Published on August 1, 2022

Dr David Kelly
Chief Global Strategist at J.P. Morgan Asset Management

The long history of financial markets, like most classic novels, is full of misunderstandings, miscalculations and mistakes. Despite all of this, the story normally twists and turns its way to a happy ending. This may yet be the case for investors in the very unusual economy that has unfolded following the pandemic recession and recovery. 

At his press conference last Wednesday, Federal Reserve Chairman Jay Powell said he didn’t believe the economy was in recession. In support of his opinion, he pointed to labor market strength, including payroll gains averaging 450,000 per month, an unemployment rate near a 50-year low at 3.6% and continued strong wage gains.

The next day, the Bureau of Economic Analysis announced that U.S. real GDP had shrunk for a second consecutive quarter, providing fresh ammunition to those who argue that the economy is in recession.

Technically, we believe the Fed Chairman is correct. However, today’s strong labor market is, in many ways, the result of extraordinary conditions at the end of the pandemic and may fade in the months ahead. If it does, in tandem with cooling inflation, a data-dependent Federal Reserve will likely become less aggressive and this could, even with recession, ultimately establish a better environment for investors.

The Technical Definition of Recession

Almost since its foundation in 1920, the National Bureau of Economic Research (NBER) has assumed responsibility for defining when a slowdown in economic activity constituted a recession and for establishing the dates of the peaks and troughs of U.S. business cycles. In 1978, the NBER formally created a Business Cycle Dating Committee to make these calls on an ongoing basis.

The Committee’s definition has shifted a little over the years but it has always been broader than just “two consecutive quarters of negative real GDP growth”. Currently, they define a recession as “….a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Determining when the economy enters recession is based on a number of economic indicators including:

(1)  Real personal income less transfers

(2)  Non-farm payroll employment

(3)  Employment as measured by the household survey

(4)  Real personal consumption expenditures

(5)  Combined wholesale and retail sales, adjusted for price changes, and,

(6)  Industrial production.

Looking at this list, there are plenty of signs of softness in the economy today. In particular:

• Real personal income less transfers has fallen in three of the last six months and is below its December 2021 level.

• Real personal consumption expenditures have risen so far this year but fell by 0.3% in May and only recovered by 0.1% in June.

• Combined real wholesale and retail sales appear to have declined in four of the last five months, and,

• While overall industrial production rose slightly in May before falling slightly in June, manufacturing production fell by 0.5% in both months.

However, payroll jobs have risen every month this year by a very strong monthly average of 457,000 while the more volatile household employment series has logged a healthy average gain of 356,000, despite declines in April and June.

The Importance of Jobs

Clearly, the labor market is stronger than the rest of the economy and too strong for the Committee to conclude that a recession has started. However, it’s important to appreciate the potential fragility in this labor market momentum.

Strong job gains in recent months can really be ascribed to two factors. 

First, statistical analysis shows that employment responds to current real GDP growth but also growth lagged over a few quarters. The U.S. economy had grown by 5.5% year-over-year by the fourth quarter of 2021 and this was very likely to produce strong job growth in early 2022, even if demand slowed. Second, the actual retarding impact of the pandemic has continued to fade in 2022. While infections remain widespread, the fatality rate has fallen due to immunity from vaccinations and past infections. In December 2021, 3.1 million workers said that they were unable to work because their employer closed or lost business due to the pandemic. By June 2022, this number had fallen to 2.1 million workers. In December 2021, 1.1 million people reported not being in the labor force due to the pandemic – six months later, this had fallen to 600,000.

While booming job growth constitutes half of the strong labor market story, a lack of potential workers has also played a key role in producing high job openings, a low unemployment rate and high wage growth. Between June 2019 and June 2022, the population aged 16 and over in the United States grew by 4.8 million, or 0.6% per year. However, the working-age population, roughly defined as those aged 18 to 64, grew by just 500,000, or 0.1% per year. This largely reflect the wave of Baby Boomers reaching the age of 65 and far fewer immigrants due to changes in government policies and the pandemic. This left the economy short of workers almost everywhere as the companies tried to ramp up staffing for a post-pandemic boom.

While this excess demand for labor is impressive, it may be a little more fragile than an excess demand that reflected current booming demand for goods and services. There are likely many business owners and corporate executives who, over the last few months, have transitioned from a singular concern about a lack of qualified workers to a realization that demand has softened and that they now no longer need, and cannot afford to hire, extra staff.

This could result in a tumble in job openings, the first hints of which may be visible in Tuesday’s JOLTS report. Our models still suggest only a modest decline in job openings to 11.1 million at the end of June from 11.2 million at the end of May and a peak of 11.9 million at the end of March. However, a sharper drop would provide evidence that the job market isn’t as strong as the Fed believes. Further signs of a cooling labor market could be provided by a continued steady rise in unemployment claims on Thursday and a slowdown in payroll job gains and wages in the July jobs report, due out on Friday.        

Why Recession is Still Possible

It is also important to recognize that the economic weakness seen in the first half of the year could persist into the second half due to some considerable drags.

• Despite some movement on long-stalled legislation, fiscal drag remains severe. The Congressional Budget Office now projects that the federal deficit will fall from 12.4% of GDP in fiscal 2021 to 3.9% in fiscal 2022. While this is positive from a fiscal stability respective, it represents a huge decline in government spending relative to revenues and is thus reducing aggregate demand within the economy.

• After a significant improvement in the second quarter, real net exports are likely to deteriorate further for the rest of the year, reflecting both overseas economic weakness and a 15% year-over-year increase in the trade-weighted dollar exchange rate.

• Home-building and home-buying will likely continue to drift down, reflecting a more than 2% increase in 30-year fixed rate mortgage rates since the start of the year.

As these drags persist, we may yet see declines in all the measures monitored by the Business Cycle Dating Committee before the end of the year and 2022 could still see the start of a U.S. recession.

The 2% Obsession

Such a recession, if it occurs, should be mild by the standards of recent contractions due to a lack of excess in the more cyclical areas of the economy and the strength of the labor market at its outset. However, recessions, like wars, are unpredictable and it is always best to avoid them if possible.

This should be the stance of the Federal Reserve. While the Fed seems determined to return inflation to its 2% target, it doesn’t need to be too aggressive in trying to achieve that goal. According to the latest Fed projections, consumption deflator inflation is expected to fall from 6.5% year-over-year in June to 5.2% by the fourth quarter of this year, 2.6% by the fourth quarter of 2023 and 2.2% by the fourth quarter of 2024. This would essentially get the Fed to target inflation within two and a half years of its peak and this pace of moderation does not need to be accelerated. After all, it took more than eight years to reduce the unemployment rate to the Fed’s long-term 4% expectation following the Great Financial Crisis. There is nothing wrong with a 2% inflation target – however, the economy would benefit from a little patience in trying to achieve it.

Fed Policy and Investment Implications

In the end, it is likely that the Fed will show this patience. Following the FOMC decision to raise the federal funds rate by 0.75% for a second consecutive time, Chairman Powell held his usual press conference. In his opening remarks, he noted that: “…while another unusually large increase could be appropriate at our next meeting, that is a decision that will depend on the data we get between now and then”.

We believe the data on both growth and inflation will be weak enough to allow the Fed to only raise rates by 0.50% in September followed by one or two 0.25% rate hikes in November and December. This could allow the federal funds rate to peak at a lower level than is embedded in current Fed projections. 

Despite a market rally in July, it has been a very tough year for investors and the short-term outlook is both challenging and confusing. However, the most likely path forward for both the economy and policy should ultimately return us to an investment landscape of slow economic growth, low inflation and low interest rates – rather like the economy that prevailed before the pandemic. Given the better valuations yielded by a painful first-half selloff in financial assets, there are now many ways to position portfolios to take advantage of this eventually more benign environment.

For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.

Disclaimers

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. The views and strategies described may not be suitable for all investors. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

Content is intended for institutional/wholesale/professional clients and qualified investors only (not for retail investors) as defined by local laws and regulations. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide (collectively “JPM”).

Opinions and comments may not reflect those of J.P. Morgan or its affiliates. Content is intended for US audience only, and should not be considered a recommendation or endorsement by JPM for any product, service or strategy specific to any individual investor’s needs. JPM is not responsible for third-party posted content. "Likes", "Favorites", shares, similar functionality or content appearing on third party websites should not be considered an endorsement of JPM products or services.”).