Paralysis of Analysis

Question:  

Why did financial markets go up after the Fed raised rates and Gross Domestic Production (GDP) reports show we are likely in a recession?

Answer:

The textbook definition of a recession is two consecutive quarters of negative GDP. So, are we in a recession or not? It’s easy to get caught up in the definitions and miss the trends and opportunities. Economic growth has slowed which is what the Fed wants. Weaker consumer demand typically helps to curtail inflation and rising prices.

The economy shrinks during a recession meaning that consumer confidence is lower and that is reflected in spending behavior. Several key indicators tell the tale of whether we’re in a recession or not. These include corporate earnings, consumer spending, jobs, and interest rates. It’s difficult to pinpoint the beginning of a recession or declare when it will end. It is time to add to your emergency fund or cash cushion to help navigate the uncertainty. We expect to see higher borrowing costs, lower levels of employment and weaker corporate earnings during this phase of the economic cycle.

One problem is that the Fed can’t control supply chains, energy costs, high food costs, or wage increases, which all contribute to inflation. The semantics of whether we’re in a recession or not can be summarized clearly by President Ronald Reagan with this quote; “A recession is when your neighbor loses his job. Depression is when you lose yours. And recovery is when Jimmy Carter loses his.” The message is that we are all impacted in a negative way by current economic conditions. Finding the road to recovery and solutions are what matters.

Fed Funds Rates and GDP are two metrics that provide indications of the strength or weakness of our economy. On July 27, 2022, as expected, the Federal Reserve raised its target interest rate (the cost of money) by 0.75 percentage points in hopes of slowing economic activity. This was the fourth-rate hike of 2022 bringing the target rate range to 2.25% -2.50%. Meanwhile, according to the most recent GDP report, the economy only declined 0.90% in the second quarter of 2022 which is supposedly better than the 1.6% decline during the first quarter of the year. 

Better Late Than Never

One reason that markets may have responded favorably to interest rate hikes and lower GDP numbers is that this shows the Fed’s commitment to curbing inflation lowered growth. The technical terminology of a recession is less important to most consumers than prices of food, gasoline, and housing. Weaker demand could inhibit further inflationary trends. The Fed and Central bankers around the world are aiming for moderation in growth, but not so severe that we tip into a harsh recession.

Delicate Dance

Higher rates and lower growth influence sales. This makes the evaluation of corporate strength and cash flow a focal point. With slowed growth and lower inflation as the goal, delayed hiring, downsizing and reduced capital expenditures are possible consequences. We watch consumer behavior as markets steer through uncertainty. For instance, when shoppers spend less on discretionary items, there is impact on companies that are less able to pass along higher costs and more sensitive to economic slowdowns. Households and corporations both are better positioned when they have capital reserves, or emergency funds on hand. Investors are encouraged by rate hikes designed to bring inflation under control while watching for clues and trends in employment and corporate earnings. 

Analysis paralysis is a real phenomenon. With so much emphasis on GDP data, Fed Funds rates and earnings, there are numerous potential outcomes and realities. It’s recommended to process and analyze information when developing long-term strategic plans but doing so while tempering judgements and impulsive moves. 

Peaks and Troughs

There are six stages to an economic cycle. The first stage is recession which is an extended period of negative economic growth; consumer spending declines, jobs are lost, and corporate profits are down. We move through the second stage which is the trough and move into the third phase of growth. The fourth stage is expansion with the return of consumer confidence. This leads to an economic peak which is followed by another recession. 

It’s easy to be consumed by conversations on what the Fed is doing or the latest noisy headlines. This is another reason why having a personalized financial plan to match your needs and risk appetite is useful. It’s challenging to align your unique situation with the economy as it responds to the effects of the pandemic, regulations, inflation, and the impact of the Russia/Ukraine War on the US and global economy. Stay focused and plan accordingly.