met, but there is still considerable debate about whether the U.S. economy is actually in one. The Commerce Department’s Bureau of Economic Analysis, in its initial estimate, reported that the U.S. Gross Domestic Product (GDP) fell at an annual rate of 0.9% in the second quarter.1 Following the 1.6% annualized drop in GDP for the first quarter, the economy has now experienced two consecutive quarters of negative growth, which is the traditional mark of a recession.
Among the doubters about whether a recession has begun is Fed Chair Jerome Powell. While making the announcement that the Fed would be raising interest rates by 75 basis points in July, Chair Powell said he didn’t think a recession had begun because “there are too many areas of the economy that are performing too well.”2 He cited the strong labor market as an example. While he spoke a day before the second-quarter GDP report was released, he cautioned that the first estimate of quarterly GDP numbers should always be taken “with a grain of salt.”
Optimists could take heart in the fact that nominal GDP, which is based on the current value of the goods and services output by an economy, came in at an annualized rate of +7.8% for the second quarter. The negative 0.9% result was the measure of real GDP, which looks at the change in economic output absent the impact of inflation on the prices of goods and services.
In Emles’ view, determining whether the economy has entered into a recession should not depend on the technical definition, but rather on the strength of the underlying economy, particularly with regard to employment and spending.
On the employment front, new jobless claims fell by 5,000, to 256,000, for the week ending July 23, 2022.3 Still, that remains close to the highest levels seen since November. The July jobs report, when it’s released in August, is expected to paint a strong picture of employment. Forecasts are that it will show another solid month of hiring, with unemployment levels holding close to a 50-year low.4
Along with the GDP number, the Commerce Department reported that consumer spending, as measured by personal consumption expenditures, increased during the quarter, but only at a moderate pace of 1%, perhaps because of people’s responses to higher prices. Spending on services rose by a healthy rate of 4.1% during the quarter, but that gain was offset by a 5.5% decline in the purchases of nondurable goods and a 2.6% drop in the purchases of durable goods.5 Overall, these numbers can still provide some reassurance to those who fear that a recession has already begun.
Many analysts are pointing to the high levels of inventory and a rise in imports, in response to the strong U.S. dollar, as key factors that have been weighing on the U.S. GDP. But the glut of inventory could also bring a positive development by helping to lower inflation, as companies look to offer promotions and price discounts to reduce the number of items they have stockpiled. Admittedly, though, that could have another, less positive, ancillary impact for stock prices as companies experience lower profits while they’re clearing that discounted inventory.
Those who want to maintain a bearish outlook on the economy and financial markets can point to the fact that we have now had two consecutive quarters of negative GDP growth and inflation has remained high, even though it may be showing some signs of moderating. The bulls can argue that the market anticipated the negative GDP number, and stock prices already reflected it. The stock market’s relatively calm reaction to the report provides some evidence to support that bullish case.
The second quarter of negative growth may also provide a reason for the Fed to declare “mission accomplished,” given that its series of rate hikes this year have already contributed to an economic slowdown that could help bring inflation under control.
After the July Federal Open Market Committee meeting, Powell said the Fed will keep closely watching economic data to determine its next move. While he conceded that another large rate hike may be necessary, he also acknowledged that there will be a point when the Fed will need to slow down the pace of increases.
Earnings reports not as negative as expected
Even amid a disappointing second-quarter GDP number, the initial earnings reports from companies for the quarter are not as negative as many had anticipated. Fewer companies than expected have missed earnings forecasts or needed to revise estimates of their earnings downward. That being said, we think it’s important for investors to find companies that are able to protect their profit margins in an inflationary environment and those that will be able to weather the storm if their sales decline amid a pronounced recession.
Small-cap companies are one opportunity that investors may be overlooking. Given the considerable amounts of money that are invested in large-cap, S&P 500-focused mutual funds and ETFs, small caps are often not a significant allocation in investors’ portfolios. It’s been a difficult year for small caps, as their prices have fallen precipitously. Now the collective valuation of these stocks, as reflected by the average price/earnings ratio of companies in the Russell 2000 Index, has reached lows not seen since the Global Financial Crisis of 2008-2009.
In our view, for a number of small-cap companies these deeply discounted prices are not warranted. In any future economic scenario short of a severe, prolonged recession, we think some of the most compelling opportunities that U.S. stocks offer now, on a risk/reward basis, are in the small-cap universe. Once again, however, it requires a discriminating investor to determine which small-cap companies are worthy of long-term investments.