The Nominal And The Real

By Erik L. Knutzen, CFA, CAIA

What might be the playbook for a potential recession in which nominal GDP grows by 8% – and are investors only just recognizing that they need one?

Recent weeks have seen market behavior apparently disconnect from economic data, with prices swinging in what can appear to be aimless, counterintuitive, or contradictory ways. Interest rate volatility has been high, and rotations between value and growth in equities have been sharp.

This could be nothing more than the usual July and August illiquidity. But might it be something deeper? Are investors beginning to recognize that they might be heading into an environment with no clear historical analog?

Puzzles

Let’s take just two puzzles from either side of the Atlantic.

Last week, European natural gas futures climbed sharply again, regaining the highs reached in the immediate aftermath of Russia’s invasion of Ukraine. Markets responded by pushing 10-year German government bond yields up – an understandable response if we focus on the inflationary effect. But high gas prices are also the major recessionary threat in Europe – and we simultaneously saw that threat reflected in wider Italian bond and high-yield credit spreads.

In the U.S. the week before, lower-than-expected prints for July consumer and producer price inflation led to a rise in long-dated Treasury yields. How might we make sense of that? Perhaps easing inflation makes the Federal Reserve less likely to induce a recession by hiking rates. But if that’s the thesis, why did equities appear to sell off in response to the decline in producer price inflation, alongside Treasuries?

On one level, investors may be trying to work out when worries about growth should displace worries about inflation as the main determinant of market behavior. But behind this, we see a more profound and structural uncertainty.

Disconnect

Consider this: according to headline real GDP data, the U.S. has slipped dramatically toward a recession in the first half of 2022; but at the same time, nominal GDP growth has soared to almost 8%. What might be the investor playbook for a potential recession in which nominal GDP grows by 8%?

As Joe Amato observed a couple of weeks ago, due to the generally moderate and stable inflation of the past 40 years, we haven’t experienced such a disconnect between real and nominal GDP growth since the 1970s. And the 1970s aren’t a useful guide, either, given how much the economy has changed since then.

This disconnect has potential implications for both equities and bonds, especially heading into a slowdown.

Over the past few decades, a recession was generally accompanied by a decline in earnings and a sell-off in equity markets, because a non-inflationary recession meant lower nominal as well as lower real GDP growth.

Should this new regime persist, however, higher nominal GDP growth could support corporate earnings and credit fundamentals even as we experience a real GDP recession? Note that, so far, the companies in the S&P 500 Index are on course to report year-over-year earnings growth of almost 7% in the second quarter of this year, according to FactSet, even as the U.S. has posted its second consecutive quarter of negative real GDP growth.

In addition, if the new regime persists, it will likely be because inflation remains relatively high even as real economic activity substantially slows. That, in turn, suggests interest rates may have to stay high even in the face of a real GDP recession.

High inflation, high rates, high nominal GDP growth: we believe the playbook for that favors stocks displaying quality, dividend yield and value over growth, credit over government bonds, and real assets such as commodities – quality aside, that’s very different from how we’ve learned to invest through the recessions of the past 40 years!

Anchored

Recent market moves suggest that investors are not yet ready to adopt that stance with confidence.

They may be dismissing the idea of structurally higher inflation, waiting instead for a modest series of rate hikes to bring nominal back in line with real GDP growth, taking us back to the conditions that prevailed since the Great Financial Crisis. Or they may simply be too anchored in the playbooks of the past 40 years to recognize that the next recession and recovery might require a different approach.

As we’ve been saying for some time now, we think we are going through four major inflationary inflections around globalization, energy, fiscal and monetary policy, and China’s place in the global economy. For that reason, we are increasingly persuaded that we have entered a period of persistently higher inflation, higher rates, and divergent real and nominal GDP growth – with everything that implies about asset allocation.

That said, we still favor broad portfolio diversification. Market participants are just developing their understanding of these new conditions: we anticipate continued heightened volatility as they lurch between the playbooks they grew up with and the still-emerging playbooks for this highly unusual slowdown.

In Case You Missed It

• Japan 2Q2022 GDP (Preliminary): +2.2% annualized rate
• NAHB Housing Market Index: -6 to 49 in August
• U.S. Housing Starts: -9.6% to SAAR of 1.45 million units in July
• U.S. Building Permits: -1.3% to SAAR of 1.67 million units in July
• U.S. Retail Sales: no month-over-month change in the level in July
• Eurozone 2Q2022 GDP (Second Preliminary): +0.6% quarter-over-quarter
• Eurozone Consumer Price Index: +8.9% year-over-year in July
• U.S. Existing Home Sales: -5.9% to SAAR of 4.81 million units in July
• Japan Consumer Price Index: +2.6% year-over-year in July

What to Watch For

• Monday, August 22:
  • Japan Purchasing Managers’ Index
• Tuesday, August 23:
  • Eurozone Purchasing Managers’ Index
  • U.S. Purchasing Managers’ Index
  • U.S. New Home Sales
• Wednesday, August 24:
  • U.S. Durable Goods Orders
• Thursday, August 25:
  • U.S. 2Q2022 GDP (Second Preliminary)
• Friday, August 26:
  • U.S. Personal Income & Outlays

– Investment Strategy Group

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