The first few months of the year have been anything but boring. We've endured the continuation of supply chain angst, a renewed surge in commodity prices, a land war in Europe, and dramatically higher interest rates. We've successfully managed the resulting market volatility, and clients are in a great position to take advantage of opportunities as they present themselves throughout the rest of the year.
In response to client/advisor questions, we'll again focus this newsletter on the economic outlook for the US economy. We try to keep things concise, but if any exhibits or commentary spark questions or a desire for additional review, please let us know – we're always happy to keep the conversation going.
Kyle and The Portfolio Management Team
News coverage surrounding the economy's eventual return to recession is picking up. Over the past roughly 100 years, there have been 15 contractions in economic growth (recessions). Those experiences ranged from the devastation of the Great Depression to more mild retrenchments that were nearly imperceptible. So, when we talk about a pending recession, let's start our discussion about how the worst recessions occur.
Debt makes the world go round. Societies worldwide have vastly differing opinions on the virtue of being a debtor. Most of us are raised to understand that debt is inherently bad or shameful. And in many instances, that couldn't be truer. Yet, as a society, we practice an entirely different approach than our preaching. The fact of the matter is, in the hyper-financialized America that emerged post-WW2, we are a debt and consumer-driven economy. And who's to say it's improper when it has worked so incredibly well?
Gross Domestic Product (a country's economic output) for every man, woman, and child in this country has marched steadily higher over the past 70 years. The grey shading denotes recessions.
The share of the USA's debt for every man, woman, and child has also undergone a steady march higher. Yet, every moment of doubt about our country's debt load over the past 70 years has been met with expanding productivity and living standards.
It's not so much that debt itself is problematic; it's an unbalanced, unmanageable debt that is dangerous. And the imbalances – those are what cause the BIG recessions. Let's look at the debt loads for consumers and corporations.
When the balance between debt and the productive capacity of a household or business gets too extreme, something must change. Either you reduce expenses, or you find more sources of revenue. Unfortunately, the first option is typically much easier. So, to reduce your debts (deleverage), you lay off employees, curtail discretionary spending, and trade down to lower-priced goods/services. And when those activities become pervasive in an economy, a recession is guaranteed.
We've established that debt loads look manageable relative to historical episodes. But for them to truly be manageable, consumers and businesses must be able to generate revenue. For consumers, revenue comes from employment, and for companies, revenue comes from retail sales.
No matter the data set, unemployment in the United States is at multi-decade lows. That's an unequivocally good thing, and the strength in retail sales is self-evident.
How about corporate earnings?
No weakness there.
...and corporate spending on long-lived equipment and facilities that improve a business' productive capacity?
So, leverage (debt) in the economy looks manageable, the job market is the hottest it's ever been, people are spending, and companies are expanding. So why do we keep hearing from clients and advisors about a potential recession?
Well, of course, inflation has permeated our psyche. And it makes us all feel lousy.
Inflation is the ultimate expectations game. You expect your toothpaste to cost a certain amount – generally less than or equal to what it was last time. You expect that your standard of living will increase over time through advancing, merit-based wages. In other words: stuff should always cost about the same, and you should always make more money over time.
Wouldn't that be a wonderful world?! Unfortunately, sometimes that ideal scenario doesn't materialize, and when that happens, we get depressed.
Despite inflation-adjusted retail sales rising more than 14% in the past two years, consumers say they're as miserable as ever. They're following Howard Beale's directive to yell, "I'm as mad as hell, and I'm not going to take it anymore." But there aren't any signs that they'll stop taking it. Retail sales will keep rising until being 'mad as hell' becomes an unwillingness to participate in the economy.
Yield Curve Inversion
If you've made it this far through the newsletter, maybe you were hoping to find some coverage of the shape of the United States Treasury yield curve. Well, you're in luck. For a fleeting moment or two in the first week of April, the financial media seized on the topic of the day – an inversion in 2-year and 10-year interest rates.
An inverted curve means that it costs less to borrow for a shorter term. When the country borrows for a 2-year term, it pays a lower interest rate than a 10-year term. Inversions tend to happen when the Federal Reserve is increasing short-term interest rates. And each time the curve has inverted, a recession wasn't far off. In finance/economics, there aren't many indicators that are 100% predictive, so when we find one, we should both pay attention and be skeptical.
Here are some comments from Federal Reserve Officials over time during periods of yield curve inversion:
Incredulity comes naturally to economists and money managers. In that vein, our opinion is that stating 'recessions always follow inversions' is about as interesting as saying 'you eventually get hungry after eating breakfast.' The statement is accurate, but not terribly helpful.
Energy – Trauma is Real
Once a dog has bitten you, you're probably going to be afraid of dogs and avoid them. We're hard-wired to avoid risk, especially after a directly related trauma. Trauma in decision-making is the same whether you're dealing with the physical threat of another dog bite or the emotional risk of destroying a business.
The oil business is notoriously prone to dramatic boom/bust cycles. But even by the extreme standards of the industry, the last eight years have been remarkably unstable. Overproduction and a pandemic led to extinction-level events in 2015 and 2020. Many companies went out of business, and billions of dollars evaporated.
The Dallas Federal Reserve recently surveyed 132 oil and gas executives to understand the state of the industry. Among the most interesting data points that emerged were related to the willingness of managers to expand their business.
More than half of the respondents indicated that capital spending would remain restrained due to new expectations of discipline from investors. Nearly 1/3rd indicated that their willingness to expand was entirely insensitive to the price of oil.
It's a good thing that production levels in the US are already extremely high relative to the past.
The politics related to exploration/production/refining/logistics are much more difficult to chart. Industry experts we've talked to have indicated that transportation and logistics problems outweigh that of limited production.
Whether you think the problems within the energy industry are driven by a political war on fossil fuels or managers that are happy with their margins, you're probably at least a little bit right. What is abundantly clear is that we've been in a consistently improving position regarding energy independence for the past 14 years. To maintain that privilege, we'll need to continue to invest in all manner of energy sources.
A recession is coming. It always is. Given the strength of household/corporate balance sheets, a repeat of the credit crunch of '08 seems unlikely. Yet a 1950's style retrenchment in growth as the economy resets from the pandemic induced supply chain and stimulus shocks would not surprise us. As your money manager, our job is to be rigorous about what we own, keep an open mind, and be ready to adapt.
If you have any questions or concerns, please let us know. We appreciate you taking the time to review our thoughts.