US Q2 gross domestic product (GDP) accelerated in last Thursday’s report, smashing forecasts and triggering a rush to revise outlooks amongst onlookers we follow.[i] We now see many suggesting a soft landing of slower growth that avoids recession (prolonged economic contraction) is likely. Others we read argue no landing is coming at all. And we have seen some others claim relatively rapid growth will spur more Federal Reserve (Fed) rate hikes, causing recession anyway. In our view, all this chatter misses the mark. Q2 GDP shows America wasn’t in recession last quarter, barring a big revision.[ii] And we think it speaks to the better-than-anticipated economy stocks have long been pre-pricing. But to us, the forward implications beyond that are very limited. Let us explain.
Exhibit 1 shows America’s Q2 GDP (dark blue line) sprang higher at a 2.4% annualised rate, much faster than consensus estimates for 1.5%.[iii] Whilst consumer spending (dark green columns) continued to chug along, business investment’s (medium green) 7.7% annualised surge stood out to us. Then, too, we find the GDP components that detracted substantially in recent quarters mostly aren’t anymore. After residential investment (light green) subtracted significantly in Q2 through Q4 last year, it did so only marginally in Q1—and again in Q2.[iv] Meanwhile, inventory changes’ (maroon) big Q1 detraction—which many commentators we follow also portrayed as a recessionary sign—turned into a small contribution in Q2.[v] With consumer spending and business investment up solidly—plus housing headwinds and inventories’ drag fading—we think it is tough to argue America was in or even all that close to recession in Q2. Hence, we see many economists rushing to update their views.
Exhibit 1: US GDP and Its Contributing Components
Source: FactSet, as of 27/7/2023. US real (inflation-adjusted) GDP and components, Q1 2022 – Q2 2023.
However, in the wake of the report, we have seen many of them draw loads of forward-looking conclusions. Whatever those conclusions may be, though, these backward-looking data don’t support them, in our view. They don’t mean a soft landing is certain. We also don’t think Q2 growth supports the more optimistic takes we have seen—that there won’t be any landing, e.g., because the Biden administration’s Inflation Reduction Act funds a big green-energy infrastructure buildout that will fuel a long-lasting investment boom. Yes, government spending flipped from early-2022 contractions to relatively large contributions since.[vi] And there is more money allocated under this legislation to dole out—with incentives for more private investment.[vii] To us, that makes a positive contribution to growth here possible but not assured.
Thing is, these investments are scheduled to trickle out slowly.[viii] And in our experience, extensive permitting processes and legal reviews have a tendency to stall projects in their tracks, blunting or further drawing out their impact. That even applies to things like solar or wind power installations, which have increasingly encountered tough opposition from localities and residents despite ostensible federal government backing.[ix] As always, we think investors will need to gauge how reality evolves against the growth projections markets have priced in already.
This isn’t to say everyone is suddenly sunny. Many economists we follow still forecast recession, and to us, that is a good thing for markets. We think it suggests stocks still reflect one, muting the impacts if it came. Bloomberg’s July survey showed forecasters still see a 60% chance of recession in the next year.[x] According to a National Association for Business Economics survey from late July, 71% of business economists think the likelihood of recession over the next 12 months is less than 50%, up from about an even split in April.[xi] Whilst attitudes may have turned a bit brighter, look at how economists’ projections (per FactSet) have progressed between then and now. (Exhibit 2) In April through June, they were staring down two quarters of contraction—one definition of recession—or something close to it. Over the last month they have upgraded their Q3 view, but that still gives way to a Q4 dip. This shows us that today’s outlook still isn’t very cheery.
Exhibit 2: Current US Economic Projections Aren’t Exactly Cheery
Source: FactSet, as of 31/7/2023. Economists’ median quarterly US GDP growth estimate, annualised.
We find colouring many economists’ views we read are two widely watched forward-looking economic indicators: The yield curve (a graphical depiction of America’s bond yields across all its debts’ maturities) and The Conference Board’s Leading Economic Index (LEI). The former is a traditional forecasting tool and inversions—when short-term yields top long rates—have preceded most post-war US recessions.[xii] However, the tool isn’t perfect. And today, it has been inverted for nine months.[xiii] Our research shows this normally signals credit contraction because the spread reflects banks’ profit margins on new loans. But we don’t think that has worked this cycle since banks’ deposit rates (their main funding cost) remain well below the Fed’s policy rate—so lending also remains profitable overall.[xiv] The economy isn’t being starved of credit despite the apparent signal from yield curve inversion, according to our analysis.
As for the US LEI, it includes the yield curve and a slew of manufacturing-tilted components like three gauges of factory orders, manufacturing employee hours worked and more.[xv] And goods-orientated industries have seen contraction for some time.[xvi] But LEI downplays services, and that sector dominates America’s economy.[xvii] It is a blind spot we think is important not to overlook.
In our view, recession warnings were likely one reason of several why stocks endured a downturn last year. That suggests to us they likely pre-priced an economic downturn, at least as long as those warnings are sufficiently broad. We find little sign of one now, but ongoing alarm is likely to mitigate a recession’s market impact, assuming we get one any time soon. Hard as it may be, we think this is key for investors to grasp now.
[i] Source: FactSet, as of 27/7/2023. Statement based on US GDP and FactSet consensus estimate, Q2 2023. GDP is a government-tabulated measure of economic output.
[ii] Source: FactSet, as of 27/7/2023. Statement based on US GDP, Q2 2023.
[iii] Source: FactSet, as of 27/7/2023. US GDP and FactSet consensus estimate, Q2 2023. The annualised growth rate is the rate at which GDP would grow over a full year if the quarter-on-quarter rate repeated all four quarters.
[iv] Source: FactSet, as of 27/7/2023. Statement based on residential investment’s contribution to US GDP, Q2 2023.
[v] Source: FactSet, as of 27/7/2023. Statement based on inventory change’s contribution to US GDP, Q2 2023.
[vi] Source: FactSet, as of 27/7/2023. Statement based on government’s contribution to US GDP, Q1 2022 – Q2 2023.
[vii] “H.R.5376 - Inflation Reduction Act of 2022,” Staff, US Congress, 16/8/2022.
[ix] Source: Renewable Rejection Database, as of 28/7/2023.
[x] “US Recession Becomes Closer Call as Economists Rethink Forecasts,” Rich Miller, Molly Smith and Kyungjin Yoo, Bloomberg, 21/7/2023. Accessed via MSN.
[xi] “Economists See US Recession Odds at 50% or Less in New Survey,” Reade Pickert, Bloomberg, 24/7/2023. Accessed via MSN.
[xii] Source: US Federal Reserve Bank of St. Louis, as of 31/7/2023. Statement based on 10-year Treasury yield minus effective fed-funds rate, 2/1/1962 – 27/7/2023, and US GDP, Q1 1962 – Q2 2023.
[xiv] Source: US Federal Reserve Bank of St. Louis, as of 31/7/2023. Statement based on US national savings deposit rate, July 2023, and effective fed-funds rate, 27/7/2023. “US Bank Earnings Poke Holes in Popular Recession Theory,” Ye Xie and Carter Johnson, Bloomberg, 14/7/2023. Accessed via Yahoo!
[xv] “Description of Components,” Staff, The Conference Board, 6/2/2012.
[xvi] Source: S&P Global, as of 24/7/2023. Statement based on Flash US Composite PMI (purchasing managers’ index), July 2023.
[xvii] Source: US Bureau of Economic Analysis, as of 29/6/2023. Statement based on private services-producing industries as a percent of US GDP, Q1 2023. Also see note xv.
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