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Would you believe that a positive development last quarter (supply chain improvement) led to a negative headline outcome (a 1.4% 1Q GDP contraction, the first since the pandemic plunge)?
This paradox may explain why markets treated the negative GDP report as good news, with equities rallying 2.5% that day. More stable core GDP components, such as investment and consumption, accelerated over the past two quarters. This bodes favorably for a growth rebound.
A negative GDP print outside a recession is not unprecedented; it was last seen in 2011 and 2014. Worries among investors about an economic slowdown caused two market-focused recession indicators – credit spreads and commodities – to worsen over the last month but overall recession risk remains low.
Yet spiking oil prices have raised recessionary fears reminiscent of the 1973 Arab oil embargo. While oil prices have spiked as much as 58% since the beginning of the year, the magnitude of the current energy shock pales in comparison to the 273% price increase at the onset of the 1973 recession.
Today may resemble 1973-1975 in some respects – higher fiscal spending, looser monetary policy, positive demographics – but our economy is starting from a much stronger foundation.
While the economic outlook bears little resemblance to the early pandemic, business activity and consumption likely will slow from elevated levels but remain positive. However, jobless claims recently hit a 53-year low and corporate earnings are growing at a healthy clip. With about 75% of the S&P 500 having reported, earnings beats have been robust and widespread, with guidance above average.
Despite this, perceptions of an economic slowdown and rising geopolitical risks led investors to demand greater compensation for investing in lower-quality bonds, and credit spreads widened. Commodities worsened due to Chinese lockdowns curbing demand for copper and steel. Rising oil prices, attributable to the war in Ukraine, have raised the specter of 1970s style stagflation.
History can lend perspective on the current situation. The oil embargo began in October 1973, after the Yom Kippur War between Israel and a coalition of Arab states led by Egypt and Syria, but the origins of the recession and period of high inflation dated back much further. Inflation accelerated in the mid-1960s when the Johnson administration pursued greater fiscal spending to finance the Vietnam War and expand social welfare programs, an ambitious initiative known as the Great Society.
To help finance higher deficits, the U.S. Federal Reserve maintained loose monetary policy. That made foreign investors question the U.S.’s ability to stick with the gold standard. A run on the dollar led the Nixon administration to move off it in 1971, followed by wage and price controls.
This must shock Americans who did not live through these periods. In the late 1970s and early 1980s, the Fed tried to choke off inflation by repeatedly raising the Fed funds rate. It hit 21% in 1981.
Fortunately, this period also saw positive demographic shifts as Baby Boomers entered the work force and drove demand – and prices – higher as they hit their peak earning and spending years.
Unlike in the 1970s, the duration of elevated fiscal spending to combat the black swan of a global pandemic has been far shorter. Government deficits have come down substantially, and they’re on track to return to pre-pandemic levels this year.
Fed support has been brief as well. More rate hikes are expected to normalize policy “expeditiously” but even the most fervent hawks don’t see the Fed funds rate rising much above 3.5%. Quantitative tightening should soon give the Fed another lever to slow inflation.
The demographic backdrop is also favorable, thanks to Millennials hitting their peak earnings and spending years. Retiring Baby Boomers are partially offsetting it, however.
Combine all that with rising incomes and efficiency gains and the U.S. economy is well-positioned to weather the storm from higher energy prices. History shows that not all oil price shocks are created equal. The economy’s starting point is crucial to determining whether a recession will follow – and this “energy crisis” is very different from what our fathers faced.
Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.
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