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An unusual economic cycle shifts gears

Jun 06, 2022 | Kelly Bogdanova


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We examine the main sticking points for the U.S. and other major economies, including inflation, and what it all means for the outlook for equities.

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  • Households on both sides of the Atlantic are changing their spending patterns due to high inflation and higher borrowing rates.
  • While inflation seems likely to ease somewhat in the second half of the year in North America, we think pressures associated with it will linger, and supply chain problems are unlikely to end anytime soon.
  • Consensus forecasts of GDP and corporate earnings growth for 2022 and 2023 could be too high—although estimates for the U.S. and Canada should remain in positive territory.
  • If a U.S. recession is avoided, as our economic indicators are suggesting, we think the magnitude of equity market downside and the duration of further volatility will be limited.

Amid the global equity market turbulence and the S&P 500’s 13.3 percent year-to-date decline, there are signs major economies are shifting gears.

With U.S. gasoline and diesel prices shooting up further in May, utility rates surging in the UK and Continental Europe, and food prices at lofty levels just about everywhere, households on both sides of the Atlantic are changing spending priorities and economic activity in Europe is starting to roll over. On top of this, China’s economy has slowed markedly due to its COVID-19 lockdowns, impacting a number of industries and global supply chains.

All of this puts 2022 and 2023 consensus GDP and corporate earnings growth estimates at risk of downward revisions—although we think estimates for the U.S. and Canada will remain in positive territory.

The good news is that the U.S. and Canadian economies have entered this dicey period in better shape than other developed economies. Both were strong before the shifts began to take hold, so they have more wiggle room to absorb additional central bank rate hikes. The main pillars of the U.S. economy—consumer spending, employment, and private investments—are holding firm. Six of our seven U.S. recession leading indicators remain in expansion mode, signaling that as yet there is no U.S. recession on the horizon. However, we can’t take it for granted the six indicators will all stay as unequivocally positive through this year and into next.

Equity markets have largely factored in much of this period’s unique economic challenges. We think any further downside will be primarily determined by whether signs develop that the U.S. economy is slipping into recession. So far, that’s not happening.

Disrupted recovery

Households on both sides of the Atlantic are changing their spending patterns due to high inflation and higher borrowing rates—allocating more for the things they need (food, gasoline/petrol, utilities) and less for the things they want, or holding back because of purchases already made during the COVID-19 stimulus-generated buying spree (durable goods, autos, other big-ticket items).

This is starting to impact economic data and corporate trends, and has hit business sentiment surveys hard in the world’s largest economy:

  • U.S. new home sales dropped 16.6 percent in April compared to March, the fourth straight monthly decline. While low inventories were a factor, we think higher mortgage rates are also biting.
  • U.S. regional business and manufacturing activity fell short of consensus forecasts in May.
  • Walmart and Target reported disappointing earnings and profit margins in Q1 and lowered estimates for the full year. The most pressing problems for these very large American retailers: an abrupt shift in customer spending away from household goods and electronics toward staples items, such as groceries, along with bloated goods inventories and high freight and warehouse costs due to inflation. Multinational companies in very different industries, such as Deere (agriculture equipment) and Applied Materials (semiconductor equipment), also recently warned about a more challenging demand environment.
  • U.S. CEO confidence has declined dramatically. According to the Conference Board’s survey, sentiment has retreated to 42 points in Q2 2022 from over 80 in mid-2021 (any reading below 50 means there are more negative opinions than positive ones).
  • The proportion of U.S. small business owners who expect better overall business conditions in the next six months fell to the lowest level since the closely watched survey began being conducted in 1974.
U.S. small business outlook for general business conditions has fallen to an all-time low
U.S. small business outlook for general business conditions

Line chart showing that the outlook that small business owners have about general business conditions has fallen to the lowest level since the National Federation of Independent Business began surveying this group in 1974. The level in the most recent survey conducted in April 2022 was -50, which was lower than the previous lowest level of -38 when the U.S. economy was still healing from the financial crisis and when sovereign debt stress was high in the European Union. Other notable low points occurred in the early 1980s around the time of aggressive inflation fighting by the Fed and a double-dip recession.


Recession periods

Small business outlook

Note: Diffusion index based on survey data of small business owners by the National Federation of Independent Business (NFIB)

Source - RBC Wealth Management, Bloomberg; monthly data through April 2022, the most recent survey

These and other developments suggest consensus U.S. GDP forecasts of 2.6 percent and 2.0 percent growth for 2022 and 2023, respectively, may be too high.

But while estimates are likely to come down, they should remain in positive territory. The unemployment rate is very low. The number of unfilled jobs remains very elevated. Household balance sheets appear to be in good shape and consumers remain in the game. Meanwhile, delinquency rates for all types of business and consumer loans, including credit cards, are at extremely low levels.

Most of the weakness that seems to be developing is on the goods-producing side of the economy where the stay-at-home spending spree of the past two years pulled forward a lot of future demand, especially for durable goods, leaving a demand “valley” for such goods that will probably extend well into next year and likely necessitate the liquidation of excess inventories at discount prices along the way. On the other hand, the much larger services component of GDP (more than 60 percent) carries no inventories and is enjoying the fulfillment of the pent-up consumer demand that built over the long COVID-19 shutdown/restrictions.

Much of the elevated concern that has produced headlines of late was triggered by the reported 1.4 percent decline in Q1 U.S. GDP. However, most of that drop resulted from an unusual surge in imports due to post-COVID-related factors and to a pronounced slowdown in inventory building after the outsized surge in the same category produced an exaggerated bulge in GDP the prior quarter. Final domestic demand in Q1—the total demand of goods and services in the country—grew at a strong 3.7 percent rate. The all-important consumer spending and private investments categories of GDP both climbed more than two percent.

U.S. Real GDP: Q1 2022 breakdown of major components
Quarter-over-quarter annualized data
U.S. Real GDP: Q1 2022 breakdown of major components

Column chart showing Q1 2022 U.S. real GDP, which was -1.4% based on quarter-over-quarter annualized data. However, the key components of GDP are also broken out, and these data tell a different story. Final domestic demand was 3.7%, which is strong. Consumer spending and private investments were 2.7% and 2.3%, respectively. Government spending was -2.7%. Net exports (exports minus imports) were -23.6%, which is very weak. Therefore, weakness in U.S. GDP was caused mostly by a steep decline in net exports rather than the other components.

*Magnitude of the decline for net exports (exports minus imports) is truncated so as to not distort the other data in the chart.

Source - National research correspondent, Bureau of Economic Analysis, Bloomberg

Thus far, economic data indicates these key components of GDP are growing again in the current quarter. The Atlanta Fed’s GDPNow indicator, tracking the main contributions to GDP so far, suggests a bounce in Q2 GDP growth to a below-average 1.3 percent rate, although much of the quarter is yet to be heard from.

Consumed by inflation

Two of the main sticking points for the U.S. and other major economies are doggedly persistent inflation and supply chain bottlenecks, especially given they have both been exacerbated lately by China’s renewed COVID-19 lockdowns, the crisis in Ukraine, and sweeping Western sanctions on Russia that have added price premiums on a broad range of energy, agriculture, and industrial metals commodities.

Supply chain problems are unlikely to end anytime soon, which has made cost pressures more stubborn and postponed or prevented some business opportunities.

In early May, proprietary research by the RBC Capital Markets Digital Intelligence Strategy team stated: “Many market participants mistakenly thought that supply chains would be untangled by now. Global port congestion is worsening and becoming increasingly widespread. Container ships are queuing for longer periods, which is elongating supply chains. A ship stuck in a queue reduces the supply available for charter. This has a domino-like negative compounding effect across various markets. Freight prices remain elevated, marine fuel prices are increasing, as are insurance costs. The lifelines of global trade are becoming increasingly expensive.”

While we don’t see inflation headwinds diminishing by much over the near term, U.S. consumer price increases should moderate in the second half of this year.

Components of U.S. consumer inflation and overall inflation trends (month-over-month data)
Bars show the four components’ percentage point contributions to the Consumer Price Index. Dotted lines show the % change of Headline CPI and Core CPI (excludes food and energy)
Components of U.S. consumer inflation and overall inflation trends

The column chart shows the month-over-month percentage point contributions of the four components of the U.S. Consumer Price Index from April 2021 through April 2022: Services, Goods, Food, and Energy. It also shows the trend of Headline CPI and Core CPI (excludes food and energy) over the same period, depicted by dotted lines. The month-over-month Headline CPI has trended higher during this period, while the Core CPI has moved in a range, most recently settling at 0.57% in April 2022, the top end of its range since July 2021. Inflation for the four key components has moved as follows: Services inflation began moderately high, then backed down through August 2021, then pushed higher, and has moved even higher recently finishing at 0.41% in April, the highest level for this component in this data series; Goods inflation started relatively high, then fell back through August 2021, then picked up again through January 2022, and has diminished more recently to 0.04% in April 2022; Food inflation was relatively low but has picked up so far this year, ending at 0.12% in April 2022; Energy inflation stared somewhat at a normal level, then began to pick up in February 2022 and surged in March 2022, only to fall into negative territory to -0.22% in April 2022. The Energy component has been the most volatile.


Services (ex Food & Energy)

Goods (ex Food & Energy)

Food

Energy
 
Headline CPI m/m %
 
Core CPI m/m %

Source - RBC Wealth Management, Bloomberg; data through April 2022, the most recent report

With households now less willing or able to spend on goods and more focused on mitigating inflationary pressures on their balance sheets, RBC Capital Markets, LLC’s Chief U.S. Economist Tom Porcelli expects there will be inflation relief in the important goods segment of the economy. It’s telling that even though a number of U.S. retailers have cut goods prices recently, many still have bloated inventories. This will require a longer period of discounting or more price cutting. Porcelli thinks a pullback in goods inflation has the potential to create a less acute situation for inflation overall, and kick-start a decline in core consumer prices, which exclude food and energy.

Currently, just like market participants, U.S. CEOs are concerned about inflation and how the Fed’s tightening cycle might impact the economy. The Conference Board’s survey indicates that 57 percent of CEOs believe inflation will come down in the next few years but not before a very short, mild recession occurs. Another 20 percent believe stagflation will be the end result with inflation remaining elevated over the next few years amid slow economic growth. Only 12 percent expect a soft landing, and 11 percent anticipate a hard landing.

Survey question: The Federal Reserve is starting to tighten monetary policy. What do you expect to be the most likely outcome for the U.S. economy?
Conference Board’s CEO Confidence Survey from Q2 2022
Conference Board's CEO Confidence Survey from Q2 2022

In the Conference Board's CEO Confidence Survey for Q2 2022, one of the questions asked, "The Federal Reserve is starting to tighten monetary policy. What do you expect to be the most likely outcome for the U.S. economy?" Respondents chose from the following four answers: Option 1) 57% for "Inflation will come down over the next few years, but the U.S. will have a very short, mild recession which the Fed offsets (reverse soft landing)"; 2) 20% for "Inflation will stay elevated over the next few years, and U.S. growth will slow significantly (stagflation)"; 3) 12% for "Inflation will come down over the next few years without a recession (soft landing)"; 4) 11% for "Inflation will come down over the next few years, but the U.S. will have a challenging recession (hard landing)"

Source - Conference Board; survey results released 5/18/22

None of RBC’s economists are forecasting a recession in the next 12 months, and they believe the Fed has scope to increase interest rates without pushing consumer activity and private investment into negative territory over a sustained period.

RBC Global Asset Management anticipates U.S. consumer inflation will recede somewhat in the second half of this year, with core inflation pulling back the most, helped along by a decline in goods prices. But overall inflation will likely remain “uncomfortably high” at year-end. It could take a few years to get back down to the Fed’s two percent target inflation rate.

For the U.S., if this is just a “growth scare”—when there is a threat of recession, but the economy ultimately dodges one—and inflation begins to recede, the equity market could deliver worthwhile gains in the next 12 months.

Recent growth scares have produced declines in the range of the drawdown that the S&P 500 has already experienced. What’s notable is that after the market bottomed in each of the four previous growth scares since 2010, the S&P 500 rallied by an average of almost 30 percent 12 months later.

Recessions, however, typically produce deeper and longer-lasting downturns. Surrounding 13 U.S. recessions since 1937, the S&P 500 declined 31.8 percent and the market took over a year to bottom, on average. On all but one occasion, the market troughed before the recession officially ended.

A mixed global economic bag

Outside the U.S., economic conditions are mixed. They’re relatively better in Canada due to its high proportion of natural resources and benefits from commodity price premiums, but worse for Europe and the UK for the opposite effects, while China has its own challenges.

  • Canada is among the leading global producers of the energy, agriculture, and industrial metals commodities that are in short supply. Commodity-producing countries are benefiting from positive balance of trade dynamics.
  • Economic indicators in China have fallen significantly, and difficulties in some aspects and to a certain extent are greater than when the epidemic hit us severely in 2020,” Chinese Premier Li Keqiang said recently. This is primarily a consequence of strict lockdowns in major cities such as Shanghai that’s associated with the country’s zero-COVID policy. While Shanghai is now opening up, it’s unclear if other major cities will get through this wave without strict lockdowns. China’s government has announced new stimulus measures, including business tax cuts, in an attempt to counteract the slowdown.
  • Within the EU, industrial leaders continue to warn about the implications of the high cost of power and natural gas, and supply chain bottlenecks. German industrial production is down 3.5 percent on a year-over-year basis. The German Institute for Economic Research found that 80.2 percent of domestic companies are struggling with a shortage of raw materials and supply chain constraints.
  • The UK may already be in recession, and households are under pressure due to inflation. According to a recent Ipsos survey, 63 percent of people in Britain are fairly or very concerned about their ability to pay their bills—and not just soaring utility bills—over the next six months.
UK utilities bills have already jumped and seem set to leap even higher
UK annual energy price cap for natural gas and electric utilities for customers with variable bills
UK annual energy price cap for natural gas and electric utilities for customers with variable bills

Column chart showing the price cap for UK annual utilities bills set by the country's Ofgem regulator for customers with variable bills held roughly steady from October 2019 through October 2021. However, in April 2022, the price cap was lifted 54% to £1,971. Recently the regulator announced it is estimated to rise further in October by another 42% to £2,800.

Source - Ofgem (UK Office of Gas and Electricity Markets); October 2022 amount is estimated by the regulator

We think more definitive signs of further slowing in the UK and EU will appear in coming months, even before all of the central bank rate hikes have taken effect, let alone have been fully absorbed.

In terms of equity prices, these markets are inexpensive on an absolute basis and on a relative basis compared to the U.S., even when adjusting for sector differences. Therefore, much of the economic weakness is likely already factored in. But there could be additional downside if European countries do indeed fall into recession.

Changing contours

Equity markets in recent months have begun to account for the downshift in economic activity. But investors are still having difficulty gauging just how long the unique inflation and supply chain pressures will last, the ability of central banks to effectively calibrate rate hike policies, and the ultimate impact on economic and corporate earnings growth.

Over the near term, we think markets will still have to contend with lingering inflation and supply chain concerns as well as the debate about whether central bank policies are too hawkish or not hawkish enough. Worries about an economic slowdown and recession will likely become more prominent, including among corporate management teams; this could affect their earnings and profit margin guidance and analysts’ forward estimates.

If a U.S. growth scare scenario plays out and a recession is avoided, as our economic indicators are currently suggesting, we think the magnitude of equity market downside and the duration of further volatility will be limited.

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