Mixed. That is the word most financial publications we follow used to describe the US’s Q3 gross domestic product (GDP, a government-produced measure of economic output) report, which hit the wires late last week. On the bright side, the 2.6% annualised growth erased Q1 and Q2’s sequential declines and brought US GDP to a fresh high, with consumer spending and business investment also notching new records.[i] But residential real estate detracted bigtime, and two of the three biggest contributors were (in our view) relatively less meaningful: government spending and net trade.[ii] Furthermore, what we consider the most meaningful segment of the US’s yield curve—the difference between 3-month and 10-year US Treasury yields—slightly inverted in recent days, fuelling warnings from financial commentators we follow that recession, or a broad decline in economic activity, is just around the corner.[iii] To be fair, we think it is possible economic conditions in the US get worse from here. But it isn’t a foregone conclusion, in our view, and for stocks, a mild US recession probably lacks much surprise power anyway.
The US GDP report did clear up one thing, in our view: It cuts against commentators’ argument that the US economy was already in recession when GDP slid in Q1 and Q2. In both quarters, consumer spending and business investment rose—and even when you factor in residential real estate’s burgeoning slide, pure private sector components overall grew.[iv] (We consider consumer spending, non-residential fixed investment and residential fixed investment to be the pure private sector components.) That repeated in Q3, contributing to US GDP more than erasing its Q1 and Q2 slide.[v] But under the bonnet, the script flipped a bit. US government spending and fast-rising imports pulled headline GDP negative in Q1, whilst the US government and falling private inventories were Q2’s detractors.[vi] Yet in Q3, net trade (exports minus imports) added 2.77 percentage points to headline growth as exports rose 14.4% and imports fell -6.9%.[vii] That isn’t great news, in our view, considering we think imports represent domestic demand and the strong dollar—in theory—should have enabled US businesses and consumers to import a higher quantity of goods for less money. So we think that is something to watch. Meanwhile, consumer spending growth slowed from 2.0% in Q2 to 1.4% as spending on goods contracted again (-1.2%) and spending on services slowed from 4.0% to 2.8%.[viii] Business investment was more of a bright spot, accelerating from 0.1% annualised growth in Q2 to 3.7%, but residential real estate’s -26.4% plunge weighed heavily on total private sector growth.[ix]
Now, we aren’t of the school that thinks slowing private sector growth is an automatic prelude to an economic contraction. Past behaviour and data don’t predict. However, we also think it is fair to presume elevated inflation (broadly rising prices across an economy) forced US consumers to cool their jets a bit, and that could continue. Imports’ slide could be a sign domestic demand overall is slipping in America. Inventories’ continued slide could mean US businesses are in cost-cutting mode. We think a lot of this stuff is open to interpretation.
So yes, we acknowledge the possibility that economic conditions could worsen and a US recession materialises. However, we don’t think the ever-so-slightly inverted 3-month to 10-year US Treasury yield curve makes a recession much likelier. Yes, our research finds the yield curve to be one of the most reliable leading economic indicators on the planet. But we think it is vital to consider why. Some experts argue its powers as a leading indicator exist because when long rates are below short, it means markets are pricing in the high likelihood that a recession will arise and force the US Federal Reserve (Fed) to cut rates. That may be so to an extent, but we think that view ignores the yield curve’s real-world impact. Bank lending is the lifeblood of economic growth, and our research shows the interest rate spread is typically its main influence. Banks borrow at short-term interest rates and lend at long rates, making the difference between the two their potential profit on each new loan. The larger the spread, the bigger the profit, and the greater we think the incentive to lend becomes. A negative spread means the profit well may have run dry, which typically freezes lending.
Normally, we find 3-month rates are a good approximation of US banks’ borrowing costs, whilst the 10-year US Treasury yield is the reference rate for most long-term loans. Today, however, US banks’ funding costs are far below 3-month rates. Per Bankrate, the national average savings account rate in the US is 0.16%, well below the current 4.04% 3-month US Treasury bill rate.[x] That means US banks haven’t passed Fed rate hikes on to consumers, and with deposits still nearly $6.3 trillion (£5.6 trillion) higher than the total amount of loans outstanding, they probably don’t need to raise rates to compete for deposits.[xi] They already have far more than they need, especially with the Fed having scrapped reserve requirements in 2020.[xii] Meanwhile, with 10-year Treasury rates at 4.10%, the prime lending rate is now over 5%.[xiii] That means US banks can lend quite profitably, which we think is a big reason loan growth in the US is running north of 11.0% y/y.[xiv]
In our experience, rip-roaring loan growth is inconsistent with a brewing recession. But we also think it is important to consider the possibility that we are wrong. So, what if a recession does strike? Well, when in doubt, we think it is most helpful to think like forward-looking markets. From its 3 January high to its most recent low on 12 October, the S&P 500 fell around -25.0% in US dollars.[xv] That is a shallow bear market (typically a deep decline of -20% or worse with a fundamental cause) and, in our view, consistent with stocks’ pricing in a shallow recession. It doesn’t mean a recession in the US is automatic, but we think it likely shows US stocks have spent much of the year considering the possibility. None of last week’s news provided stocks with materially new and more negative information, in our view. Slower private sector growth? GDP Nowcasts—statistical models designed to estimate quarterly GDP based on incoming data and forecasts—have hinted at that for weeks.[xvi] A mild yield curve inversion? Our research shows that historically (and notwithstanding the difference between bank rates and Treasury rates) that would point to only a mild recession in the US. Nothing that we see on the dashboard today points to a severe shock where American consumer spending and business investment tank, which is what we think it would likely take to deliver a negative surprise at this juncture.
In our experience, stocks don’t need perfect conditions to mount a recovery—all they need is a reality that goes a little better than anticipated, in our view. Right now, forecasts amongst economists we follow for the US’s economy are rock bottom. Recent surveys show a majority of economists expect the US to slip into a pretty bad recession early next year.[xvii] An economy that muddles through or has only a minor slide would probably qualify as positive surprise, and to us, that looks pretty likely. So no, we don’t think last week’s backward-looking GDP report is reason to be overly optimistic. But we don’t think it is reason to be pessimistic, either, and nor—in our view—is a very mild yield curve inversion.
[i] Source: US Bureau of Economic Analysis (US BEA), as of 27/10/2022. The annualised growth rate is the rate at which GDP would grow or shrink over a full year if the quarter-on-quarter growth rate repeated for four quarters.
[iii] Source: FactSet, as of 2/11/2022. Statement based on 10-year minus 3-month US Treasury yield spread, 31/12/2021 – 31/10/2022. A yield curve is a graphical representation of one issuer’s interest rates across the spectrum of maturities. A recession is a decline in broad economic output.
[iv] Source: US BEA, as of 27/10/2022.
[x] Source: Bankrate and FactSet, as of 2/11/2022. National average savings account rate and 3-month US Treasury bill interest rate.
[xi] Source: Federal Reserve, as of 27/10/2022.
[xii] “Federal Reserve Actions to Support the Flow of Credit to Households and Businesses,” Board of Governors of the Federal Reserve System, 15/3/2020.
[xiii] Source: FactSet and St. Louis Federal Reserve, as of 2/11/2022.
[xiv] Source: St. Louis Federal Reserve, as of 27/10/2022.
[xv] Source: FactSet, as of 27/10/2022. S&P 500 total return, in USD, 3/1/2022 – 12/10/2022. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[xvi] “GDPNow,” Federal Reserve Bank of Atlanta, 2/11/2022.
[xvii] “Odds of Recession in Next 12 Months Now 63 Percent in Survey of Economists,” Zach Schonfeld, The Hill, 16/10/2022.
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