Economic Update: Watch out for the next Recession
Let me preface this post by saying I can’t predict the future, just like everyone else. I’d don’t have a crystal ball or a heavily modified Delorian. But I have learned a thing or two about economics over the years both from schooling and from experience in the professional world. Also I’ve been investing since 2005 so I have a couple of economic cycles under my belt at this point.
Note that there is a good amount of economic jargon in this post which may be above a beginner’s level of economic understanding. Beside Google, a great place to look up confusing terms is at investopedia.com.
What we are heading into economically looks like a classic textbook example of a late economic cycle. Growth is slowing, employment is tight, inflation is high and the Fed is raising rates. If the Fed over tightens as they attempt to wrangle in inflation, this could cause a slow down in economic activity to the point of causing a recession.
I think it is highly likely that the Fed won’t be able to produce a soft landing as they raise rates and taper the Fed’s balance sheet. But there is chance that they could extend the cycle a bit longer if the Fed becomes more dovish as they raise rates this year. In 2019, the Fed dropped the Fed funds rate by 75bps as the economy was fraying on the edges. Even if Covid never hit in 2020, it’s quite possible that the US economy was already heading for a recession by late 2020 to early 2021.
The yield curve briefly inverted in March looking at the 2 to 10 year spread. It also inverted at other spreads this year, too. Some people argue what you should really be watching is the 3 month to 10 year spread inverts. Although the 3 month to 10 year portion yield curve has not inverted, based on what the Fed wants to do with the Fed funds rate and considering the 3 month and the Fed funds rate are highly correlated, it’s only a matter of time before the 3 months swings much higher, putting the 3m - 10y spread at risk of inverting by next year, possibly earlier. Even if the 3m - 10y spread inverting does a little better at getting the timing right (on average just 4 months before a recession if it correctly predicts one), the 2 to 10 year spread works well as a prophetic warning sign.
The 2 to 10 year curve inverting does not have perfect predictive power, but over the past 6 recessions, it has predicted 5 of them within 24 months. 83% predictive power is not too shabby. And the only time it didn’t work was when the curve inverted in 1998 and it took 33 months before the Dot Com recession hit in 2001. The Fed lowered rates which arguably delayed the inevitable recession. The curve reverted to being positive before then inverting again in 2000. And that inversion did follow the “recession within 24 month” rule.
What we still need to happen to get the rest of the picture perfect textbook example would be inventories start to rise, unemployment starts flattening then ticking up and credit standards start tightening. It would be harder to get loans on top of rates going up as banks are more concerned about defaulting loans in an economic downturn. Credit spreads would also rise as bond investors would be more wary of higher risk bonds due to increased default risk.
Because of inflation, consumers are already concerned as you can see in low consumer sentiment. Looking back it makes sense that inflation is high given the massive amount of stimulus used to get the economy out of the Covid recession (which only lasted 2 months officially). If there wasn’t record amounts of stimulus, the recession likely could have been a lot worse or longer lasting. However, even “free” money isn’t free. Now we have to pay for it in the form of inflation. The M2 money supply increased by over 40% in 2 years since the US locked down in March of 2020. Which means if everyone spent all of the extra money that had been created, then we could have seen close to 20% annualized inflation over the past 2 years. Suddenly current 8.5% inflation doesn’t sound so bad. But the reason why it’s not higher inflation given all of the stimulus is because people don’t go out and immediately spend their new stimmy checks (this is where the Austrian school of economics gets it wrong). Some people save it to pad their savings accounts (personal saving rates and bank balances were up big time after Covid hit). Some invest it in assets (like in meme stocks or crypto or real estate). So despite there being 40% more money supply, it’s not all flowing through the economy so the velocity of money as decreased.
But 8.5% still is bad. Over 60% of Americans live paycheck to paycheck now so if the average cost of stuff is increasing then either you have to cut back on spending or go into debt to continue buying the same amount of goods. So that’s going to have a negative effect on the economy sooner or later. Inflation is essentially at tax, but it hurts lower income earners harder. Generally people in the bottom 3 income quintiles are already reeling from the increased prices. People in the top 2 quintiles may be bummed by the higher prices, but it’s probably not hurting them as much (unless you make good money but still live paycheck to paycheck). But because the employment picture looks positive at the moment and wage growth is up, people are still spending. But eventually all the people getting employed after the massive loss of total jobs from Covid will have entered back into the workplace That growth tailwind will start to die down, although average wage growth is strong. Because of strong wage growth, I think in nominal terms, growth will continue be decent even if it slowing. But if growth slows down while inflation doesn’t as much, we could see negative growth in real (inflation adjusted) terms. For instance if nominal GDP growth is 4.5% but inflation is 5%, then real GDP growth is -0.5%. This is I think where the real risk lies - above average inflation persists and we enter into a stagflationary recession. All it could take is one more straw to break the camel’s back.
I don’t know when this recession will happen but if history serves us well, there’s arguably a ~83% chance of recession within the next 24 months. IF I had to make a bet, I would say there’s a ~70% chance a recession starts by the end of 2023. But it could happen sooner. If we don’t see another major Covid variant in the US, the reopened economy would just throw coals on the fire and keep inflation hot. Which means the Fed will be more hawkish and forced to raise rates to combat inflation. While inflation for goods may decrease as supply shortages correct and inventories start to build up, inflation for services probably will increase as people get out more to experience life. So the decrease in inflation for goods may be largely offset by an increase in inflation for services.
We have started a game of musical chairs. We can’t predict exactly when then game ends, but every investor should start thinking now about grabbing a seat before it’s too late. My advice would be to reassess your portfolio allocation to make sure you are not taking on more risk than you can psychology handle. If you are 100% invested in equites, can you handle a 30%+ drop in your portfolio? If the answer is no, then pull back on risk. And you may want to shore up other financial consideration like your emergency fund and employment plans as best you can as you prepare for the next recession.
I’ve started to put my money were my mouth is and increased cash from ~6% at the end of February to ~19% as of Mid-April. And cash in not a cheap asset class to right now considering over the past 12 months you’ve lost 8.5% to inflation.
I’m not predicting impending doom and gloom and it would be nice if I had a better sense on the timing. Because with a recession, you can expect a bear market. But you can’t time the market, although that would be really convenient if you could. Hopefully as time goes on I will be able to get a better sense of when cracks in the economic foundation start getting worse. But you only get 20/20 vision looking back on the past.