Should we be in a recession already?

We have been optimistic about the prospects for equities this year despite fears of recession. And even though investors have listed a deeply inverted U.S. Treasury yield curve, a sharp drop in the oil price, falling consumer demand, credit tightening and declining M2 money supply as reasons to justify expectations of a recession, the outcome is not guaranteed.

Meanwhile, equities are climbing the wall of worry. Since the beginning of the year, the S&P500 is up 9.65 per cent, Nasdaq composite is up 24.06 per cent, the Nasdaq 100 is up 30.79 per cent and the MSCI ACWI, which captures large and mid caps across 23 developed markets is up 13.58 (AUD) per cent / 7.68 per cent (USD).

My reasons for optimism back in November were both historical and fundamental. Looking back 100 years, we discovered terrible years – such as that experienced in 2022 – tend to be isolated. Bad years, it seems don’t like to be preceded or followed by bad years. We also discovered that particularly poor years – declines of more than 20 per cent – are more likely to be followed by a positive year. And more fundamentally we saw evidence global central banks were engaging in net quantitative easing (QE) again.

Shifting to the present, and the gains since the beginning of the year may have priced-in some of our optimism. It may be worth reflecting on whether or not our bullish posture should be maintained. And since March, fears of recession have gained a foothold although those fears are somewhat less acute now than when they first emerged.

Given the slumping credit demand and tightening lending standards in the U.S., which typically precede or accompany a recession, one wonders why we aren’t in a recession yet. We should be.

But as we have noted here at the blog in recent weeks, U.S. reporting season did not resemble a recession. The much-feared contraction in earnings of circa nine per cent simply failed to materialise, and at the time of writing, earnings for the second quarter of CY23 fell just 1.5 per cent year-on-year.

What is curious is the obviously bearish sentiment failing to correlate with the performance of the equity market. Are equity investors unreasonably optimistic, or are the pessimists missing something?

One observation is that recessions vary in flavour. The recessions associated with the global financial crisis (GFC) and the COVID-19 Pandemic were unusual in that both real and nominal economic growth went negative. This is atypical. In the 1970s and the 1980s nominal economic growth remained largely positive during relatively deep recessions. Again, in 1990 and 2001 when the U.S. economy was in recession, nominal GDP growth hovered around 2-2.5 per cent.

Why is any of this relevant?

To most of us, recession relates to declines in real economic indicators such as employment or output. Nominal economic growth however also takes into account prices. When inflation is high, as it is now compared to the decades prior to the pandemic, it offers companies with pricing power some protection against steep falls in earnings. This is because revenue and profits are nominal variables. In other words, vanilla-flavoured recessions – the type being predicted currently – are associated with positive nominal GDP growth.

Global Macroeconomic research house Alpine Macro note that strong pricing power associated with higher inflation, and therefore higher nominal growth, was the reason earnings per share EPS drawdowns were milder during the 1970s and 1980s recessions. EPS drawdowns have been much deeper since the 1990s, when inflation is lower. The recessions of 1990 and 2001, when inflation was lower, saw EPS contractions of 40 and 50 per cent respectively.

So today, even though a recession is entirely possible, the higher level of inflation and margin expansion (plenty of companies have reported record gross margins recently), may mean earnings growth remains robust, or at least better than what some investors fear.

Think of it this way; nominal GDP, according to Alpine Macro, is 6.9 per cent. The GDP deflator (inflation adjustment) is 5.3 per cent. That means real GDP is about 1.6 per cent. Therefore, if inflation falls by another 150 basis points by the end of the year and a mild recession takes real GDP growth to zero, nominal GDP would still be just under four per cent.

And keep in mind our oft-repeated argument that even anemic positive economic growth combined with disinflation (which is not deflation) has historically been the backdrop for solid gains in innovative growth stocks. Perhaps the stock market has already got it right, and the pessimists need to recalibrate.