Recession Semantics

by Joseph V. Amato, President and Chief Investment Officer—Equities, Neuberger Berman

Whether the U.S. is actually in a recession is debatable, but high inflation will affect companies both positively and negatively.

The release of second-quarter Gross Domestic Product numbers late last month set off a debate around the state of the U.S. economy and whether it is currently in recession. After all, the -0.9% year-over-year print followed a 1.6% decline in the first quarter, and the informal definition of a recession has generally been two successive quarters of negative GDP growth. However, the official recession “call” is actually made by an eight-member panel within the U.S. National Bureau of Economic Research (NBER), and it’s worth taking a look at what they consider.

What’s a Recession?

Broadly speaking, NBER’s Business Cycle Dating Committee defines a recession as a “significant decline in economic activity that is spread across the economy and lasts more than a few months.” The group considers three criteria: depth, diffusion and duration. Each must be present to some degree, but extreme conditions in one may partially offset weaker indications from another. For example, while the 2020 downturn was brief (two months), it was also so severe and widespread that it merited the recession label.

The Committee pinpoints the timing of the economic peak and trough that frame a recessionary period based on a range of measures, including real personal income, employment, retail sales and industrial production. There is no fixed rule as to what measures are used and how they are weighted, but in recent years, the panel has tended to emphasize real personal income and nonfarm payrolls.

Are We There Yet?

Based on some of these measures, the recent picture has been mixed, as nominal income gains have risen sharply (+5.7% year-over-year in June), but trailed the inflation rate (+9.1% year-over-year in June based on the Consumer Price Index). That said, employment statistics remain quite strong. This past Friday’s July payroll employment report was surprisingly robust, with the unemployment rate declining from 3.6% to 3.5% and the creation of 528,000 jobs (much higher than the 250,000 consensus estimate). This is fairly consistent with the average of the last six months.

It’s worth noting that, since 1948, two successive negative GDP prints have always been associated with a recession, according to the Bureau of Economic Analysis. However, to us, the question of whether we are in a recession is somewhat semantic—by most measures, the economy is clearly getting weaker, particularly when inflation is taken into account. Friday’s employment report demonstrates how confusing the economic picture is. Generating more than 500,000 jobs is hardly consistent with being in recession.

A big part of explaining the inconsistency between weak first-half GDP and a very strong jobs number is that the economy is still normalizing post COVID-19. Oversimplifying a bit, first-half GDP weakness was mostly about goods and Friday's job strength was mostly about services. (During lockdowns, consumers shifted heavily to goods away from services and are slowly shifting back.)

Nominal vs. Real

In this context, investors may find that the distinction between nominal and real levels of GDP to be particularly relevant. When inflation is, for example, 1.5% and real growth is 2%, leaving nominal GDP at 3.5%, there’s not much practical difference among these various measures when it comes to impacts on a company’s earnings and cash flow. It is important to appreciate, however, that companies report those earnings on a nominal basis. So, when inflation is very high, as it is today, it can help companies maintain revenue and earnings growth potential, despite slower overall economic activity. Looking at consumer companies, for example, the Albertsons grocery chain grew same-store sales by 6.8% in the latest quarter, much of that likely tied to inflation, but it also saw earnings increase 12% year-over-year; Procter & Gamble reported 7% organic sales growth, driven by an 8% increase in pricing. Meanwhile, Home Depot and Lowe’s are expected to increase earnings for the year—even with elevated inflation and a softer economy. That said, multiple crosscurrents have resulted in disappointing earnings at other companies, including Colgate-Palmolive and Bed Bath & Beyond, to name a couple. Similar stories can be found across multiple sectors.

This huge difference between nominal and real growth is something markets haven’t seen in a long, long time. We believe investors should keep an eye on whether companies can maintain pricing power and control labor and other rising costs. If they can, it may well mitigate the typical impact of softer economic conditions. Those companies could get the benefit of operating leverage and continue to increase (or at least minimize the decline of) revenue and profits. This would likely support equity valuations while, from a credit perspective, cash flows would continue to cover fixed-cost interest payments. Such dynamics could be a real driver of how specific names and the broader equity and credit markets can perform in an economy that will likely continue to slow in the second half of the year.

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