Wentz Weekly Insights
Recession or No Recession?
While there were a substantial amount of earnings reports to break down last week, the media was focused on the most grabbing headline of the week – the second consecutive quarter of negative GDP growth which led many to claim we are in a recession. A well-known rule of thumb says you need two consecutive quarters of negative GDP to have a recession. However, as we noted in our Jun 9, 2020 Recession newsletter (click here), a recession is determined, and always has been, by the Business Cycle Data Committee of the National Bureau of Economic Research and is defined by “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” You see GDP is only one input in determining a recession. There are several reasons to believe a recession did not start in the first quarter and continued to the end of the second quarter (although the second half of 2022 and 2023 is a little more uncertain).
For one, the first quarter GDP decline was due entirely by a massive growth in imports, indicating U.S. demand was strong in Q1. One of the components to GDP is net exports, or exports minus imports. GDP is meant to calculate goods and services produced in the U.S. and when the U.S. imports more than it exports, GDP is reduced as Americans are buying more foreign goods versus U.S. goods. The second quarter decline was due to inventories growing at a slower pace than the prior quarter. Inventories are calculated by the change in growth, meaning inventories can detract from GDP if they are growing at a slower pace than the previous quarter.
Second, the labor market remains very strong. Over 2.7 million jobs were added over the first half of the year, averaging 456k new jobs per month and there are still two job opening for every person unemployed. In addition, unemployment claims have remained near multi-decade low levels. Third, the consumer remains strong and makes up 70% of GDP. Consumer spending rose 2.7% in the first quarter and 1.0% in the second quarter. Fourth, industrial production continued to improve in the first half of the year. Finally, a better measure of U.S. growth is final sales to domestic purchasers, a number that reflects spending by U.S. residents. This number grew 3.7% in the first quarter and was flat in the second quarter.
While these numbers were solid in the first half of the year, recent data shows us they have been slowing. Final sales to domestic purchasers were flat in the second quarter, job growth has slowed, unemployment claims have ticked slightly higher, manufacturing indices suggest manufacturing activity has weakened, and consumer spending is slowing – all of this telling us the probability of a recession in the second half is substantially higher than several weeks ago.
Despite the recession headlines grabbing the most attention, the bigger event last week was the FOMC meeting and Jerome Powell’s press conference. The Fed raised rates 75 basis points as expected with Powell foregoing forward guidance and signaling rates are at a neutral level. Forward guidance was an important tool because it is what caused bond yields to move higher and markets to pull back since the beginning of the year. The Fed’s goal with this tool was to influence the markets by communicating what it is going to do. It sets an expectation for investors and the markets, and knowing the market is forward-looking it will begin to trade on what is expected. Powell also indicated the Fed is at a neutral rate, an interest rate that does not stimulate growth but also does not destroy demand. He reiterated the Fed will go above the neutral rate in effort to bring inflation down, but the pace of doing so will be on a meeting-by-meeting basis and determined by incoming economic data.
The markets took this as a more dovish statement and began to expect a Fed pivot as future markets are now pricing in two rate cuts in the first half of 2023 and stocks rallied as a result. The fact is rates will continue to rise and inflation will remain high, and above the Fed’s 2% target, for quite some time which we expect will keep the Fed on path.
The other big event was second-quarter earnings results from the largest U.S. companies which came in very mixed. The big five tech companies Apple, Microsoft, Alphabet, Amazon, and Meta make up almost a quarter of the S&P 500 (by market cap) and generated a total of $355 billion in revenue and $57 billion in net income in the second quarter. Apple reported sales grew 2% driven by strong iPhone demand and another record quarter in services, but it declined to provide Q3 guidance due to uncertainty. Amazon reported another strong quarter for its cloud computing segment Amazon Web Services with 33% growth, but inflationary pressures increased costs and it took a $3.9 billion write-off from its investment in Rivian Automotive. Alphabet (Google parent) reported solid results from Google search but ad revenue weakened and warned on tough comparisons in the second half of the year from a year ago over when the pandemic fueled growth. Microsoft also had strong results from its cloud segment, Azure, and provided strong guidance, but said the PC market missed expectations due to slowing demand. Finally, Meta (Facebook parent) got hit the hardest after providing guidance below estimates due to slowing ad revenue from Apple privacy changes, but said its reels was seeing better growth and said expenses will be lower than previously expected.
While the markets digest the recent earnings reports, the S&P 500 saw a 9.11% increase in July for its best month since April 2020 and is now 13.6% above its June lows. This will most likely turn out to be a bear market rally driven by the recent decline in yields as the 10-year treasury yield fell from a high of 3.48% to 2.64% on Friday. From a technical perspective, the internals have been weaker than what we would see in a sustained rally and we are near levels that will provide resistance. There remains a number of uncertainties and until those get figured out we continue to favor defensive and income producing investments.
Week in Review:
Stocks opened the week mixed but mostly higher on Monday in a quiet trading day that had stocks trading in a relatively narrow range with value taking the lead. The Dow rose 0.28% while the NASDAQ fell 0.43%. The highlight of the day came after the close with Walmart announcing two weeks before its earnings date that its profits will fall short of expectations as inflation eats into consumers’ purchasing power, particularly in food which is taking spending from other general merchandise items. The stock fell 11% in after hours trading.
Disappointing data on new home sales and consumer confidence, along with a profit warning from Walmart and Shopify cutting 10% of its labor force, sent stocks lower at the open Tuesday where they traded for the remainder of the day. Defensive sectors like utilities and health care were positive for the day while cyclical and sensitive sectors underperformed as the broader market fell 1.15%.
After a more defensive day on Tuesday due mostly to Walmart’s profit warning, stocks were higher Wednesday on not as bad as expected results from the large tech companies where the bar was set pretty low coming into the earnings reports. Tech led the way on Wednesday, but all stocks got a boost after the Fed meeting concluded with an as expected 75 bps rate hike and stocks kept rising after Powell started speaking as he backed away from the forward guidance the market have gotten accustomed to the past several meetings. The NASDAQ had its best day since April 2020, rising 4.06%, while the Dow rose just 1.37%.
One word dominated Thursday’s headlines and that was recession. The Q2 GDP print in the morning showed growth declined 0.9% in the quarter, making it two consecutive quarters of declining GDP, what some consider a recession. It was another very busy day of earnings reports with results very mixed. It was another solid day for stocks, but defensive sectors continue to lead the way higher with utilities and real estate gaining at least 3.5% while the broader market, the S&P 500, gained 1.21%. On the political front, Senator Manchin, who was one of two holdouts on the Democrats reconciliation bill that included tax hikes and climate initiatives, changed his stance and supports the bill, increasing the probability of it becoming law. The bill is now being known as the “Inflation Reduction Act” despite the $433 billion in new spending it provides. Separately, the Senate and House passed the CHIPS bill that provides billions in support to the semiconductor industry to better compete with China.
Important data on the consumer was released Friday morning that showed income and spending continue to grow, although that is being driven by higher prices with the June report suggesting consumers had to spend more to buy less. Despite this, markets continue to be in rally mode with positive large tech earnings reports from Amazon and Apple driving the index higher. The S&P 500 capped off the last trading day of July with a 1.42% gain while the NASDAQ gained 1.88%.
Markets capped off the month with a solid week, supported by the move lower in bond yields. The 10-year treasury moved about 15 basis points lower with the yield curve remaining inverted as the spread on the 2- and 10-year notes remained near 20 basis points. Crude oil was relatively unchanged for most of the week over continued recession fears until a move higher at the end of the week had oil 4.1% higher for the week. The major U.S. stock indices finished as follows: NASDAQ +4.70%, Russell 2000 +4.34%, ,S&P 500 +4.26%, and Dow +2.97%.
Recent Economic Data
- There was a wide range of expectations for second quarter GDP and actual results ended up coming in at the low in of the range with an annualized decline of 0.9% in Q2. The decline was driven mostly by a slowdown in inventory growth as businesses restocked at a slower pace in the quarter, which contributed -2.0% to GDP. The next drag was residential investment which fell 14.0% and contributed -0.7% to GDP, while nonresidential/business investment fell 0.1%. A 1.9% decline in government outlays contributed a -0.3% to GDP. Net exports, which was an enormous drag on Q1 GDP, resulted in a 1.4% addition to GDP thanks to exports growing 18% while imports grew just 3.1%. Finally, the most important category, consumer spending which makes up nearly 70% of GDP, contributed 0.7% to GDP thanks to a 1.0% increase in spending (service spending up 4.1% and spending on goods down 4.4% as consumers continue to shift spending habits to services like travel, and away from goods like appliances, electronics, etc). The other important data point in the report was the GDP price index which increased at an 8.7% annualized rate, the most since 1981, which is up 7.5% from a year ago.
- The Case Shiller home price index reported home prices rose another 1.5% in May, near expectations, and 19.7% from a year earlier, down from the 20.6% annual gain seen in April. Strength continues to be broad-based with all 20 cities in the index showing double-digit annual increases, however, there are signs of deceleration. Tampa (+36.1% year-over-year increase), Miami (+34.0%), and Dallas (+30.8%) continue to round up at the top of the list while Minneapolis (+11.5%), Chicago (+12.9%), and Cleveland (+14.3%) were the bottom three of the 20 cities.
- Sales of newly built homes fell by a more than expected 8.1% in June to an annualized pace of 590,000 homes, and 17.4% below the pace June 2021 of 714,000, for the lowest sales rate in two years. The median price of a new home sold in June was $402,400, a 9.5% drop from May but 7.4% above the median price a year ago. There were 457,000 new homes for sale in the month, representing a supply of 9.3 months at the current sales pace, improving from 8.4 months in the previous month and 5.7 months at the beginning of the year. There was a jump in sales in the Midwest which mostly offset a large decline in sales in the West. The housing market is in a steady decline as prospective buyers deal with declining affordability. The average mortgage payment on a new 30-year mortgage for the median new home is 32% higher than a year ago thanks to higher interest rates and higher home prices.
- The survey of consumer confidence by the Conference Board resulted in an index level of 95.7, a larger than expected decline from 98.4 in June for the third consecutive monthly decline. The assessment of the present situation deteriorated with an index of 141.3, down from 147.2 in the previous month, while expectations flattened at 65.3 in July compared to 65.8 in June. Notes from the survey said purchasing intentions for large items all pulled back further in July while consumers remain worried about inflation.
- Durable goods orders rose 1.9% in June, much better than the 0.5% decline expected, and follows a 0.8% increase in May. Orders for transportation-related goods which tend to be volatile from month to month rose 5.1% while durable goods orders excluding transportation rose 0.3%. But the most important number due to it being a direct input in GDP, non-defense capital goods excluding aircraft, rose 0.7% in the month, following a 1.0% and 0.8% increase in the prior two months. These orders were up an annualized 9.0% in Q2 which will be a tailwind for Q2 GDP growth.
- The U.S. trade deficit in May was $85.5 billion, still elevated relative to the historical deficit and near record highs, but $1.1 billion lower than in April. Exports rose 1.2% in May to $255.9 billion, while imports rose 0.6% in May to $341.4 billion. Exports were driven by energy like crude oil and natural gas, offset by a large decline in soybean exports, while imports were driven by energy as well and offset by a decline in consumer goods.
- The number of unemployment claims filed for the week ended July 23 was 256,000, down 5k from the prior week and almost 100k above the levels from 3-4 months ago. The four-week average was 249,250, up 6k from the week prior. Continuing claims were 1.359 million, down 25k from the prior week, with the four-week average at 1.362 million.
- Another important data point the Fed looks at is the quarterly read on employer’s compensation cost with the employment cost index. In the second quarter, the index showed total employer compensation costs rose 1.3% which was slightly above expectations. Wages and salaries increased 1.4% while benefits increased 1.2%. Compared to Q2 2021, compensation costs increased 5.1%, about half a percent above expectations, with wages/salaries up 5.3% while benefits rose 4.8%. Although employees are being compensated more by 5.3%, they are still losing purchasing power as inflation rose at an average 8.7% rate in Q2 compared to the period a year earlier, meaning real wage/salary growth was negative 3.3%.
- Personal income and outlays:
- Americans’ income rose 0.6% in June, slightly ahead of expectations and matching May’s increase (which was revised up from 0.5%). The important wages & salaries category of income was up 0.5% and is 11.8% higher than a year ago, driven by larger increases at the lower end of the wage tier. With an inflation rate of 9.1%, real wages according to this report are 2.7% higher than a year ago, but has slowed in recent months.
- Consumer spending rose a solid 1.1% in June, better than the 0.9% expected, and follows a disappointing 0.3% increase in May, but with inflation up 1.3% in the month real spending declined 0.2%. Compared to a year ago spending was 8.2% higher, also lagging the rate of inflation, indicating consumers are being forced to spend more to buy less. The increase has been driven by spending on services lately as the economy shifts to service spending like travel and away from goods spending like home upgrades.
- The personal savings rate fell to 5.1% for the lowest level of the pandemic. In fact, it was the lowest savings rate since 2004 as consumers continue to spend down savings as they deal with higher prices.
- The all-important personal consumption expenditure price index, the Fed’s preferred measure of inflation, rose 1.0% in June, slightly ahead of the 0.9% expected, and is 6.8% higher than a year ago, accelerating from the 6.3% rate in May. The core price index rose 0.6% in June, also more than expected, and was 4.8% higher from a year earlier, accelerating from 4.7% in May.
- Two weeks before its earnings date, Walmart said it is lowering its profit outlook to now be down 8% for the quarter and 12% for the year, which is down from flat to up slightly. It said there has been a heavier mix of food and consumables, as consumers are being forced to spend more on food due to inflation, which is a lower margin category, and less on other general merchandise, higher margin items. Walmart said that has required it to make more markdowns to move through inventory, particularly apparel. It also expects a $1.8 billion headwind in the second half due to currency fluctuations. Its sales are expected to be in line or slightly better than its original forecast – “Customers are choosing Walmart to save money during this inflationary period, and this is reflected in the company’s continued market share gains in grocery.”
- In its scheduled earnings release, 3M said it will spinoff its healthcare business that will create two publicly traded companies. The new 3M will be a global material science company servicing industrial and consumer markets. The new healthcare company will focus on wound care, healthcare IT, oral care, and biopharma filtration. The spinoff is expected to be completed by year-end 2023. New 3M will retain a 19.9% stake in the healthcare business.
- Shopify, whose software helps businesses create websites and an online marketplace, said it would cut 10% of its workforce, or about 1,000 employees. In a blog post, the CEO said the company made a bet during the pandemic that money going to e-commerce rather than physical retail stores had accelerated by 5-10 years and the company needed to adjust with aggressive hiring and spending, which turned out to be wrong as the economy returns to pre-Covid activity.
- Two Senators are working on new legislation that would give merchants choice to process credit cards over different networks. The goal of the legislation is to create more competition across credit card networks that would allow merchants to choose the networks and reduce the amount they pay to networks like Visa and Mastercard. The bill would be a hit to Visa and Mastercard, who both dominate the industry, but as of now appears dead on arrival in Congress.
- After reports the shareholder vote would fail to gain enough support due to its superior offer from JetBlue, Spirit Airlines said it was terminating its merger agreement with Frontier, ending a months long bidding war between the airlines. The next day, Spirit agreed to be acquired by JetBlue for $3.8 billion, or $33.50 per share in an all cash deal. The combination of Spirit and JetBlue will create the fifth largest U.S. airline behind Delta, American, United, and Southwest.
- Russia’s state-owned energy firm Gazprom said it would cut its gas exports to Europe in half through the Nord Stream 1 pipeline. The pipeline just resumed gas exports after maintenance, but was running at 40% capacity and with the new cuts will run at 20% capacity. Gazprom said the cut was due to a turbine problem in addition to sanctions from the West, while Europe blames the cut on the West’s support of Ukraine. Natural gas futures in Europe rose 10% after the announcement on Monday.
- The New York Times reported last week the White House has concerns China could take action in Taiwan in the next 18 months. Separately, but related, House Speaker Pelosi will partake in a trip to Asia and is rumored to be stopping in Taiwan, which is generating angry responses from China who said there could be consequences and retaliation, including military action.
- The Democrats’ reconciliation bill has gained momentum again as Senator Joe Manchin (D-WV) agreed to support the legislation that includes climate, healthcare, and tax initiatives. The package is still up in the air, needing 50 votes in the Senate to pass. All eyes are now on Senator Kyrsten Sinema (D-AZ), who has remained undecided on the package and whose vote is needed to secure the 50 votes needed in the Senate. Despite the package including $433 billion in new spending, it is now being referred to as the Inflation Reduction Act. It includes $396 billion in climate initiatives such as clean energy investments and tax credits for electric vehicle purchases. It still includes healthcare provisions such as a prescription drug pricing plan. The third major component includes around $750 billion in tax increases, including a minimum corporate tax rate of 15%.
- After initial resistance, the House and Senate passed the CHIPS Act that provides $280 billion to increase semiconductor manufacturing competitiveness with China. Rather than being funded by tax increases, the legislation will be funded by additional deficit spending as it was classified as a matter of national security. It includes $53 billion in direct financial assistance for the construction and expansion of semiconductor manufacturing facilities, $24 billion in tax incentives, and $170 billion for technology research and development across several federal agencies for the next five years.
As an update we would like to announce that David Trainor has departed Wentz Financial Group. Over the past year many of you have probably talked with David at various times and it is with great excitement that we announce he is leaving to take the Head Golf Coaching Position at Boise State University. David brought great passion to our team and was always focused on our clients but is real passion is with being a golf coach. While we are sorry to lose him around the office, we are very excited for the tremendous opportunity he has earned to once again lead a division one golf program. Good Luck David and Go Broncos!
Please be aware that starting Memorial Day and running until Labor Day, Wentz Financial Group will begin its summer hours. Our hours on Monday will be 8:30 to 4:00 and Tuesday through Friday will be 9:00 to 4:00. As always, if you need to speak or meet outside of those hours, please reach out and we will be happy to set up an appointment.
The Week Ahead
This week will remain busy, particularly on the earnings calendar where another 30% of S&P 500 companies will report second quarter results. Notable reports this week will come from Pinterest and Simon Properties on Monday, AMD, Airbnb, Caterpillar, Marathon, PayPal, and Uber on Tuesday, CVS, eBay, and Yum Brands on Wednesday, Alibaba, Warner Bros. Discovery, and Block on Thursday, and Goodyear and Western Digital on Friday. The economic calendar includes manufacturing data with the PMI and ISM manufacturing surveys on Monday and factory orders on Wednesday. Construction spending will come on Monday and trade data will come Thursday morning. There are several labor market data reports including the job openings and labor turnover survey on Tuesday, the ADP employment report Wednesday, jobless claims on Thursday, and the employment report on Friday. Consensus estimates see a 250,000 increase in jobs for July with wages decelerating slightly to a 5.0% annual rate. After the FOMC meeting last week, the blackout period ends for Fed officials and we will see several public speeches this week as well. Finally, OPEC will conduct its monthly meeting this week where it will announce its decision on production. There is growing speculation the group will keep output levels unchanged in the upcoming month.