Please find commentary as of 7/28/2022 by Garrett Melson, CFA®, Portfolio Strategist, Natixis Investment Managers Solutions.
https://www.im.natixis.com/us/markets/are-we-in-a-recession
Are we in a Recession?
As inflation continues to rise, so do concerns about a recession. First quarter of 2022 GDP (gross domestic product) decreased at an annual rate of -1.6% according to the Bureau of Economic Analysis. GDP is the standard measure of US economic growth, and the most common rule of thumb for determining a recession is two consecutive quarters of negative GDP readings. Second quarter GDP, released on July 28, came in at -0.9% further heightening already elevated recession concerns. But rules of thumb are just that – they don’t always hold.
So what is a recession?
There seem to be as many definitions as people you ask. The extreme negativity of consumer sentiment leads many to believe that if things feel so bad, it must be a recession. But the final arbiter of recessions is the National Bureau of Economic Research (NBER), a nonprofit research organization that has been declaring official recession dates since 1920.
Yes, they deserve criticism for their slow and often obvious declarations of the beginning and end of recessions, but the NBER’s definition is far more robust than the “two negative quarters” rule. The NBER defines a recession as a significant decline in economic activity that is spread across the economy and lasts more than a few months, which meets the committee’s view of depth, diffusion, and duration. No mention of consecutive quarters or real GDP.
Considering the nuances of this cycle - thanks to the Covid-induced economic sudden stops, restart, and ongoing normalization of the post-pandemic economy, this framework may be far more useful than the old two consecutive quarters rule.
Why does this look like a recession?
Even if you subscribe to the two-quarters rule, there’s good reason to discount the first quarter GDP print and the current data as well. GDP can be subject to significant fluctuations due to the mechanics of its measurement. Specifically, two components can create a lot of noise and, in the case of today’s continuing economic normalization, a lot of distortions: net exports and change in inventories.
Let’s start with net exports
The simple product of robust US consumer demand and weaker global consumption is a massive trade deficit. With the US a largely insulated economy, exports represent a relatively small portion of GDP – on the order of about 10%.
US consumer demand has been strong and requires sizeable imports to meet it. The net effect is a trade deficit: more imports than exports represent a drag on US GDP. That’s not unique, as the US has consistently run a trade deficit for the last 30 years (Figure 1).
Figure 1 – US Trade Deficit (1/31/92-5/31/22)
Source: Bloomberg
But, as the pandemic drove a massive shift in consumption away from services and towards goods, that trade deficit exploded, accelerating further as global growth has lagged behind US growth. This created a material drag that has led to an average reduction in GDP of 1.6% per quarter since the third quarter of 2020. In Q1 2022, that drag accelerated to 3.2%. The trend of elevated trade deficits continued into Q2, albeit at a more moderate pace, but a sharp drop in goods imports and significant pickup in goods and services exports, likely the result of increased energy exports and international tourism, resulted in a net contribution to GDP growth of 1.4% in Q2. A sharp reversal from the drag of preceding quarters, but still showing clearly the fingerprints of the continued post-pandemic normalization and geopolitical events.
The second culprit: change in inventories
Remember that GDP growth is a flow. A slower rate of inventory growth translates to a drag on overall growth meaning companies are producing less as they draw down on inventories generated in prior quarters. So, even if inventories are growing, representing increased production and economic activity, if they grow at a slower pace than the prior quarter, it translates into lower GDP growth.
Over time, contributions to growth from inventories tend to net out, but over short windows they can have significant impacts. These impacts have been magnified as the world continues to normalize from the Covid shock. In Q1 2022, inventories grew at the second fastest pace on record, increasing by $188.5 billion. But that was on the heels of the largest inventory growth on record – in Q4 2021. The result was a 35bp (0.35%) drag on headline GDP growth.
So, what did we see in the second quarter? More of the same. Much-maligned goods shortages have quickly morphed into a supply glut as business inventories have exploded in recent months. Retail inventories (excluding autos, where production is likely to continue to hold up as the well-known semiconductor shortage continues to ease) are now 17% above the pre-pandemic trend.
Too much inventory paired with continued normalization in consumer spending away from goods and back towards services means retailers are now rolling out plans for major price discounts to draw down those inventories. As a result, corporates grew inventories at a substantially slower pace of $81.6B in Q2 as compared to breakneck pace in Q1 resulting in 2% drag on GDP growth (Figure 2). (The good news is price slashing is exactly the help we need on the inflation front.)
Figure 2 – Change in Private Inventories (12/31/99–6/30/22)