Does Q2 GDP Cancel the Recession?

US Q2 GDP accelerated in Thursday’s report, smashing expectations and triggering a rush to revise outlooks among onlookers. Many now say a “soft landing” of slower growth that avoids recession is likely. Others say no “landing” is coming at all. Some also suggest a rapid rush will spur more hikes, causing recession anyway. In our view, all this chatter misses the mark. Q2 GDP shows America wasn’t in recession last quarter, barring a big revision. And it speaks to the better-than-feared economy stocks have long been pre-pricing. But the forward implications beyond that are very limited. Let us explain.

Exhibit 1 shows Q2 GDP (dark blue line) sprang higher at a 2.4% annualized rate, much faster than consensus estimates for 1.5%.^[i] While consumer spending (dark green columns) continued to chug along, as we wrote yesterday, business investment’s (medium green) 7.7% annualized surge stood out. Then, too, GDP components that detracted substantially in recent quarters mostly aren’t anymore. After residential investment (light green) subtracted significantly in Q2 through Q4 last year, it did so only marginally in Q1—and again in Q2. Meanwhile, inventory changes’ (yellow) big Q1 detraction—which many also took as a recessionary sign—turned into a small contribution in Q2. With consumer spending and business investment up solidly—plus housing headwinds and inventories’ drag fading—it is tough to argue America was in or even all that close to recession in Q2. Hence, pessimists’ rush to update their views.

Exhibit 1: GDP and Its Contributing Components

Source: FactSet, as of 7/27/2023. Real GDP and components, Q1 2022 – Q2 2023.

However, in the wake of the report, we have seen many draw loads of forward-looking conclusions. Sorry, but whatever those conclusions may be, these backward-looking data don’t support them. They don’t mean a soft landing is certain. Q2 growth also says nothing about more optimistic takes some are assuming—that there won’t be any landing, e.g., because the Biden administration’s Inflation Reduction Act funds a big green-energy infrastructure buildout that will fuel a long-lasting investment boom. Yes, government spending flipped from early-2022 contractions to relatively large contributions since. And there is more money allocated to dole out—with incentives for more private investment. That makes a positive contribution to growth here possible but not assured.

Thing is, these investments are scheduled to trickle out slowly. And extensive permitting processes and legal reviews have a tendency to stall projects in their tracks, blunting or further drawing out their impact. That even applies to things like solar or wind power installations, which have increasingly encountered tough opposition from localities and residents despite ostensible federal government backing.^[ii] As always, investors will need to gauge how reality evolves against the growth expectations markets have priced in already.

This isn’t to say everyone is suddenly sunny. Many still expect recession, and to us, that is a good thing for markets. It suggests they still reflect one, muting the impacts if it came. Bloomberg’s July survey showed forecasters still see a 60% chance of recession in the next year. According to a National Association for Business Economics survey Monday, 71% of business economists think the likelihood of recession over the next 12 months is less than 50%, up from about an even split in April.^[iii] While attitudes have turned a bit brighter, look at how economists’ projections (per FactSet) have progressed between then and now. (Exhibit 2) In April through June, they were staring down two quarters of contraction—one definition of recession—or something close to it. Over the last month they have upgraded their Q3 view, but that still gives way to a Q4 dip. Today’s outlook still isn’t very cheery.

Exhibit 2: Current Economic Projections Aren’t Exactly Cheery

Source: FactSet, as of 7/28/2023. Economists’ median quarterly GDP growth estimate, annualized.

Coloring many economists’ views are two widely watched forward-looking economic indicators: The yield curve and The Conference Board’s Leading Economic Index (LEI). The former is a traditional forecasting tool and inversions have preceded most postwar US recessions. However, the tool isn’t perfect. And today, it has been inverted for nine months. This normally signals credit contraction because the spread reflects banks’ profit margins on new loans. But that hasn’t worked this cycle since banks’ deposit rates (their main funding cost) remain well below fed-funds—so lending also remains profitable overall. The economy isn’t being starved of credit despite the apparent signal from yield curve inversion.

As for the LEI, it includes the yield curve and a slew of manufacturing-tilted components like three gauges of factory orders, manufacturing employee hours worked and more. And goods-oriented industries have seen contraction for some time. But LEI downplays services, and that sector dominates America’s economy. It is a blind spot we believe is skewing observers’ views.

Recession fears were likely one reason of several why stocks endured a downturn last year. That means they likely pre-priced an economic downturn, at least as long as those fears are sufficiently broad. There is little sign of one now, but ongoing concerns should mitigate a recession’s market impact, assuming we get one any time soon. Hard as it may be, we think this is key for investors to grasp now.