By William Sterling, Ph.D. Global Strategist, GW&K Investment Management
The Outright Ugly
Let’s get the worst out of the way. Without question, inflation data in June was terrible. In fact, June was significantly worse than expected, with headline Consumer Price Index (CPI) and Producer Price Index (PPI) inflation running at 9.1% and 11.3% versus a year earlier, versus expectations of 8.8% and 10.7%, respectively
Headline CPI and PPI Inflation Continued to Shock in June Amid Evidence of Broad-Based Price Increases
Source: GW&K Investment Management, BLS, and Macrobond.
Core CPI was also worse than expected at 0.7% m/m versus 0.5% expected and 0.6% previous. The only hint of moderation was in core PPI, which gained 0.4% m/m versus 0.5% expected and (downward revised) 0.4% previous.
The Bad
Consensus forecasts for the world economy in 2022 have changed dramatically. Despite upbeat June jobs and retail sales reports, economists slashed 2Q GDP estimates in recent days, with Bloomberg’s consensus median for 2Q moving from 3.0% on July 14 to only 0.9% currently.
Bloomberg Survey of Economists Now Projects “Stall Speed” 2Q Growth of Only 0.9%
Source: GW&K Investment Management and Macrobond.
Over the same period, projected 2022 4Q y/y growth estimate went down from 1.4% to 0.8%. These numbers indicate a “stall speed” growth, which suggests that economists see coin-flip odds of a recession ahead (per Bloomberg survey). Bloomberg’s results are also echoed in data from the Federal Reserve Bank of Atlanta.
The Atlanta Fed’s tracker puts Q2 GDP growth at -1.5% following a -1.6% contraction in Q1. That would meet the unofficial definition of a recession as two consecutive negative GDP quarters. But it would not meet the “official” NBER definition, which defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale and retail sales.”
The fallout from the war in Ukraine on energy prices, hawkish central banks, and prolonged lockdowns from China’s Zero-COVID policy have also been major drivers of the forecast revisions.
The Good
If there is a silver lining to be found, it is that after being large net debtors for several decades, American households overall have developed “fortress balance sheets” during the pandemic. Liquid assets (by our definition*) now exceed total debt for the first time in three decades. While rate increases will likely continue to rise and slow the economy, the good news is that households may be net beneficiaries of rising short-term interest rates if they start earning serious interest income on their $17.9 trillion in liquid assets.
U.S. Household Liquid Assets Exceed Debt for the First Time in Three Decades
Note: Liquid assets are defined as the sum of currency and checkable deposits, money markets fund shares, time deposits, and short-term investments.
Source: GW&K Investment Management, Federal Reserve, and Macrobond.
Elevated Inflation is Boosting Retail Sales: Nominal vs Real Retail Sales
Source: GW&K Investment Management and Macrobond.
Further, while inflation has clearly eroded consumers’ spending power, American households are spending more even if they are enjoying it less. In June, retail sales jumped 1.0% m/m versus 0.9% expected and a (revised upward) -0.1% decline in May. This was a new record for retail sales in dollar terms, up 29% from February 2020. That said, deflated by the CPI component for goods, the real value of retail sales peaked in March 2021 at 15% above its February 2020 level.
Where Do We Go From Here?
Inflation remains top of mind for everyone, but perhaps even more so at the Federal Reserve. If the Fed increases rates by 175 bps by November 2nd (as is widely expected), the 3m-10y and 3m-2y yield curves will invert by about 25 bps and 45 bps respectively. Unless the Fed pauses soon, recession odds will rise substantially. The cautious optimism on inflation that we saw back in April has dissipated and the call for tighter monetary policy and slower growth to curb inflationary pressures has left no room for complacency at the Federal Reserve.