What makes this "recession" different?

The week has been a mixed one for the stock markets. Stocks reacted with wild glee to the inflation data, only to fall off later.

Yesterday, the Fed raised the policy rate by 0.5%, as expected. The main message was that rates will continue to be raised, but slowly. What matters is not the steepness of the hikes but how long rates stay up. This graph shows the Fed board members' current assumptions about the path of interest rates. Next year would be tight, but then the situation gets better as inflation recedes. It's good to know what the Fed expects going forward but it's worth remembering that the same bunch completely missed the inflation threat. They don't have a crystal ball either.

In this post, we talk about the cooling of inflation, the beginning of capitulation in hype stocks based on the ARK ETF and finally I’ll share a little point on why this recession or economic slowdown is different.

Inflation is now cooling rapidly 

Tuesday's inflation data in the US was encouraging. At monthly level, inflation remained at 0.1% instead of the expected 0.3%. Prices are even cooling in goods already. Core inflation, which the Fed is keeping a close eye on, continued to be driven up most by the shelter category. But as my regular readers know, the methodology for calculating shelter is inherently slow and therefore not up to date. Housing prices and rents are already falling in the US. This Bloomberg graph shows annual inflation without energy, food and shelter. On an annual basis, inflation is down to 5% and seems to be dropping like a stone.

Let's not get ahead of ourselves yet, even though investing requires us to anticipate things well into the future. Wages continue to elevate inflation. The Atlanta Fed's wage tracker was updated a short while ago. On an annual basis, wages in the US continue to rise at a stubborn pace of over 6%. By eating into their savings, people can consume scarce goods in excess of their income for a while, but eventually the growth of consumption will depend on the increase in nominal income. In this sense, rapid wage growth makes inflation a more nefarious villain. In addition to inflation data, investors should monitor wage developments with a magnifying glass.

I was delighted to discover that the same data analyst, Indeed, that helped the Bank of Ireland put together the agile wage tracker for Europe that I talked about in a recent post a is doing the same thing in the US. Based on the wages in job advertisements posted on the internet, the rise in wages for new jobs is already slowing gradually. If the same trend continues, wage growth will slow to its pre-pandemic level of just under 3% in the second half of next year.

Often, talk of rapid wage growth threatens a price-wage spiral, where wages feed inflation and inflation in turn fatten wage demands. Our economist Marianne highlighted a recent IMF study a while ago. The study revealed that, contrary to what is often thought, historical data doesn’t in fact suggest that such a cycle can easily emerge. Since the 1960s, researchers identified 79 episodes where inflation accelerated and wages rose, but only in a few cases did wages jump for more than two years. While each situation is new and different, this study gives some encouragement that wage inflation can also settle down quickly.



Capitulation among ARK investors

One of the symbols of the feverish and speculative pandemic-era bull market was Cathie Wood's ARK ETF. This fund was effectively a collection of the most dubious claptrap stocks, from Tesla to Zoom and numerous loss-making but, according to Wood, "disruptive" tech stocks. As you might expect, after massive returns, the ARK ETF has melted down as interest rates have risen. More expensive money is clearly not suitable for companies whose cash flows wait somewhere in the future. The ARK ETF has collapsed by 75% from its peaks.



What has been even more amazing (if anything can still amaze after all these years) is the fact that even this year investors shoveled almost a couple of billion dollars more money into the blazing bonfire of Wood's shareholder value. But now the tide has turned. According to Factset's data, some hundreds of millions have been withdrawn from ARK. If the flow continues, the ARK ETF will have to sell more of its large positions such as Tesla.

Be as it may, the investors' abandonment of ARK is something of a spiritual turning point in the market. After all, many smaller technology stocks have already bottomed over the summer and fall. If economic growth cools down and interest rates moderate in the coming years, this sector, which is now being spat on, shouldn’t be forgotten. 

What makes this "recession" different?

Investors expect the coming recession as a virtual fait accompli. It's starting to become the same kind of living room conversation staple as the fact that you should start investing as young as possible for compound interest. Of course, the energy crisis is a logical reason to expect the economy to cool down literally. Many gloomy economic forecasting models track purchasing managers' indices, which indeed reflect this cooling. After all, many of the key industrial purchasing managers' indices are below 50.

Peter Berezin of BCA Research had a good perspective on this. After all, the pandemic completely disrupted the economy and goods consumption went through the roof as people ordered laptops, graphics cards and televisions online. At the same time, services were closed. Now the weak industrial sentiment may well be due to the normalization of goods demand. This would explain the contradiction of the manufacturing indices grumbling while the services purchasing managers indices look very strong. What looks like a recession may well be a normalization.

 
An investor should not necessarily apply the same playbook to an economic cycle as different as the one we are in now. Talking about the whole economic cycle is deterministically misleading. After all, the economy has gone from one exceptional situation to another in recent years. First a pandemic-era total shutdowns, followed by shock stimulus, and now a mild war economy. The economic cycles of recent decades are of little use as a guide in such an environment.

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