Financial Professionals

May 9th, 2022

Does the Economy’s Contraction in Q1 Signal a Recession?

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The news caught many investors and even economists off guard – U.S. gross domestic product (GDP) contracted at a -1.4% annual rate in Q1 2022, which also marked a drastic turn from the 6.9% annual growth rate registered in Q4 2021.

To make matters more challenging, the equity and bond markets both endured sharp volatility as the Fed took steps to cool the economy, announcing a half a percentage point increase in the fed funds rate. The U.S. economy was supposed to be firmly in growth mode, with Zacks projecting ~3% GDP growth for the full-year 2022.1

So, what happened? And should investors be worried?

Let’s first address market volatility, which I understand can be unsettling. Pronounced selling pressure in the bond markets pushed the 10-year U.S. Treasury bond yield above 3% for the first time since 2018. Stocks also enduring wild swings, with acute selling pressure in high valuation categories, like the technology sector. Media narratives during corrections often invoke a sense of hysteria, like something is gravely wrong in the markets and the economy.

My advice to all readers is not to take the bait. These are precisely the times investors should stay cool, even-handed, and focused on fundamentals and the long-term. I continue to firmly believe the market is in a correction, not a bear. Corrections can span several weeks or even months, and they almost always test investor patience. This time is no different.

The number of jobs available in the U.S. economy are at a record high, with nearly two open jobs for every one unemployed person. 55% of S&P 500 companies reporting Q1 earnings, 80% of them have reported a positive earnings-per-share surprise and 72% have reported a positive revenue surprise. These figures are high by historical standards. Profit margins also remain quite strong for U.S. companies. Over the last 12 months, S&P 500 companies have reported a collective net profit margin of 12.18%, representing the highest after-tax corporate profits relative to GDP that have ever been recorded (records date back to the 1940s). This is not the stuff of recessions and bear markets.

Investors should flip the script and think of this correction in another way. Consider that from the beginning of the year through the end of April, the S&P 500’s multiple has fallen from 21.4x to 17.5x, while the consensus forward outlook for earnings has actually improved by 5.7% over the same period. Stocks have gotten cheaper as earnings outlooks have improved! In my view, this is a setup where I want to own or buy stocks, not sell them.

Bringing the focus back to the U.S. economy, there were many factors that pulled the U.S. GDP number lower in Q1 2022, and I would argue that investors should not be too worried about any of them. There were three main detractors from the GDP headline figure:

  1. Trade Deficit – Imports are subtracted from GDP figures while exports are added. Imports often make their way into other parts of GDP, most notably in consumer spending, which is the reason they detract from GDP. But as I have written before, investors should not get too fixated on trade deficits as a measure of an economy’s overall health. What matters more is total trade, which gives a better indication if more goods and dollars are trading hands overall.

To that point, total trade was up solidly in Q1. The imports of goods soared 11.5% to $294.6 billion, while the exports of goods also rose 7.2% to $169.3 billion. The fact that imports rose at a much faster clip than exports is a negative for GDP calculations, but does not necessarily signal trouble in the economy. In fact, trade has subtracted from U.S. GDP growth for the last six quarters, which has been a strong period overall for growth.

In my view, none of the above three factors are recessionary at these levels, and a closer look at the most meaningful components of GDP– consumer spending and private sector demand – show very solid strength.

In the first quarter, consumer spending grew at a 2.7% annual rate, and spending accelerated from Q4 2021. It is worth mentioning again that GDP grew 6.9% in Q4 2021, meaning that consumer spending accelerated from already strong levels.

We also note consumers shifted spending materially in Q1 from goods to services, which is a trend that should help ease inflationary pressures in the coming months. A prime example is rising spending on travel and hospitality – U.S. hotel occupancy was at 65.8% in the last week of April, which is up from 49.6% at the end of January. The Transportation Security Administration (TSA) also reported that 2.1 million travelers passed through security in late April, up from 1.4 million in January.

Private sector demand showed strengths in other categories as well, with business investing rising at a solid clip. Investments in areas like software, equipment, and research grew 9.2%, contributing to the 3.7% annualized increase in overall private demand. These data readouts are not the stuff of recessions. Far from it, in my view.

Bottom Line for Investors

Here is some final data to consider: the Conference Board’s Leading Economic Index (LEI), which has historically been a reliable harbinger of economic conditions that lie ahead. While imports, government spending, and inventory investment were all detracting from GDP, the LEI continued to show a U.S. economy that was firmly in expansion mode. LEI increased by 0.3% in March, which followed a 0.6% increase in February and also marks a 1.9% increase over the past six months. 2

A negative GDP reading for one quarter may make the U.S. economy look weak, but that does not mean it is weak.

Disclosure

1 Wall Street Journal. April 28, 2022. https://www.wsj.com/articles/us-economy-gdp-growth-q1-11651108351

2 The Conference Board. April 21, 2022. https://www.conference-board.org/topics/us-leading-indicators


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This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

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