While many market commentators remain focused on equity indexes, the underlying economic environment continues to decelerate on a rate of change basis. Before reviewing the latest macro trends, the charts below provide some historical context to equity index performance heading into economic slowdowns. The point of this analysis is not to highlight the drawdowns or make direct comparisons to the current setup, but to recognize the signal, or lack thereof, that equity indexes have historically provided. Intra-year there were several episodes of substantial rallies, followed by more steps down. The other important takeaway from these charts is the lag in the declaration of recession from the NBER. Thus, we believe it is prudent for an investor to monitor the rates of change in leading economic indicators in real-time instead of waiting for the NBER recession bell to chime.
The economic backdrop has been deteriorating across most key measures for several months now and we received more evidence of that this week. For the month of June, retail and food services sales decelerated to 1.5% y/y, and industrial production decelerated to -0.4% y/y. With only a few key data points remaining for 2Q23, the signal from these two macro indicators remains the same – demand slowdown.
To bring the historical picture back into view, the charts below highlight the rate of change slowdowns in those measures leading up to the 2001 and 2008 recessions.
As we move into 3Q23, we await the first estimate of 2Q23 GDP growth that will be released July 27th. For continuity of this analysis, we can compare the current q/q and y/y changes in real GDP growth to 2001 and 2008. Also, it is worth pointing out that 2001 was widely regarded as a mild recession and did not endure back-to-back negative q/q GDP prints (even if equity indexes did not move mildly to downside). Today, GDP has slowed sequentially on a q/q basis, but the y/y pace was better than expected in 1Q23. Given where industrial production, consumer spending, and other economic data has moved since then, we believe the probability of a rate of change deceleration has increased.
Turning to the near-term prospects of an acceleration in real economic activity, we can look at loan growth. If activity was going to pick up, we would expect to see accelerating loan growth. However, if banks are risk averse given the macro trends or their own balance sheet is impaired or expected to be impaired, they will likely lend less. Ultimately, credit growth is the primary driver of real economic growth, thus a contraction in credit extension from the banking sector likely leads to a contraction in real economic activity. Using data from the Federal Reserve, we can monitor commercial bank loan growth in the aggregate to control for variance among market leaders and laggards. When reviewing these charts, it is important to remember that a flatlining in dollar terms is a negative and outright declines are even more negative with respect to boosting real economic activity from here. Loans from commercial banks have slowed to 5.6% y/y, a 700-basis point deceleration from their peak in the final weeks of 2022. Commercial real estate loans have slowed to 7.6% y/y, a 422-basis point deceleration from their peak in the third week of February this year. Commercial & industrial loans have slowed to 1.9% y/y, a deceleration of more than 13% from their peak toward the end of 2022. Lastly, on the consumer side, credit cards and other revolving plans have slowed to 11.9% y/y (down from 18.5% in the first week of October 2022), and auto loans fell into negative territory at -2.0% y/y (down from 9.9% in the third week of February 2022). From a credit growth perspective, activity has decelerated right in line with the rest of the economic data we monitor. Importantly, the y/y growth in these charts mostly occurred in the second half of 2022, which was a much different funding environment than today. Since then, deposit rates and the overall costs of funding have increased, and loan growth has stalled out (we will provide more on this dynamic in future posts).
From now until the next GDP release, we will receive several bank earnings reports. This should provide more insight into lending activity, the consumer setup, and where we are likely heading in terms of the real economy. We will continue to provide updates on the aggregated loan data and earnings reports as a larger sample size becomes available.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Economic Analyst
Boyd Watterson Asset Management, LLC