Why “Technical Recession” is not as Misleading as it Sounds [2022 Economy Series Part I]
Sorry for the hiatus but we are back! I hope I can make it up to you, our readers and subscribers, through an exciting pipeline of articles in the coming months! A new format that this blog is going to use in many cases going forward are multi-part series: these will help break up these complex topics into digestible pieces easier to read.
We are going to relaunch with a multi-part series on the 2022 economy and what it means for tech: why the economic numbers so far are complicated (good, bad, and mixed), if we are in a recession and what it means, and how this will affect tech. A lot has happened since we last posted: Ukraine, inflation heating up, COVID easing, COVID lockdowns (China), negative US GDP numbers, rate hikes, etc. All this has resulted in high volatility for the market, with sharp declines but also some strong rallies. Multiples have declined, growth has slowed, and valuations for some tech giants (*ahem* Netflix) have dropped precipitously. There’s not only uncertainty in the economy, but even in what the data that is coming out practically means. Now, this is not an economics blog, but what is happening in the economy has disproportionately affected tech and sorting through the noise can critically help us understand tech’s path forward.
Introduction
“We’re not going to be in a recession” [1]; “Technical Recession” [2]; “It is unlikely that the decline in GDP … indicates a recession” [3]. We’ve heard variations of these refrains this week from the White House, Biden, economists, and the like as they attempt to assuage American economic concerns following a second straight quarter of declining GDP. On the other hand, other politicians and the media accuse the “technical recession” camp of downplaying serious economic pain and trying to “redefine” around bad news [4]. Though it is clear that some players on both sides are making politically motivated arguments, how can they disagree so much about seemingly plain economic facts?
The truth is, economic news is complex, especially when dealing with something as gargantuan as the US economy. First, there is a plethora of reports that come in with varying frequency measuring different parts of the economy from various angles: GDP, production, commodity prices, trade balances, prices, wages, etc. [5] These can differ in their scope, time period measured, and methodology to make cross-report comparisons not as seemingly straightforward. Second, many of these measures, such as GDP data, are estimates that can continue to be revised for months and even years [6].
Most importantly, we cannot take the data simply at its face value. This data — spending, prices, employment, etc. — represents an aggregation of the economy into one set of numbers. We need to look beyond the topline at the underlying drivers to get a clearer picture. GDP for example, can be divided into consumption, investment, imports, exports, and government purchases (shown below) [7]. Any trend in GDP is simply the weighted sum of the trend in these components, which themselves break down into simpler pieces. Looking at the last two quarters alone, we can see how the declines in GDP came from very different places.
With this philosophy in mind, let’s dive deeper into the Q2 GDP data and other economic metrics. Here is the good(ish), the bad, and the mixed on why the economic picture remains muddy and why “technical recession” may not be all that misleading. This article focuses on the good(ish) points in the economic data and the following article addresses the bad and mixed points.
The Good(ish)
1. Q1 GDP Decline was Driven by Imports
The first quarter of declining GDP was Q1 2022, where GDP fell 1.6%. While this was a decline, if we look at the GDP contribution table, we can see that consumption and investment all contributed positively to growth. It was a large increase in imports that drove the GDP decline.
Let’s take a look deeper into trade with the above chart [7]. Here, we break down trade into goods and services, looking at the absolute change, percentage change, and contribution. While the US’ net exports of services changed little in Q1, the country brought in significantly more goods imports (a record high goods trade deficit) [8]. This is consistent with the global economy opening up post-Omicron and the Ukraine war. Looking at the US Foreign Trade Report [9], we can see that the greatest change in imports in Q1 came from gasoline-related products, electronics and components, and food/feeds. The US economy reopening, especially airlines and manufacturing, drove US demand for foreign energy and component resources. Furthermore, (ultimately correct) fears about an invasion of Ukraine by Russia caused firms to order more stockpiles of energy and food [10].
So was the Q1 GDP report “bad news” for the economy? Ultimately this depends on what you think the “economy” is. GDP is just that — gross domestic product; It is measure of production within the US. So just domestically, production was a bit less in Q1. That being said, not everyone thinks of just “production” when they hear “economy”. Another fair measure of economic health is “gross national expenditure”, which is spending in a country (so we don’t count exports or imports) [11]. If we look at spending instead of production, the economy continued to grow at ~1.6%.
2. Recession = f(Chg. GDP, NBER Magic, Employment, etc.)
The “common” definition of a recession may be two quarters of declining GDP, but that is not the official definition. The actual process, in the US, is more complex and holistic. The NBER (National Bureau of Economic Research) is the independent, nonprofit, nonpartisan, research organization that evaluates the economy and declares recessions. A group of economists evaluate a broad swath of data, including output, incomes, wages, employment, retail sales, and more to determine the health of the economy [12]. As will be covered later, many of the other metrics they consider are healthy, like wages, consumption, employment, etc. In fact, most economists do not expect the current economic data to constitute a recession [13].
Another way to look at this is that the decline in GDP is associated with a recession, but not necessarily causatively linked. In fact, the deterioration in the economic metrics the NBER looks at influence other factors in the economy and cause a recession, and some of this deterioration presents itself in the GDP data.
3. Consumption: Goods => Services
Consumption is one of the most important parts of the economy at ~70% of GDP. Comprising private purchases of goods and services, this segment remains one of the bright spots in economic data. As the GDP contribution chart shows, consumption has continued to grow inflation-adjusted in all quarters since the beginning of the pandemic. This means that consumers still have a propensity to spend despite negative economic news.
The GDP contribution chart also highlights a trend some might find concerning: since Q2 ’21, most quarters have seen GDP declines in consumption of goods and inclines in the consumption of services. Part of this is certainly due to goods inflation in 2021 and 2022 [14]. However, seeing this as the harbinger of economic disaster is a misinterpretation. In fact, the shuffling to services and away from goods is part of a broader trend back to the “status quo”.
Consumption is divided into three categories: services, durable goods (vehicles, electronics), and nondurable goods (food, clothing). The chart above [6] has the percent of consumption over the last 20 years that went to services and durable goods. Over the long term, services’ allocation has decreased, owing to more durable goods in Americans’ lives: cars [15], advanced electronics [16]. That being said, the right end of each graph shows the impact of COVID. Stockpiling in anticipation of shortages and dining at home due to lockdowns increased nondurable consumption relative to services like dining out.
As the economy has reopened, consumers have started to shift back to historic consumption patterns and services’ percentage has gone up. If we look deeper into the GDP report, this becomes clear, as some of the largest declines in goods consumption comes from food and some of the largest inclines in services consumption comes from eating out and medical care (seeing doctors after holding off in the pandemic).
4. Decreasing Government Purchases
The GDP contribution chart highlights that for the last three quarters, lower government spending has detracted a cumulative 1.3% from GDP growth. Does lower GDP from decreased government spending spell economic peril? In this case, I would say it does not. The below graph analyzes government purchases (ex-national defense) and the federal budget deficit over the last five years [6,17]. While budget deficits were on the rise pre-COVID, the pandemic caused a massive spate of government spending, most of which was financed through debt (the deficit). The decreases in government spending and the associated deficit reduction represent not a government pullback but, like with consumption above, a return to the status quo pre-pandemic. Furthermore, lower deficits are good news long-run as they serve to prevent US debt from ballooning to unsustainable levels.
This highlights again the need to look beyond just GDP to evaluate the economy. GDP represents the entire economic production and consumption of a country; it can be driven down by any of these factors while others can remain healthy and steady. The easiest way to boost GDP is to borrow and spend heavily, but this does not a healthy economy make.
5. A Resilient Labor Market
Despite inflation, mediocre earnings, reports of hiring freezes, and the “great resignation”, the labor market remains resilient and growing. The graph above looks at employment in the US private sector and how it has changed over the last five years [7]. COVID resulted in an employment drop of a jaw-dropping ~20 million people, an drop that took 26 months (until this June) to fully reverse. Given the individuals that have entered the labor force since then, there is still likely a supply of willing job seekers to grow this metric out. Concurrent with this, unemployment remains low at 3.6%, still above its pre-COVID level of 3.5%.
Looking a level deeper, healthy employment statistics are spread out across economic sectors. The table below analyzes the YTD changes in employment and wages across labor areas like manufacturing and retail [7]. All sectors added workers this year and all but one sector saw wages increase. It is this employment picture which especially complicates calls for the recession label. Domestic production did drop, but individuals have continued to get hired and wages have continued to increase.
6. Core Inflation is Moderating
Inflation has emerged as one of the biggest economic woes, points of political contention, and area of concern for Americans heading into the midterm elections. Since January 2021, inflation has taken off from a balmy 1.4% to the recent stratospheric print of 9.1%. This inflation has depressed real wages [19], eaten into savings (especially for lower income Americans) [20], and created business turmoil [21]. While stimulus payments and pandemic savings are partly to blame [22], Russia’s invasion of Ukraine has upended commodity markets and supply chains, significantly raising prices for energy and food [23].
While inflation will continue to affect key parts of the American economy, there is some potentially bright news in the inflation data this year. The graph below compares headline inflation (the full consumer basket) to “core” inflation (the basket less volatile food and energy). Core inflation reflects the non-commodity-staples pressures on the economy; this is preferred by many policy makers as better representing price trends and their effects on consumer behavior. Gas and food, as staples, are largely inelastic goods subject to different pricing pressures than the “core” economy. The graph shows the blue and orange lines separating, indicating that food and energy price increases have outpaced those of other goods and services. The bright point comes in March of 2022, where core inflation appears to have peaked. Oil and food prices have continued to drive overall inflation higher, but the underlying “controllable” economy of goods and services is starting to cool, though still has quite a bit more to fall.
This news of core inflation moderating is welcome because it provides evidence that the economy is beginning to return to “normal” inflation levels. There is, however, an argument to be made that the Federal Reserve is cooling demand through rate hikes but the US is not adequately addressing the root of the problem: sluggish supply chains. The Fed can only depress consumer activity so much without a serious economic downturn, so the full return to “normal” with inflation will have to wait on the restoration of global supply chains.
Conclusion
Clearly some of the hysteria about economic collapse is misplaced. Many of the signals we have seen in the economy are a return to the status quo, and still others signal a movement in the right direction. Conditions have certainly deteriorated versus a year ago, but there are signs of a potential turnaround. Critically, when we discuss the economy it is very important to understand that just what the “economy” means varies from player to player (production, spending, consumption, etc.) depending on what they view as “healthy”. This means we need to dig past the topline metrics and look at the underlying data to really understand what is going on.
Additionally, we have to differentiate between the economy and the stock market. The stock market reflects fully priced in information (probabilities, discounting, payoffs, cash flows) and its value should theoretically change as the expectations and information change. So, it is possible to be optimistic on the economy in a down stock market. This year, for example, the bear market does reflect recession probabilities, but a good portion of the downturn was due to expectations of slowing growth and lower corporate profitability from inflation and supply chain issues.
This article is a bit rose-tinged, I will admit. To balance the tables, next time will be a more somber update. In the next part in the “2022 Economy”, we will dive into why “Technical Recession” IS EXACTLY as misleading as it sounds: economic indicators that spell bad and mixed news. Following this, we will consolidate our analysis to examine if we are actually a recession and finally examine what this all means for the tech industry.
As always, thank you for your readership!
Sources
