Wednesday, July 6, 2022
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Will There Be a Recession in 2022?


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These past few weeks have been an excellent time to get out, enjoy the nice weather, and ignore the financial markets because YIKES, have they been volatile!

The Dow Jones Industrial Average lost 1,063 points, or 3.12%, to close at 32,997.97. The tech-heavy Nasdaq Composite fell 4.99% to finish at 12,317.69, its lowest closing level since November 2020. Both of those losses were the worst single-day drops since 2020.

Dow tumbles 1,000 points for the worst day since 2020, CNBC.com

The S&P 500 fell more than 13% between January and April of this year. That’s the worst four-month start to a year since 1939, when longtime legendary investor Warren Buffett was just nine years-old.

The S&P is having its worst start to a year since 1939, CNN.com

I guess this goes to show you how unpredictable, in the short term, stock markets can be. Going into 2022, everything was looking up and to the right. COVID was receding, vaccines were plentiful, countries were opening their borders again. We even managed to start travelling again for the first time in two years! In short, normality looked right around the corner and the world was eagerly getting ready to open back up for business.

Then…stuff happened.

Inflation reared its ugly head for the first time in 20 years. A war in Ukraine broke out. Central banks started hiking interest rates. And from there, all hell broke loose on the financial markets.

What’s Going On?

To a casual observer, 2022 feels like the total breakdown of traditional portfolio management rules. Stocks and bonds are supposed to be moving in opposite directions, yet right now they’re both dropping like a stone. The S&P 500 is down 16% year-to-date, but the bond index is not much better, down about 10%. The International Index, as tracked by the MSCI EAFE ETF (EFA) is also down 15%. Up here in Canada, the TSX is doing better due to Canada benefitting from the recent increase in oil prices, but we’re still down about 8%.

Other traditional safe havens of wealth haven’t exactly performed as advertised either. Holding cash means you’re guaranteed to lose purchasing power when savings accounts and money market funds are paying less than inflation. Real estate, traditionally useful as a hedge against inflation, is getting hammered with price declines already being felt due to rapidly increasing interest rates. Even gold hasn’t been useful as a safe haven, having retreated 8% from its high in March 2022. And of course, as FIRECracker noted, Bitcoin (and other crypto assets) have been useless as a stable hold of value, having plummeted a breathtaking 37% from so far this year. Far from being digital gold, Bitcoin has revealed itself to be just another speculative tech investment, its performance closer to the NASDAQ this year than gold or cash.

And oh yeah, US GDP shrank for the first time since the pandemic.

Gross domestic product unexpectedly declined at a 1.4% annualized pace in the first quarter, marking an abrupt reversal for an economy coming off its best performance since 1984, the Commerce Department reported Thursday.

U.S. GDP fell at a 1.4% pace to start the year as pandemic recovery takes a hit, CNBC.com

On April 28, the US Commerce Department reported a decline of 1.4% in GDP for the first quarter. Analysts had been expecting an increase of about 1% as the economy continued to recover from the pandemic despite all the news coming out of Ukraine, so this was a surprise.

So of course the dreaded R-word starting circulating in the media.

Recession.

Are we headed towards one? When, and how painful would it be? Could the world economy even handle another recession having not completely recovered from the last one?

All good questions that nobody can really answer with 100% certainty. But since this is a financial blog and I’m a highly qualified (?) finance blogger, I thought I’d toss in my two cents on where I think the global economy is headed.

The Four Most Dangerous Words

Before I get into that, I want you to ponder something.

If you knew for sure that a recession was coming up in the next 12 months, what would you do?

Maybe you’d do nothing. Or maybe you might delay some planned ETF buys so you can get them later at a better price. But the majority of retail investors would answer something to the effect of “Sell everything and move to cash until the dust settles.”

In the financial advisory world, “until the dust settles” are considered among the four most harmful words to a person’s investment portfolio. Because “until the dust settles” is just code for “until I feel more confident about investing in the stock market.” Here’s why that’s bad.

Let’s say that you knew that a correction of 10%-20% was going to happen in the next 12 months, so in order to avoid that loss, you sell everything and move to cash.

Then what?

You can’t just sit on the sidelines forever. If you want to retire early, you’re going to have to get back into the market at some point. So when, and at what price, should you do it?

There are three possibilities. You could buy back in when prices are…

  • lower than your sell price
  • the same as your sell price
  • higher than your sell price

The last option is bad because it means you waited too long and missed out on a buying opportunity. The second option is better, but not great because it means your performance turned out to be the same as if you had done nothing, plus you would have missed out on dividend payments while you were out of the market.

That means that if you plan on cashing out your investments, the only way to make that decision worth it is if you buy back in at a lower price. That way, you will have avoided the losses on the way down, but able to participate in the gains on the way back up.

Unfortunately, none of the people who choose to sit on the sidelines “until the dust settles” will be able to do this. After all, if they’re getting nervous enough to pull all their money out at the mere hint of an upcoming recession, how are they going to feel when markets are down another 10%? 20%? 30%? That fear will paralyze them and keep their cash on the sidelines until the crisis has passed, at which point prices will likely be as high or even higher than when they sold.

So to a certain extent, trying to time recessions is pointless, because only people who get out and successfully get back in at (or near) the bottom of the market will be able to benefit, and the vast majority of investors (including myself) have no idea how to do that.

Better to stay invested and, if possible, buy the dip as markets go down. And remember, you’re still going to get your dividends and interest as you hold.

Behind The Numbers

So that being said, back to the original question: Do I think there’s a recession coming in 2022?

In short, no I don’t.

As scary as the headline numbers seem, I don’t think they tell the whole story. If we dig into these stats a little bit, we can see that there are actually some pretty strong signs of an economy that’s actually pretty healthy. I’m going to focus on three of them, and they are: Imports, Earnings, and Employment.

Imports

Why do imports matter here? They matter in understanding the context behind the drop in the US Q1 GDP.

A decrease in GDP is normally a pretty big deal, and when problems are identified, economies as large as the US are slow to change course. The time it takes for a new government policy to be visible in GDP typically takes at least 6 months, so a negative GDP number is cause for alarm because a) the definition of a recession is two consecutive quarters of negative GDP growth and b) anything the government does now to fix it won’t be felt in time to avert that negative second quarter.

But in this case, a negative GDP number isn’t quite the bad news we think it is. The reason? Imports.

The way GDP is calculated is that things that a country produces, and especially things that a country exports, all count positively towards their GDP. Conversely, things that the country imports count negatively.

And as you recall, during the second half of 2021, the US desperately needed things from other countries like computer chips, cars, and MacBooks but couldn’t get them because of supply chain issues. That means that a lot of orders got pushed forward until overseas suppliers could deliver.

And deliver they did. In Q1 of 2022.

That swell of pushed-forward import activity counted against the US GDP number big time, to the tune of 3%.

A burgeoning trade deficit helped shave 3.2 percentage points off growth as imports outweighed exports.

U.S. GDP fell at a 1.4% pace to start the year as pandemic recovery takes a hit, CNBC.com

This means two things. One, if all those imports hadn’t hit at the same time, Q1’s GDP would have been something around 1.6-1.8%, which would have beat analyst expectations of 1% growth. Second, this effect is temporary rather than systemic. Now that the backlog has been mostly filled, we’re not going to keep seeing this negative weight on GDP going forward. The underlying economy is still strong, and still recovering, and once imports are taken out of the equation, analysts are predicting Q2’s GDP to come in positive, with even more positive numbers going forward.

In other words, the drop in GDP was a sign of a one-off blip rather than a harbinger of an impending recession.

Earnings

But what about the stock market? Why is it dropping so far and so fast?

When an index falls in value, there are basically two reasons: Either earnings are falling, or the price-to-earnings multiple is collapsing.

Earnings fall when companies makes less money. When this happens, it’s natural for stocks to fall since those companies are worth less. The price-to-earnings multiple, or P/E ratio, however, is a measure of how a stock trades relative to its earnings, and is entirely driven by investor sentiment.

What we’re seeing in 2022 in the stock markets is a curious, and abnormal, pattern. Stocks are falling precipitously, but earnings are not. In fact, earnings are continuing to go up as the economy continues to recover from the hangover of the pandemic.

Looking ahead, analysts expect earnings growth of 7.0% for Q2 2022, 11.7% for Q3 2022, and 11.2% for Q4 2022. For CY 2022, analysts are predicting earnings growth of 10.9%.

S&P 500 EARNINGS SEASON UPDATE: APRIL 22, 2022, FactSet.com

When earnings go down, it’s common for the P/E ratio to compress as well. I would consider this a “real” correction since it’s actually based on the financial performance of the underlying companies.

However, when earnings are stable (or going up) and the P/E ratio is still compressing, that’s just irrational. The companies are making more money now as they were 3 months ago, yet those same companies are somehow worth 16% less? That doesn’t make sense.

Markets sometimes behave irrationally, but if you wait long enough they always correct. That’s why I’m not too worried about what’s happening in the stock markets now. The underlying companies in the index are still doing well, and that means that once investors get all that fear out of their system things will return to normal.

Which brings me to the final piece of the economic puzzle, and that’s…

Employment

There’s a quote I love from President Truman, and it goes…

A recession is when your neighbour loses their job. It’s a depression when you lose yours.

Harry S. Truman

Declining stock markets are part of recessions, but the really harmful part is the spike in unemployment. When the economy slows down so much that workers start getting laid off left and right, that’s when you should be worried.

We’re not there yet. Not even close.

In the US, unemployment is sitting at a rock bottom 3.6%. In Canada, it’s 5.3%. These numbers are in line with the clicking hot economy we all enjoyed in 2019 before COVID hit. Not only that, our economies are still having trouble hiring people. As I walk down the street, seemingly every restaurant has a sign up that says “Now hiring: Cooks, hostesses, waiters.” Job boards are bursting at the seams. Even wage pressures are picking up, as workers have been quitting their jobs, hopping between companies and getting pay raises each time.

Job markets are red hot right now, and that’s completely incompatible with the idea that a recession is around the corner. When recessions happen, the signs popping up all over the country usually say something like “Out of business” or “Foreclosure.” Not “Help Wanted.”

Of course, things could change at any moment, but the tight labour market is giving the Federal Reserve (and the Bank of Canada) plenty of assurance that they can tame inflation and engineer the soft landing that everyone wants. By not raising rates too fast and keeping an eye on their impact on the job market, they can cool the economy without throwing people out of their jobs. And if that happens, there won’t be a recession.

Conclusion

Recessions are scary things, and when I first read the headlines I was among the many who thought “Oh great. This again. As if we didn’t have enough shit to worry about.”

But upon closer inspection, I think the risk of a recession in 2022 is way overblown. The Q1 GDP number looks to be a red herring. Corporate profits remain healthy. And anyone who wants a job can get one. In that economic environment, a recession seems extremely unlikely and the recent market volatility so far appears to be just full of sound and thunder, signifying nothing.

What do you think? Do you think a recession will happen in 2022? Why or why not? Let’s hear it in the comments below!


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