Trading Desk: The Simplest Recession Signal

Wall Street is notorious for predicting more recessions than play out in the real world, so if  you spent most of last year waiting for the government’s economists to call a recession, you’re still in suspense.

If anything, while this morning’s shock job creation numbers were largely a mirage of “seasonal adjustments,” the trend on paper still points in the other direction . . . companies are hiring people as fast as they can. Layoffs in Silicon Valley just aren’t moving the unemployment rate at all.

Maybe that will change and maybe it won’t. Fed Chair Jay Powell basically shrugged a few days ago. As long as inflation gets back down to 2% a year, he’s happy to avoid the kind of mass layoffs that heralded both the 2008 crash and the 2020 COVID recession.

But investors need to know whether the economy is on strong enough footing to support corporate cash flow. Luckily, we don’t need Jay Powell or anyone in the government to tell us when a real contraction — and not just another Wall Street phantom — is underway.

You don’t even need an advanced math degree to know when interest rates and inflation have tipped the economy as a whole decisively into a contraction cycle. Just compare what companies are taking in to what they’re paying out.

When revenue grows slower than costs, profit goes down. Last quarter, for example, producer prices climbed 9.6% from where they were in 4Q21. Revenue for the S&P 500 in that quarter is tracking 4.3% above year-ago levels.

Is it any wonder that earnings are tracking down 5.3% to cover that operational gap? These companies are still bringing more money to the top line than ever . . . but inflation is just that much hotter, taking away ever dollar in new sales plus a whole lot more.

And with inflation finally weakening, it’s now a race to see whether costs drop enough to relieve the pressure before sales growth finally hits a wall. After all, we’re only expecting the S&P 500 to report 2% higher revenue in the current quarter than it did a year ago.

After that, these companies might finally be capturing every dollar they can. There’s no projected relief coming from the top line . . . which gives the Fed a clear ultimatum.

If they can’t get producer inflation back below 4-5% in the next six months, the recession we’re already seeing in corporate earnings will accelerate. When that happens, executives get anxious and do their best to both close the gap and conserve cash.

That’s when they really start cutting payrolls. The Fed has six months to engineer a soft landing from the inflation side. Otherwise, we get that unemployment spike that most investors still associate with a recession.

Nobody wants a world where millions of Americans from all lines of work lose their jobs and suddenly need to scramble to pay their bills. The Fed thinks that decisively killing inflation could take the unemployment rate back up to 4.6% . . . which means about 6.5 million jobs created in the post-pandemic economy would vanish.

Think back to October 2021. That’s where the Fed recently projected we’re going. Depending on where you were in the economy, the job market didn’t necessarily feel bad or good, but there were real winners and losers.

That’s true in the stock market as well. Stick to companies and sectors that have pricing power and cost control. Look for margins that are at best expanding or contracting less fast than the market as a whole.

You don’t have to pick perfection. You just have to be invested in areas of the economy that are “doing less bad” than the worst parts. Last quarter, that was energy, the airlines, Tesla (TSLA) and maybe, if you squint, real estate.

This quarter, even if inflation stays hot, it means the airlines, Tesla (TSLA) and, maybe surprisingly, the banks. They’ve finally cracked the code on how to make money when the Fed is raising interest rates.

Unfortunately, the banks are also running hot in terms of costs. But they’re in much better shape than the S&P 500 as a whole.

Do they have what it takes? It depends on how much you trust the Fed to take the heat off the cost side. We know sales growth is stalling across the market. We won’t get much help there beyond the industries I’ve already mentioned.

I’m thinking commodity costs have gone as far as they can on a year-over-year basis. Remember, the Ukraine war broke out roughly a year ago. Its inflationary impact is already built into the math now.

And without that artificial supply shock, costs may not go down but cost inflation should recede. All companies need to do at that point is stick to what they’re doing.

That means no mass layoffs and no deep recession. Is it possible? The Fed thinks so.