Two quarters of negative GDP growth means the business cycle is headed for — or is in — the contraction phase, right? In our view, it is not that simple. While aggregate economic measures like GDP provide broad indications about the direction of the cycle, it is important to also consider the underlying drivers to get a clearer picture of the landscape. Additionally, we use a mosaic approach and put measures like GDP in context with other indicators we track. The bottom line right now, in our view, is we are still in a slowing expansion phase of the business cycle, and recent GDP readings are heavily skewed by transient pandemic-related factors.
COVID-19 Still a Factor in the Business Cycle
One key pressure on the latest GDP readings was the decline in corporate inventories. In our view, falling inventories were not driven by demand destruction — a key ingredient for economic contraction — but rather stem from pandemic-driven corporate decisions.
The arrival of the Omicron variant in late November led to significant inventory builds as firms braced for an onslaught of renewed goods demand from U.S. consumers. While the global case count reached a peak in January of nearly 3.5 million daily cases, the severity of cases never reached levels many feared would take shape, and case counts fell just as fast as they rose.
Figure 1. COVID-19 New Cases, Seven-day Rolling Average
The Omicron variant is still impacting economic activity
As of 8/10/2022. Source: Bloomberg, L.P.
View accessible version of this chart.
As a result, the same inventory preparations that supported economic growth in the fourth quarter became major headwinds in the first and second quarters. Earnings reports for both quarters this year have highlighted inventory issues remain, especially within the retail industry, leading to write-downs, price reductions and profit margin compression.
Figure 2. S&P 500® Retailer Profit Margin (%)
Profit margins falling sharply due to rising inventories
As of 6/30/2022. Source: Bloomberg, L.P.
View accessible version of this chart.
We believe the inventory glut can also be blamed for a decline in new orders, which under a “normal” scenario could be a warning about the health of the economy. Two other leading economic indicators we track — prices paid and customer inventories — are suggesting inventory issues may be on the cusp of resolving. In the most recent ISM Manufacturing report, the Prices Paid Index fell to its lowest level since 2020, and the Customer Inventories index reached its highest level since 2020. With prices falling and customer inventories potentially normalizing rapidly, inventories may finally begin to improve, which would benefit both GDP and the more forward-looking new orders indicator.
GDP at Odds with Leading Economic Indicators
LEIs turn negative 4.5 months before a recession on average
Where do we go from here?
The business cycle is slowing, but it is still growing despite what some reports may suggest. While multi-asset portfolios have struggled this year due to equity valuation compression and rising interest rates negatively impacting bond performance, periods like this have happened before and are not indicative of an economic contraction. For historical context, oftentimes when stocks and bonds both deliver negative returns, it is during periods when the Federal Reserve (Fed) is raising interest rates, which is precisely where we find ourselves today. Furthermore, based on our analysis going back to the 1970s, during quarters when both stocks and bonds perform poorly, returns over the next 12 months have been positive for both asset classes. While past performance is not a predictor of future performance, it should serve as a reminder to investors to take time horizon into consideration as we advocate those with long-term orientations remain invested during turbulent periods.
We continue to be mindful of the numerous macroeconomic headwinds; however, the concern that we are careening towards the contraction phase of the business cycle is not supported by our analysis. We remain confident long-term investors should maintain current asset allocations as the slowing expansion phase of the cycle continues.
Figure 4. S&P 500 and Bloomberg Aggregate Returns After Negative Stock/Bond Performance in Same Quarter
When both stocks and bonds perform poorly, it can lead to positive returns for both over the next 12 months.
As of 6/30/2022. Source: Bloomberg, L.P.
Recommended asset allocations for the slowing expansion phase of the cycle:
- Growth tilt: Growth stock valuations across the market capitalization spectrum have become attractive relative to their value counterparts. We believe the earnings outlook for value stocks in 2022 is being skewed by the Energy sector. Longer term, the current earnings imbalance is expected to shift back toward favoring growth companies.
- U.S. small- and mid-cap overweight: As global growth slows, small- and mid-cap (SMID-cap) companies have more exposure to the U.S. economy compared to their more multinational large-cap counterparts. Therefore, as global growth slows, we expect large cap to be more susceptible to that slowdown. Furthermore, SMID-cap valuations have seen meaningful compression and are now lower than large cap, with small-cap valuations even dipping below their 20-year average.
- Emerging markets overweight: We continue to see a stronger path forward for emerging markets relative to developed markets due to a stronger earnings outlook and stronger economic growth expectations. We believe China is in a unique position coming out of the pandemic and is just beginning its monetary policy easing cycle, whereas developed markets such as the U.S. and Europe are in tightening mode. Therefore, as global growth slows, we expect China to begin providing support on a lagged basis.
- Credit overweight: In addition to flexible strategies such as unconstrained fixed income that can be nimble in a high-volatility regime, we continue to have conviction in credit allocations such as high yield, leveraged loans and emerging market debt. We believe as extreme levels of fixed income volatility recedes, credit spreads should continue to decline as corporate balance sheets generally remain healthy despite the macroeconomic uncertainties still confronting investors.
Accessible Version of Charts
Figure 1: COVID-19 New Cases, Seven-day Rolling Average
The Omicron variant is still impacting economic activity
Date |
COVID-19 7-day rolling average new cases |
8/1/2020 |
256,642 |
8/15/2020 |
265,251 |
8/31/2020 |
263,897 |
8/1/2021 |
599,005 |
8/15/2021 |
650,427 |
8/31/2021 |
648,685 |
8/1/2022 |
1,006,416 |
As of 8/10/2022. Source: Bloomberg, L.P.
Figure 2: S&P 500 ® Retailer Profit Margin (%)
Profit margins falling sharply due to rising inventories
Date |
S&P 500 Retailer Profit Margin (%) |
6/30/2013 |
4.25 |
6/30/2014 |
4.97 |
6/30/2015 |
4.44 |
6/30/2016 |
5.19 |
6/30/2017 |
4.57 |
6/30/2018 |
5.77 |
6/30/2019 |
6.12 |
6/30/2020 |
5.53 |
6/30/2021 |
8.39 |
6/30/2022 |
5.85 |
As of 6/30/2022. Source: Bloomberg, L.P., PNC
LEIs turn negative 4.5 months before a recession on average
Date |
Conference Board LEI Rolling 6 month Y/Y Growth Rate (%) |
U.S. Recession? |
7/31/1962 |
10.1 |
|
7/31/1963 |
7.3 |
|
7/31/1964 |
8.1 |
|
7/31/1965 |
8.6 |
|
7/31/1966 |
7.4 |
|
7/31/1967 |
0.6 |
|
7/31/1968 |
6.8 |
|
7/31/1969 |
3.3 |
|
7/31/1970 |
-5.2 |
yes |
7/31/1971 |
4.4 |
|
7/31/1972 |
8 |
|
7/31/1973 |
7.7 |
|
7/31/1974 |
-6.8 |
yes |
7/31/1975 |
-9.7 |
|
7/31/1976 |
9.3 |
|
7/31/1977 |
7.6 |
|
7/31/1978 |
4.5 |
|
7/31/1979 |
0.4 |
|
7/31/1980 |
-9.5 |
yes |
7/31/1981 |
-1 |
yes |
7/31/1982 |
-5.6 |
yes |
7/31/1983 |
7.3 |
|
7/31/1984 |
11.4 |
|
7/31/1985 |
4.7 |
|
7/31/1986 |
4.3 |
|
7/31/1987 |
4 |
|
7/31/1988 |
3.8 |
|
7/31/1989 |
1.7 |
|
7/31/1990 |
-1.2 |
yes |
7/31/1991 |
-8.4 |
|
7/31/1992 |
5.1 |
|
7/31/1993 |
6.8 |
|
7/31/1994 |
7.6 |
|
7/31/1995 |
5.4 |
|
7/31/1996 |
1.5 |
|
7/31/1997 |
6.2 |
|
7/31/1998 |
5.4 |
|
7/31/1999 |
0.5 |
|
7/31/2000 |
4.2 |
|
7/31/2001 |
-7.8 |
yes |
7/31/2002 |
-1 |
|
7/31/2003 |
1.2 |
|
7/31/2004 |
10.9 |
|
7/31/2005 |
7.1 |
|
7/31/2006 |
2.3 |
|
7/31/2007 |
-1.6 |
|
7/31/2008 |
-8.7 |
yes |
7/31/2009 |
-17.5 |
|
7/31/2010 |
7.9 |
|
7/31/2011 |
5.9 |
|
7/31/2012 |
2.2 |
|
7/31/2013 |
1.7 |
|
7/31/2014 |
5.5 |
|
7/31/2015 |
4.3 |
|
7/31/2016 |
0.3 |
|
7/31/2017 |
3.2 |
|
7/31/2018 |
6.9 |
|
7/31/2019 |
2.5 |
|
7/31/2020 |
-6 |
|
7/31/2021 |
7.8 |
As of 6/30/2022. Source: Bloomberg, L.P.
Figure 4: S&P 500 and Bloomberg Aggregate Returns After Negative Stock/Bond Performance in Same Quarter
When both stocks and bonds perform poorly, it can lead to positive returns for both over the next 12 months
|
S&P 500 |
Bloomberg Agg |
Recession |
S&P NTM Return |
Agg NTM Return |
60/40 NTM Return |
3/31/1977 |
-8.40% |
-0.80% |
No |
-4.60% |
4.40% |
-1.00% |
12/30/1977 |
-1.50% |
-0.10% |
No |
6.60% |
1.40% |
4.50% |
12/29/1978 |
-6.30% |
-1.40% |
No |
18.60% |
1.90% |
11.90% |
12/31/1979 |
-1.30% |
-3.10% |
No |
32.50% |
2.70% |
20.60% |
3/31/1980 |
-5.40% |
-8.70% |
Yes |
40.10% |
13.10% |
29.30% |
6/30/1981 |
-3.50% |
-0.30% |
No |
-11.50% |
13.40% |
-1.60% |
9/30/1981 |
-11.50% |
-4.10% |
Yes |
9.90% |
35.20% |
20.00% |
6/29/1984 |
-3.80% |
-2.10% |
No |
31.00% |
29.90% |
30.60% |
3/30/1990 |
-3.80% |
-0.80% |
No |
14.30% |
12.90% |
13.80% |
3/31/1992 |
-3.20% |
-1.30% |
No |
15.20% |
13.30% |
14.50% |
3/31/1994 |
-4.40% |
-2.90% |
No |
15.60% |
5.00% |
11.30% |
6/30/1994 |
-0.30% |
-1.00% |
No |
26.10% |
12.60% |
20.70% |
3/31/2005 |
-2.60% |
-0.50% |
No |
11.70% |
2.30% |
7.90% |
6/30/2006 |
-1.90% |
-0.10% |
No |
20.60% |
6.10% |
14.80% |
6/30/2008 |
-3.20% |
-1.00% |
Yes |
-26.20% |
6.10% |
-13.30% |
9/30/2008 |
-8.90% |
-0.50% |
Yes |
-6.90% |
10.60% |
0.10% |
6/30/2015 |
-0.20% |
-1.70% |
No |
4.00% |
6.00% |
4.80% |
3/29/2018 |
-1.20% |
-1.50% |
No |
9.50% |
4.50% |
7.50% |
3/31/2022 |
-4.60% |
-5.90% |
?? |
?? |
?? |
?? |
6/30/2022 |
-16.10% |
-4.70% |
?? |
?? |
?? |
?? |
Average NTM Return |
11.50% |
10.1% |
10.90% |
|||
Average NTM Return (No Recession) |
13.50% |
8.3% |
11.40% |
|||
As of 6/30/2022. Source: Bloomberg, L.P.
