At midpoint in the third quarter we are very pleased that both stock and bond markets have recovered significantly from their June 30 low points. While this progress is encouraging, the mix of economic and market data continues to provide a less than clear path forward.
Two recent economic releases illustrate the lack of clarity on the future course of the economy. The first was the initial estimate of second quarter real Gross Domestic Product (GDP). At -0.9% it was the second straight quarter of GDP contraction, and as such meets the popular definition of a recession. Because so much other data is positive, there is much discussion of whether we are, in fact, in a recession. Supporting that question, the July employment report indicated that over 500,000 new jobs were created that month, and the unemployment rate dropped to 3.5%, its previous all-time low. This report was a surprise to everyone, far exceeding expectations. These two reports obviously point in different directions: one toward a weak economy and one toward a very strong one, thus providing a confusing backdrop to the current economic and market environment.
While the popular definition of a recession requires two consecutive quarters of negative real GDP, the official designation of when recessions begin and end is rendered by the National Bureau of Economic Research, an independent research body. They define a recession as a period when there is consistent, persistent, and broad declines in economic activity. By this standard, the U.S. economy is not currently in a recession. We agree.
We would caution, however, not to ignore the fact that the economy has contracted for two consecutive quarters. This unusual occurrence must mean something. A review of the GDP report reveals why the second quarter number was negative. There were big declines in important categories such as private domestic investment (-13.5%), which includes expenditures for physical plants and equipment as well as residential investments. Inventories shrank and net imports over exports was a negative. On the other hand personal consumption expenditures rose by 1%, and since this category is nearly 70% of GDP, it almost offset the large declines in other categories. This illustrates how important consumption is to our economy, so it behooves us to keep our eye on that line of any GDP report. This number needs to remain positive, preferably by more than 1%.
The more important question may not be whether we are in a recession, but if we are headed for one. We will refrain from a prediction, but we will note that there are a number of indicators that are not moving in the right direction. For instance, the volume of retail sales has declined in five of the last seven months, the housing market has been softening, trucking volume has flattened, and rail freight is declining. Importantly, initial claims for unemployment benefits have been trending upward, although from a very low level. The conclusion is that the economy is not in recession, but slowing.
We could list other pre-recessionary indicators, but perhaps the best way to frame the recessionary question is within the context of inflation and Federal Reserve (Fed) policy. We know that inflation is very high, and we know that the Fed has embarked on an aggressive approach to this problem. Because of recent declines in several of the inflation components, most observers expect to see improving inflation numbers in coming months. In fact, inflation in June ticked down on a year over year basis and was flat month over month. This is very encouraging but, of course, does not mean that the inflation fight is over. Obviously the Fed does not want a recession, so they are hoping to engineer a “soft landing.” Their goal is to reduce demand just enough to take the edge off of inflation, while at the same time being aided by some improvements on the supply side as disruptions diminish. If the Fed can pull off a soft landing, it would be a rare accomplishment. It is not impossible, but considering the lag time that monetary policy requires to be effective, we believe it is extremely difficult to know exactly when monetary restraint has achieved its goals and it is time to stop or reverse policy.
We always prefer the optimistic stance regarding future developments but at the same time recognize the need to be realistic. Currently, we are optimistic about the fight against inflation. We believe the ultimate outcome is likely to be favorable. The realistic side of our view is, however, that the fight entails risk. The risk is that the Fed goes too far with their restrictive policy and the economy falls into a recession. In the end, if a tradeoff between inflation and recession becomes necessary, we would opt for a recession in the belief that it would be a mild one. Inflation is a more pernicious threat to the economy since it hits everyone, while a recession affects fewer people, mainly those who become unemployed. Also, experience tells us that recessions can be managed. We believe we have policy tools available and sufficient for the task. But inflation, if it becomes embedded in the economy will prove much more difficult to control. We are hoping that the Fed perseveres in their fight against inflation.
Recognizing that many client portfolios still remain in negative territory year to date, we nevertheless are pleased that the inherent quality of the holdings have been working to the relative advantage of the portfolios. We remain committed, as always, to the quality stance, and believe it will serve us well through this period of uncertainty.
Crawford Investment Counsel is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Crawford Investment Counsel, including our investment strategies, fees and objectives, can be found in our Form ADV Part 2, which is available upon request.
This material is not financial advice or an offer to sell any product.
Crawford reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.
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