What? No Recession?

Consumer sentiment may be pointing down, but US economic indicators are not displaying many other signs of an impending recession. The Interactive Brokers team discusses their favorite signposts.

Summary – IBKR Podcasts Ep. 80

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson 

Welcome to this week’s Economic Podcast for Interactive Brokers. Joining me to discuss US economics this week. Steve Sosnick, our chief strategist, welcome, Steve. 

Steve Sosnick 

Hi, Andrew, how are you? 

Andrew Wilkinson 

I’m pretty good, mate. Ahead of fixed income trading, Joe Burke. How you doing, Joe? 

Joe Burke 

Doing well, Andrew and. 

Andrew Wilkinson 

And senior economist down in West Palm Beach. How are you, Jose? 

Jose Torres 

Doing great, very excited to be here. Looking forward to it. 

Andrew Wilkinson 

We’re looking forward to a good discussion. So just to put this in context for the audience, we’re recording today’s podcast at the start of June and two weeks ahead of the next FOMC meeting at which the broad consensus already is that the Federal Reserve has reached a plateau in terms of its monetary tightening. And what’s built into many investors’ mindset is the prospect of cheaper money towards the end of the year, i.e. lower interest rates should the US economy tip into recession? So, we’re here to dig into that concept a little deeper. Let’s start with Steve. 2023 has been characterized by extreme volatility, but that settled down as the potential end to the monetary tightening phase is insight. Should investors expect volatility to resume or is volatility by definition unexpected? 

Steve Sosnick 

Some of each. You know, one of the things that’s interesting, and I’m just going to contradict you a little because we are taping this in the afternoon on May 31^st, and earlier today, the S&P was exactly unchanged for the month. Zero change for the month. That said, at the same time NDX was up about 7 1/2%. So, you know there is volatility within things, but we haven’t had a lot of 1% moves. We haven’t had a lot of big days. We managed to escape the debt ceiling crisis, at least so far, without much. You know you can never get too complacent with volatility. I do think we’ve been sort of in a trading range as far as VIX is concerned, let’s call it 16 to 21. I think as we approach the lower end of the range, it’s prudent to think that something usually creeps in and pushes it back toward towards the middle to the higher end of that range. 

Andrew Wilkinson 

Jose, can you give us a textbook definition of ‘what is a recession?’ 

Jose Torres 

Although I haven’t published this textbook just yet – it’s currently in the works – what I would say is a broad decline in economic activity measured in real terms that lasts at least a few months, and an important aspect here, because we haven’t dealt with inflationary recessions in a long time, it’s in real terms, so even low earnings hold up consumers. Inflation serves as a barrier to that growth. 

Steve Sosnick 

If I may jump in, a lot of people always think about a recession as being too negative prints in GDP, which we actually got recently. But that wasn’t enough to call it a recession. It’s sort of not a recession until a bunch of folks on the NBER say it is. How do you characterize it? It’s much easier to categorize with a simple rubric, but how do you bring it into if you’re if you’re trying to be more subtle? 

Jose Torres 

Well, I you’re absolutely right, Steve. The technical definition is two back-to-back quarters of negative real GDP growth and I think the labor market, because it’s remains so strong, albeit real consumer spending, has been treading water. I think that’s what the NBR was looking for to call last year a recession. And then also you had in the second-half of 2022 stronger growth and that sort of made 2022 a flat kind of year. 

Andrew Wilkinson 

So Jose, where, where would you say the US economy is right now heading into the June FOMC? 

Jose Torres 

Well, we’re certainly late cycle. Earnings reflect that we are significantly off the peak. Leading indicators continue to point downward. And what’s really made this cycle much more difficult to read than previous cycles is the pandemic. The pandemic really unleashed unprecedented amounts of liquidity. If you would have told folks last year that the Fed was going to five or five and a quarter or five and a half [percent], they would have said, ‘Ohh, that means we’re immediately going into recession’, and as we can see through 2023, you know we’re still not there, albeit we are sort of flatlining but things are still holding up because it takes a while to run down all of that liquidity. You know in the past you’ve had one trillion in liquidity injections. This time you had roughly 8 to 10 [trillion], when you combine both the fiscal authorities and the monetary authorities. So, that’s made it really challenging this cycle to gauge when the liquidity is going to run out. And I’m sure Steve will talk more about this later and maybe Joe as well: In the markets we’re seeing just buyers show up day in, day out no matter the headwinds. I think that reflects that unprecedented amount of liquidity that was injected. 

Andrew Wilkinson 

Let’s turn to to monetary policy. So let’s let’s bring in Joe. The Fed lifted rates by 5 percent, 500 basis points in a very aggressive pace of tightening, and over a relatively short period of time. Joe, how quickly does monetary policy usually bite?  

Joe Burke 

Well, I think the answer to that is that most typically you see 18 months to two years before you see any real impact of monetary policy. But, if you look at CPI, CPI was about 9% in June of 2022 and it’s just under 5% in April of this year. So, you know clearly, it’s having an effect, but you know, to Jose’s point employment is strong while we’re hearing talk about tech [sector] layoffs or white-collar layoffs. 

Steve Sosnick 

More and more. 

Joe Burke 

The employment numbers are still very strong and I think as long as the consumer continues to spend, I think that the Fed’s going to have a challenge to bring CPI down further. 

Andrew Wilkinson 

So it’s not biting in the same way as it possibly has in the past: Is that perhaps because it’s come from practically zero [percent] to begin with? 

Joe Burke 

I think that could have something to do with it because if you go from zero to 5% versus say 5 to 9%, it’s going to have a greater impact at the higher end than that at the lower end. 

Andrew Wilkinson 

Can you talk about the pace of borrowing? So we talk about sensitivity of demand for loans relative to the cost of borrowing. Talk about how corporate debt issuance has responded to higher interest rates? 

Joe Burke 

Well, prior to the tightening cycle, when everyone sort of knew that the Fed was going to tighten, corporate issuance was just massive, and everyone wanted to get ahead of that tightening. But then, it was sort of slow in 2022. But as we get in, you know sort of middle of 2023 here, it seems like corporations are starting to see this as business as usual. There was a big refinancing with, I think it was Caterpillar. Apple just issued a big bond recently, so you’re starting to see large corporations that are issuing debt again. Whether or not that persists, I don’t know, but it certainly seems like it’s more of a business-as-usual type of approach. 

Andrew Wilkinson 

Steve, share prices have already had a tough time navigating monetary policy tightening earlier this year by the Fed. What does a recession mean for the stock market? 

Steve Sosnick 

Well, it’s important always to remember that the stock market and the and the economy are two distinct items, so they echo, they rhyme, they play nicely together. But they’re not one in the same. And so, I think Jose hit on it before with the amount of liquidity that we’re seeing is keeping is keeping markets, particularly equity markets, afloat despite the monetary retrenchment that we should be seeing and that we are seeing and so that’s why we’ve been able to muddle along. There’s a psychology when I look at a chart of NVIDIA and some of these other ones that have gone parabolic. When you get a parabolic move, it means that someone is in real pain actually on the other side of the trade. In this case of an NVIDIA, I’m not going to say it’s like lumber futures or copper futures where someone’s caught short and they have to panic to cover their short. This is FOMO, which is in and of itself, its own fear. Investors want this situation to be behind us, whether it’s realistic or not. And I think that’s why we get these big moves in big flurries. Even in the face of some of the most staunch monetary tightening that any of us can remember. 

Andrew Wilkinson 

Let’s come back to Jose: I think everybody’s touched upon the labor market, the overall labor market is slowing. Consumer confidence is down, but we’re seeing concentrated pockets of weakness or resilience. So, I say that seems to characterize the economy. Can you describe some contrasting trends amongst various economic sectors for us? 

Jose Torres 

Interest rate sensitive sectors have been doing bad [are] manufacturing and real estate. When consumers go to furniture stores, when they go to electronics and appliance stores and they’re looking to make big purchases, because of higher interest rates and because of tighter credit standards. So not only do you have to pay more to get a loan on a particular durable good that you want, you also run the risk that a bank won’t lend to you. So that’s made manufacturing conditions contract significantly from 2022. Also, pandemic shifts [saw spending change] from goods spending to services [spending]. Spending made it where a lot of the folks have already all the goods that they need in the real estate sector, pretty much it’s been very tough with the inventory shortage as well as those high interest rates. And on the other side, services spending has been on fire. And part of the reason is propensity to save in this economy if housing affordability is so far out for most younger folks. So, Americans aren’t saving as much as they were pre-pandemic. And they’re spending a ton of money on services. This is airfares, restaurants, drinking parlors, amusement parks; they’re having a good time. And that’s really the juxtaposition that we’re seeing now. The interest rate-sensitive sectors are doing poorly in terms of transactions, and money going in. But services are on fire and services inflation is actually the toughest kind of inflation to pull back because services are very labor-intensive and what’s happened is that employers, employees and patrons are all learning to live with inflation and it’s working its way into expectations, and it’s been very challenging for the Fed to bring that core CPI, that core PCE down hitting on with Joe said earlier 9% CPI down to 5%. That’s the easy part. That’s commodities and supply chains doing that work for you. But from 5% to 2% is a lot more challenging. 

Andrew Wilkinson 

We’re going to talk about the mother of all recessionary indicators in a moment when we talk to Joe about the yield curve. But Steve, let me ask you, beneath the surface, for stocks, are there other recessionary indicators that that are that that you monitor that are flashing? 

Steve Sosnick 

One of the earliest adages that I was taught was you can’t really have a sustainable equity market rally if retail stocks are not [rallying]. And it’s a little tricky to separate that out because Amazon so dominates a lot of the measures of retail. And when I say retail, I mean the stores, not people, not retail investors. But we’re not seeing a very robust retail sector, you know stock-wise and you know, every so often you’re getting some of these disasters du jour, which tend to be in the retailing sector. So, it’s a tricky one because the consumer, as Jose is mentioning, is out there spending. They’re spending it on services though not goods. You know ultimately the consumer does have to show up sort of more broadly. Taste. It’s tough to fight. What is it, Jose? 65-70% of the economy through consumers? But their spending is not necessarily conducive in sectors that might be stock market friendly. So that’s what I’ve been keeping an eye on. 

Andrew Wilkinson 

Joe, to what extent is the Fed in control of monetary policy, specifically monetary tightening, when the yield curve inverts the way it has done and starts to predict recession? 

Joe Burke 

I think when we look at what the Fed can actually do is they can raise the Fed funds rate, they can’t really do anything about the longer end of the curve that’s based upon so many things like inflationary expectations, technical issues, debt issuance, a variety of things. So, to the extent that there’s an inverted curve, is it a predictor of a recession? Yes, in the past it has been, I think every time except for one instance where it didn’t. So, the smart money would be on the recession going forward, but we don’t know yet. 

Andrew Wilkinson 

Steve, any glimmers of optimism for the economy and share prices? 

Steve Sosnick 

Well, the fact that we’re seeing money just flowing into to the best performing names means that there is a lot of interest in the stock market. Though it’s clearly narrowing and I point people to the piece I published today, the 31st of May. But the fact that people are still willing to participate and buy their favorite names if that can turn into broad based rotation, if the divergences, let’s say, between the equal weighted S&P or the equal weighted and the cap-weighted versions narrows because the bottom comes up rather than the top comes down. Well, that’s a potential. But that remains to be seen. 

Andrew Wilkinson 

Jose, let’s wrap up with you. Is there a recession on the horizon from where you’re sitting? 

Jose Torres 

I think so. I think second-half of 2023 we get there. I think this cycle has just been taking a longer time for monetary policy tightening to weigh down inflation and consumer spending. But we have some headwinds on the horizon, one of those is student loan repayment, which may begin in a few months, so that can hamper consumers. And we’re starting to see initial unemployment claims start to tick up, albeit they’re not surging, but they’re starting to tick up and some conflicting information as well. Like this morning we got information on job openings that was higher than the previous month. So, but I do think that ultimately 5 ¼% is too much for the economy to handle. I think if the Fed didn’t boost the balance sheet by $320 billion back in March, we’d be having a different conversation and I don’t think that April spending would have come in that strong had it been for that loosening in financial conditions that occurred specifically to save the regional banking sector. So, I think we’re going to have some economic pain in the second-half of 2023. 

Andrew Wilkinson 

Joe Burke, Steve Sosnick. Jose Torres, thank you very much for stopping by the studio today. 

Andrew Wilkinson 

It’s terrific. And don’t forget folks, if you’ve enjoyed today’s podcast, please leave us a review wherever you download your podcasts. And don’t forget to check us out online at ibkrpodcasts.com.