Investing in the US – is there opportunity across the pond?

Recessions, opportunities and what could be next

The US economy plunged into a shock recession in the second quarter of this year. On face value, this suggests the US economy is on its knees, and is underperforming other major economies, including Europe, the UK and many parts of Asia.

However, aside from the Gross Domestic Product (GDP) reports themselves, there are powerful indicators that suggest the US economy isn’t in as bad shape as the headline figures suggest.

Dissecting the GDP report

The technical definition of a recession is two quarters of negative growth. The US GDP reports for the first and second quarters of this year were -1.6% and -0.9%, respectively. This is a hefty slump for an economy the size of the US.

However, when you dig into the numbers, the weakness in the US economy is not as clear cut as you might think. The Bureau of Economic Analysis think the reason for the decline in the second quarter was down to a decrease in company investment spending, residential fixed investment and lower government spending. There were some bright spots – an increase in exports and a boost to consumption.

Looking a bit deeper, the decrease in company inventories was led by a decline in autos, however, this comes after strong sales in 2021, so a slowdown is to be expected.

Likewise, the decrease in non-defence government spending was due to the sale of crude oil from the strategic petroleum reserve, rather than budget department cuts.

This shows that some of the reasons for the decline in US GDP was down to technical factors. This has already had an impact on US headline inflation. It retreated to 8.5% in July from 9.1% in June, which is lower than inflation rates in the Eurozone and the UK.

What GDP doesn’t tell us about an economy’s strength

GDP gives a narrow view of the health of the US economy. For example, it doesn’t include a measure of employment. It also doesn’t look at the micro-data, like actual retail activity on the ground.

The US Non-Farm Payroll report for July saw jobs increase by 528,000. Since the start of 2022, the average monthly Non-Farm Payroll job creation was 470,000. The total number of jobs created in the US so far this year is 3.29 million. This certainly isn’t a sign of a down and out economy.

Although more timely economic indicators, including the preliminary S&P Global August PMI report, showed that US companies had scaled back their hiring efforts in August, this isn’t a cause for concern yet. The US unemployment rate was 3.5% in July. This shows there is room for a slowdown in employment growth and an increase in the unemployment rate, without wreaking havoc on the US economy.

This isn’t a repeat of 2008

The current ‘recession’ isn’t directly comparable to the financial crisis in 2008. For example, in the aftermath of the financial crisis, US unemployment peaked at 10% in 2010. During the current slowdown, there’s significantly less stress in the labour market, and there‘s room for employment growth to slow further as the Federal Reserve tries to tame inflation.

There are other notable differences this time, including the rate of bankruptcies in the US and the spread between higher-risk high yield bonds and Treasury bond yields. The bankruptcy rate in the US fell by 24% in 2021 compared with 2020. While this isn’t the timeliest indicator, it does suggest US individuals and businesses weren’t in financial stress coming into this recession.

US unemployment rate

Source: U.S. Bureau of Labor Statistics, 31/07/2022.

Recession risks and high yield bonds

In 2008, financial markets were at risk of collapse, which caused the credit crunch and led to a deep recession and soaring unemployment. This time, there’s less financial stress. A good way to measure this is by looking at the low number of bankruptcies and the ICE/ BoA High Yield Index Option Adjusted Spread.

Towards the end of August, this spread was at 4.78% and has been declining since reaching a high of 5.87% in June. In 2008, the high yield bond spread with Treasuries surged to nearly 20%. The high yield bond index includes US companies that are below investment grade quality. Recent data suggests that companies with the lowest credit quality in the US aren’t in distress, even though the US Federal Reserve (Fed) are hiking rates so aggressively. Again, this doesn’t support the case that the US is in a typical recession.

An atypical recession

So, if the US is not in a typical recession, what type of recession is it having?

This is a recession caused by a global inflationary shock, and the damage inflicted by a fast and aggressive pace of rate hikes from the Fed. Hence why this recession has mostly hit sectors of the economy that are sensitive to interest rates increases, notably the consumer and the housing market.

The data on the housing market is especially bad. For example, Housing Starts saw a 9.6% monthly fall in July, and are 8.1% below the July 2021 level. After a boom in housing demand during 2020 and 2021, demand is weakening at a fast pace. House prices could suffer steep falls in the coming months.

The Fannie Mae Home Purchase Sentiment Index can be a good indicator of how the housing market is faring. The index fell 2.0 points in July, to 62.8, its lowest level since 2011, and well below the historic high set in 2019. Only 17% of respondents said that now is a good time to buy a house in the US. Sentiment in the housing sector will likely remain weak for as long as the Fed continues to hike interest rates.

Fannie Mae Home Purchase Sentiment Index

Source: Fannie Mae, 31/07/2022.

Green shoots of recovery

For most of this year, consumer and business sentiment has been at historic lows, as inflation continues to bite personal and business finances. This is hardly surprising as rising gas prices along with higher interest rates is a toxic mix for consumption. However, as gas prices have been in retreat in the US, there’s been a notable pick up in sentiment.

The University of Michigan Consumer Sentiment Survey rose in August, and all components of the index moved higher. The year-ahead economic outlook also moved substantially higher and is now above its average reading during the second quarter.

This has been reflected in actual retail sales data. Sales data from Walmart were higher than estimated, with Walmart noting that traffic to stores had picked up in July and August.

The S&P Global preliminary PMI survey for August, also showed some green shoots of recovery. There was greater overall optimism for the 12 months ahead, even if sentiment remains weak. Overall sentiment is recovering at a faster pace in the US compared to elsewhere, because the country is largely self-sufficient when it comes to energy. That means it’s unlikely to experience black outs this winter, unlike Europe.

The price of most energy and commodities is also priced in US dollars. So the US economy isn’t exposed to rising energy prices when its currency is weak, unlike in the UK or Europe.

What’s next for the US?

In the current environment, the type of recession that you have matters, as does the future outlook. The US is experiencing a recession in the technical sense because inflation is rising, and interest rates are moving higher to combat this. However, headline inflation is likely to fall faster in the US, and this could have a positive impact on the US economy in the future.

The fact that consumers and businesses are more positive on the outlook for the US economy in 12-months’ time is also likely to help boost it towards the end of this year and into 2023. Even if there’s a double dip recession in the US, it will likely be milder than in Europe.