US economy

Recession? We just don’t know yet

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Good morning. Yesterday I scolded the market for being too enthusiastic about the Fed chair’s comments. Today stocks went up more. It’s almost as if people aren’t listening to me. This is hard on my ego, so email me:


The US economy shrank for the second quarter in a row — on an initial estimate, anyway — so we appear to be in a technical recession. Inevitably, that has set off a political fight about whether we are experiencing an actual recession, that is, a widespread and persistent fall in economic activity. Nothing about the basic concept of a recession is hard to grasp, even if it’s hard to specify a neat set of necessary and sufficient conditions for one.

Importantly, though, recessions are not like pornography: you do not know one when you see one — or are in one, rather. Often we figure out we are in a recession many months after it has begun, after the good-quality data has rolled in. Hence the opportunity for a political fight in the meantime.

Investors do not have to quibble over the niceties, but they do have to prepare. Recessions are usually tough on risk assets. If we are tipping into one now, that matters to asset and risk allocation.

So, was there anything in the advance GDP estimate for the second quarter that would make us think the slowdown isn’t widespread or deep? Qualifying factors analogous to the big swings in trade and inventories that made the first quarter report less scary than its headline?

Optimistic types are entitled to point out that real personal consumption rose in the second quarter — a result that is backed up by what we have heard from, for example, banks and credit card networks (though there are less reassuring signals coming from the lower end of the income spectrum). But it won’t do to suggest, as the apologists did in the first quarter, that the big swing in inventories (a two per cent drag) is not indicative of underlying activity. The inventory decline in the second quarter happened party because consumption of goods fell (services consumption accounted for all the total consumption growth).

Similarly, the fall in private investment (a drag of almost three percentage points) is real enough, and is the sort of thing that tighter monetary policy is designed to cause, for example by slowing the real estate market.

The report does not scream recession — how can it, with real consumption growing? — but I don’t see how the negative top line can be waved away.

Fed chair Jay Powell argues that we can’t be in a recession when the jobs market is creating almost 400,000 jobs a month and the unemployment rate at 3.6 per cent, a multi-decade low. I share this intuition, but there is a powerful counter example: the 1974-75 recession. In the month the country entered that recession, in November of ’73, the economy added 313,000 jobs, and indeed job creation remained respectable for months after the recession began:

Column chart of Thousands of US jobs added/lost, by month; shaded area indicates recession showing Jobs are a lagging recession indicator

This is alarming in the current context, especially because of the other analogies between 1974 and today (inflation, supply shocks). But it helps to explain why the market is so confident that inflation will soon roll over, freeing the Fed to back off next: it considers the job market a lagging indicator. It may be right.

Several people have noted to me that in the 70s there was structural employment growth from women entering the workforce, which would have obscured the start of a cyclical employment downturn. But that offers limited reassurance. Skanda Amarnath of Employ America pointed out that you can strip out that gender effect by looking at the employment-to-population ratio among men — and even that turned over after the recession began, in January of ’74:

Chart showing jobs among men in the 1970s

Amarnath says he would not be too surprised if it turns out that economic history concludes that a recession began in May, when industrial production peaked. But it is just too early to tell.

Cheap stocks are even cheaper in Europe

Last week’s comment on value stocks generated a lot of mail, including a fair amount of crowing from longtime value investors experiencing some much-delayed vindication.

One interesting argument came from Ben Arnold, of Schroders’ value equity team. In last week’s piece I wrote that the US “value spread” — the ratio of the price/earnings multiples of growth and value stocks — was at a 20-year low. Arnold noted the situation is even more extreme in Europe. In Europe, the spread has fallen to .4, against .6 in the US:

Line chart of The value spread showing Europe's cheap stocks are really cheap

Arnold also writes “value stocks in Europe are currently trading on lower PEs than they were five years ago . . . there are very few, if any, parts of developed market equities that the market is so pessimistic about that they’ve actually de-rated over the last five years.”

On top of the gap between the valuation of European growth and value, there is the gap between US value and European value: “The Russell 1000 value index is a 16.5 forward PE, while the equivalent in Europe is on 11, an enormous differential in its own right. A cheap stock in the US is held in much higher regard than a cheap stock in Europe. Value stocks in Europe are the unloved of the unloved!”

Finally, Arnold writes that “over the last five years Europe’s cheapest companies have delivered more profit growth than their growth counterparts . . . so over that 5 year period the real growth stocks in Europe, in terms of fundamentals anyway, have been the value stocks!”

I struggled to believe this, so I checked the MSCI growth and value indices. Looking at the five-year period before the pandemic, average quarterly earnings growth for the value index was 11 per cent, against 6 per cent for the growth (or “growth”?) index. The pandemic has only increased value’s lead.

As long as I have been in the investing world (18 years or so now) people have been pitching the idea that valuations of European stocks would catch up to US stocks. It’s been a bad trade almost the entire time. But European value stocks look really, really cheap now. This time could be different.

One good read

Always read Thomas Edsall.

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