BY GUY CARSON
US advance GDP for the March quarter came out last week and the number was weaker than expected at -1.4% annualised (-0.4% in quarterly terms). Whilst it is not a huge negative number, it does place us one quarter away from a technical recession (noting that a technical recession is two consecutive quarters of negative GDP). Also, notably it is the first quarter since the early days of the pandemic that we have seen negative growth.
The question then becomes, is this a mid-cycle slowdown or is there something more severe? To begin looking at that we need to examine the breakdown of the GDP number. The two things that stand out are that consumers are robust with spending growing despite soaring inflation, and that businesses are cautious with fixed investment falling.
What is driving this dichotomy between consumers and businesses? We suggest there are two main causes:
• Rising interest rates; and
• The share market.
Interest rates have just begun to rise, increased interest payments to consumers are coming, but at this stage they are yet to hit the household budget significantly. Wage growth also remains strong as unemployment remains at very low levels, and as result households continue to spend. On the flip side, businesses can see the interest rates rising via the bond markets, their debt costs going up and when looking at long term investment that becomes a hindrance.
The second part holding back business investment is the share market. Share prices, particularly in the unprofitable tech space, have collapsed. This is something we wrote about in our 2022 outlook (see The Death of Growth Investing as an Outlook for 2022). High growth investors which focused on untraditional metrics such as Price to Sales ratios as opposed to the more common Price to Earnings and Price to Book ratios. The Ark Innovation ETF that we spoke about in our outlook is now down over 70% from its peak.
Companies are no longer being rewarded purely for growing the top line. Instead, the focus for investors has switched back as it always eventually does to Free Cash Flow. The below is an extract from an internal email from the CEO of Uber to all staff that sums up the current environment:
“In terms of uncertainty, investors look for safety. They recognise that we are the scaled leader in our categories, but they don’t know how much that’s worth. Channelling Jerry Maguire, we need to show them the money. We have made a ton of progress in terms of profitability, setting a target for $5 billion in Adjusted EBITDA in 2024, but the goalposts have changed. Now it’s about free cash flow. We can (and should) get there fast. There will be companies that put their heads in the sand and are slow to pivot. The tough truth is that many of them will not survive.”
What this tells us is that tech companies are now in cost cutting mode. Again, this is particularly true for the unprofitable side which are reliant on capital markets for funding. This means lower corporate investment, less hiring (and potentially more firing) and in general, reduced spend. And given the collapse in share prices, it appears that capital markets will be closed to them for some time. No access to capital equals no investment.
Ultimately, this all comes back to rising interest rates. Interest rates have been falling since the 1980s. Since the 1990s, the economy and the financial world has been driven by asset speculation. There was meaningful investment in the 1990s as the modern-day internet was essentially built. However, the speculation around the tech boom came. The Federal Reserve hiked rates and we had the “dot-com” bust. The Fed was forced into an easing cycle which ultimately led to the housing boom.
This current cycle has continued on longer than many would have thought, ironically in part to the COVID pandemic. The fiscal and monetary stimulus has pushed unemployment down to historically low levels and the share market to record highs. The withdrawal of that stimulus is well overdue as inflation has risen significantly (although part of this is supply driven, as we wrote about in ‘Inflation Transitory or Here to Stay?’. In recent cycles, interest rate hikes have led to slowdowns and recessions. Each time the peak in interest rates is below the previous peak. This is due to households and businesses having taken on more debt over the easing cycle. If we follow that trend, the Fed would not have to raise very far this time around. Small rises will have a bigger impact.
So, are we in a recession right now? It is hard to say yes, with the consumer still showing little signs of weakness. However, there are some similarities with 2001 building. If tech firms are slowing their hiring and focusing on cashflow, if will flow through to the employment market. In economic terms, 2001 was a mild recession but the impact on the technology sector within the share market was dramatic. We are seeing that share market impact playing out now. The remaining question is what happens to households as interest rate rises flow through at the same time the tech sector reduces employment. That is the key question that will determine the remainder of 2022.