After reporting slightly disappointing earnings on April 21, just over a month later, on May 23, SNAP, Inc. (owner of social media app SnapChat – ask your kids if you are not familiar) had this to say:
“Since we issued guidance on April 21, 2022, the macroeconomic environment has deteriorated further and faster than anticipated. As a result, we believe it is likely that we will report revenue and adjusted EBITDA below the low end of our Q2 2022 guidance range.”
The market reaction was severe as SNAP declined over 40% in one day, while sending the stock market careening at the same time.
When the world economy is rolling along smoothly, making reasonable accurate forecasts isn’t all that hard. Likewise, the economy has rolled over and is declining, making reasonable forecasts is relatively easy. What’s really hard is making forecasts at what appear to be inflection points. Is the new trend transitory, to overuse that word a little bit more, or is the new trend the real deal?
By all appearances, we are at such a moment, when a new trend may be emerging, but has not yet been sufficiently established to convince the world of its arrival. The violent reaction to the SNAP announcement is evidence of that. Is this an economic inflection point that ushers in a period of weak economic activity?
One school of thought is that we are just feeling our way around a bizarre set of circumstances, ushered in along with the pandemic, and economic growth is poised to continue. The economy will turn down at some point, but not now. The overall argument for this is based roughly on the following:
- Unemployment is very low and there are more jobs available than there are workers available. It’s very hard to have a recession when labor is so short.
- Consumer balance sheets are strong. Money in checking and savings accounts are near record levels. Consumer spending is more than 70% of GDP, so a strong consumer does not match up well with economic weakness.
- Although demand for goods is diminishing, demand for services is taking off post-pandemic. This is just an odd result of our response to the pandemic and declining goods demand is not a fundamental problem.
- Business investment remains very strong and indicators like the Purchasing Manger Surveys, while declining, are still well above the 50 level, which denotes continued, albeit slower, economic growth.
The conclusion is that economy remains strong and is able to withstand higher interest rates as the Fed works to reduce inflation and the risk of a recession is very low.
Are We Seeing an Inflection Point?
The other side of the argument is that we are at an inflation point. We are still growing, but growing at slower and slower rates and in coming months, that growth will reverse and become a contraction (recession). The argument is based roughly on the following:
- Housing, which is a powerful economic feeder, is rolling over under the weight of prices rising some 20% in the last year and compounded by mortgage rates exceeding 5% when they were under 3% not long ago. This is making it especially difficult for first time buyers, new home sales have now fallen for five months in a row, and inventory is back up to a more typical 9 months’ supply.
- The supply chain problems, caused by both an incredible demand spike as well as reduced production capability when the pandemic hit, has now caused a massive overreaction by retailers and suppliers. Both Target and Wal-Mart again reported very large inventory increases in the April quarter. Demand that must now contract to bring those inventories back into line.
- Consumer strength is a statistical anomaly. Although aggregate consumer data is good, the strength is concentrated in the top 10%, while the rest are not so lucky. The evidence here is in the rapid rise in credit card debt. If consumers were in such good shape, why would expensive credit card balances be spiking up?
- Unemployment is low, but some very large employers are now looking to cut back. For example, Amazon discussed reducing staff as well as warehouse space in its most recent comments.
The conclusion is that economy, while still growing, is weakening faster than we realize and is not able to withstand higher interest rates as the Fed works to reduce inflation. As a result, the risk of a recession is increasing.
We don’t know. We are certainly in the recession camp, but that doesn’t mean we’re right. What it means is that our portfolios are a bit more defensive than usual. Our portfolios are always diversified, but we aren’t making bets on one outcome or the other. We use our opinions to tactically lean portfolios to a more offensive or defensive position and the current position leans defensive.
What We’re Reading
‘Cash is still trash,’ says Bridgewater Associates’ Ray Dalio (4 min video)
50-50 chance of a recession in 2023, says Citi’s Scott Chronert (4 min video)
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TerraUSD Crash Led to Vanished Savings, Shattered Dreams
Commodities Will Be the Next Market to Succumb
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Are We in a Recession? Some Historically Reliable Indicators (3 min video)
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