Falling Markets - Is A Recession Near or Over Feared?

Like many others, you have likely recently engaged in speculative, and often fearful, dinner table conversation of a potential recession. Significant economic and global unrest are fueling these concerns, with grim news headlines and financial markets hurting. We are witnessing unprecedented levels of inflation, the Russian invasion of Ukraine, an energy crisis, further worsened by the fact that the S&P 500 is down around 25% from its 52-week high, signaling a bear market. Nevertheless, widespread concerns about a recession could be amplifying existing bearish market characteristics through a self-fulfilling prophecy and social stigma. This article considers both arguments, adding impartiality and context to the glaring news headlines in the public eye. 

Before we delve further, what is a recession? The word is alarming, associated with job losses and plummeting financial markets as many remember the 2008 catastrophe. However, recessions vary significantly in severity and are rarely as disastrous as in 2008. A recession is “a significant decline in economic activity that is spread across the economy, and that lasts more than a few months” (NBER, n.d). The definition is broad; however, critical indicators for evaluating and predicting a recession include “GDP, employment, household income, consumer spending, retail sales and industrial production” (Mitchell, 2022). In our current economy, interest rate hikes to tame inflation, supply-side issues and corporate earnings will primarily dictate whether a recession is near. 

A Central Bank Induced Recession 

Many banks and traders believe a recession is on its way as interest rates increase, uncontrollable supply-side issues persist, and corporate margins thin.  

Interest Rates - The leading argument supporting a recession is that the surging of inflation and, in turn, interest rates, will lead to one. Various factors, such as pent-up consumer savings, the Russian invasion of Ukraine, and supply chain challenges are contributing to price increases as demand outpaces the supply of goods. US inflation rose to a 41-year high of 8.6 per cent, while Canada rose to a 39-year high of 7.7 per cent, forcing central banks to aggressively hike interest rates to tame inflation (Bloomberg). The Federal Reserve hiked interest rates by 75 basis points in June, the largest increase since 1994, and expectations are that they will do the same in July (Cox, 2022). These hikes are significantly contributing to the risk of a recession.   

But why? Higher interest rates make borrowing more expensive; so, demand should decrease when people no longer have enough income. A decline in demand helps lower prices and ease inflation - but can also disastrously affect the economy when hiked too quickly by hindering employment and economic growth. The Federal Reserve themselves predict unemployment rates to increase over the next three years from 3.6 per cent to 4.1 per cent in 2024, assuming all goes well, and inflation successfully slows to around 2.2 per cent (FED, 2022). However, inflation and supply issues will likely persist, despite interest rate hikes. 

Supply Issues & Commodity Prices - Anna Wang, the chief U.S. economist at Bloomberg, believes that supply issues are larger drivers of inflation than demand (Boesler, 2022). However, central bankers cannot drill for oil, grow more crops, or repair global supply chains. The only tool at their disposal is raising interest rates to dampen demand to offset supply-side issues. Central banks must therefore induce extraordinary declines in economic activity because demand is mainly inelastic for essential commodities such as agricultural and energy products. Their prices will remain high, above past averages, for some time because conflict resolution, infrastructure investments and additional supply will take time to emerge. In addition, higher interest rates can discourage capital expenditures. This makes lowering demand for commodities without damaging the economy very difficult (Boesler, 2022).  

Exhibit 1 // Source: Bloomberg - Global Commodity Prices

Corporate Returns - Hikes will hurt corporations by lowering demand, while supply chain issues and high input costs persist to create a profitability crunch. This could have a rippling effect on the economy as a precursor to layoffs and plummeting financial markets. For these reasons many believe central banks will tip the economy into recession. It also begs the question of whether inflation is or will be at a point, where central banks are prepared to intentionally induce a recession? 

Too Much Momentum To Fail  

Contrarian beliefs argue that a recession is improbable and that the economy will only face economic pressure.  This point, however, appears to elude news headlines. Arguments include interest rates will lead to a soft landing, supply chain issues are temporary, and corporations have too much momentum for margins to be a concern.  

Interest Rates – Yes, interest rates are increasing aggressively, but employment rates are very high and accounted for in central bank estimates, leaving room for rises in unemployment. Furthermore, household balance sheets are strong, exiting the pandemic with high savings and stimulus spending from the government. For these reasons, consumers and the economy could overcome the challenges of higher borrowing costs.  

Exhibit 2 // Source: Bloomberg - CAN and USD Unemployment Rates

Furthermore, contrary to common belief, stocks have climbed as the Federal Reserve hiked rates at an average annualized rate of 9 per cent (Menton, 2022). This means that hikes rarely impede returns immediately and could help the economy in the long term by slowing inflation. Furthermore, supply-side issues should slow down, minimizing the delayed consequences from rate hikes.

Exhibit 3 // Source: Bloomberg Article by Jess Menton

Supply Chains & Commodity Prices - Supply chain and commodity price difficulties are temporary, and many associated challenges could peak soon. For example, inflation is already increasing at a slower rate, and sticky inflation has remained flat compared to flexible inflation in our current economy (Goodkind, 2022). Sticky inflation includes goods for which prices change more slowly and permanently, whereas flexible inflation includes items that frequently fluctuate in price. Commodities like agriculture products and energy have been some of the most significant drivers of inflation and affected by the invasion of Ukraine. However, these prices are flexible and can revert relatively quickly. Furthermore, the government can help ease supply-side challenges and inflation with various policies such as increasing commodity production and lowering tariffs.  

Corporate Returns – Corporations are currently thriving despite inflation, so higher interest rates can be overcome for a soft landing. In fact, corporate bankruptcy filings through the first five months of this year are at their lowest level since 2010 (La Monica, 2022), and profit margins are substantial, leaving ample room for contraction. Profit margins in Q2 2022 for the S&P 500 were 12.70 per cent compared to 2.32 per cent in 2008. Employment rates, margins and household balance sheets are near historical highs; however, markets are still pricing an 85 per cent likelihood of a recession according to J.P Morgan (Jaisinghan, 2022). This begs the question of whether unreasonable recession concerns are causing the plummeting of financial markets?   

Exhibit 4 // Source: SPX Profit Margin on Bloomberg

In conclusion, a recession is not inevitable because our economy is still prospering with record low unemployment rates, bankruptcy filings, and considerable profit margins. However, the blunt impact of sharp interest rate hikes, while supply chain issues and high commodity prices persist, is likely enough to overtake our economy’s momentum. Consumer spending, profit margins and employment rates will decline, tipping us into a recession; however, our economy’s momentum should help delay its occurrence. It is likely not a question of if, but when. What do you think? Is a recession inevitable or disproportionately feared?