As Recession Talk Gets Louder, It’s Time for Some Critical Thinking

Truly inspiring words from Apple’s founder, Steve Jobs. Another corporate icon and legendary investor, Warren Buffett, has brilliantly held tight and kept it simple over the seven years he has owned Apple stock – allowing ‘uninterrupted compounding’ to do the work. In the process, he created great wealth for his shareholders. I think Mr. Jobs would approve!

Jobs’ philosophy of working hard to find a simple solution is still relevant today as the discussion about a coming recession is ratcheting up once again. Stubbornly high inflation, elevated interest rates, and geopolitical tensions, among other forces, have many investors and economists believing that a U.S. recession is inevitable before the end of the year. But the biggest catalyst may have more to do with sentiment. When sentiment is down, consumers tend to go into bunker mode and they stop spending. This is causing many in our industry to say there is no doubt of a coming recession. In a recent interview, Brent Schutte, Chief Investment Officer at Northwestern Mutual, suggested that a recession is largely baked into the market, and that he “can't remember a more well telegraphed recession.” But even recession hawks like Schutte are predicting a shallow and short recession when it occurs.

There are plenty of headline topics for the stock market to be watching; the Fed, inflation, jobs, etc. But it requires some critical thinking to avoid reacting to the loudest voices of the day. Recently, the market rallied on the prospect that the Fed won’t raise rates in September. Why did the market seem to believe this? For one, the Job Openings and Labor Turnover Survey (JOLTS) that came out in August indicated that fewer job opportunities are available at a time when consumer confidence is already slowing. This tipped the sentiment balance towards a higher probability of recession, and increased likelihood that the Fed won’t raise rates this month.

Looking deeper, inflation came down in the first half of the year, then it was sticky, and now it’s going back up. This can be viewed as a good set up for both bonds. Why? Yields have remained high (above 4%) and investor money has flowed into fixed income assets with the shortest terms, largely due to an inverted yield curve. Though rare, such an occurrence reflects bond investors’ expectations for a decline in longer-term rates which is typically associated with recessions. However, with compelling yields, investors are being “paid to wait” until they can gain more clarity on the direction of the economy and equity markets.

The bull case for stocks is less clear. Until August, stocks rewarded investors as the market recovered. But is this recovery sustainable? The demand for credit is decreasing. The housing market has cooled off. If we have a GDP reading that is negative or close to zero in October, then negative sentiment could escalate.

Remarkably, it was only a few weeks ago that we were talking about a soft landing from the Fed. Fed Chair Jerome Powell said a soft landing has long been his base case, and his confidence in it had grown. However, the Fed has never pulled off a soft landing with inflation so far above its 2.0% target and a labor market this overheated.

History has shown that expansions don’t die of old age. A recession can result from either excess speculation or the Fed going too far and breaking some part of the economy. The breaking part causes the most severe pain. In 2020, it was the COVID-19 lockdowns and precautions taken early in the year that caused a Q2 recession.

Is this time different? The answer may come from history. Since 1945, there have been 12 expansions and 13 recessions, according to the National Bureau of Economic Research, the academic organization that dates business cycles. The four expansions since 1981 have ranged from six to nearly 11 years. Instead of inflation, they usually ended with some sort of financial crackup: the technology bust in 2001, or the bursting of the housing and mortgage bubble in 2007. Dislocations like these dealt severe blows to investors, with the S&P 500 shedding more than 40% in both instances. Conversely, stocks catapulted 185% from 1975-85 during a similar stagflation period as now.

To understand what may be coming requires some critical thinking. Investors must analyze the possible causes and impacts of a dislocation or recession. The recession examples cited above highlight why this is important—markets respond differently in recessionary periods depending on their cause and severity. At DBR, we focus our efforts on having a clear understanding of the following:

1. Factors that may be contributing to the recession: Global events, national policies (interest rates, fiscal policy), and industry-specific issues (housing market crashes, technology disruptions). And as we have seen most recently in the August JOLTS numbers, a sharp decline in consumer confidence and job openings.

2. The response of the government and central banks: The financial system survived the pandemic shutdown in early 2020. Together, the government and central banks implemented stimulus packages, interest rate cuts, and passed the green new deal. But the appetite for more debt is much less today - especially with a divided congress. Projections are now calling for a rate cut in 2024. However, there has been no official signal of this.

3. How global markets and international events are influencing the recession: In an interconnected world, economic issues in one country can quickly spread to others.
   Recently, we have seen the market’s response to the Chinese banking crisis caused by a failed property boom and we know Europe is already in recession.

4. Historical Context: What caused the 2008 recession? Excess in the form of a mortgage crisis as banks got greedy. Some would not survive. Inflation has typically been caused by excess demand. Where is the excess now? Too much government spending which has created a potential debt bomb. This is why we are experiencing stagflation.

5. Explore long-term trends: The four expansions since 1982 lasted an average of 8.6 years. Any recession now would halt the expansion started in April 2020 at four years. That is historically short. While the case can still be made for things being different than in the past, we shouldn’t ignore the data from previous recessions: The 1981-82 recession lasted 1 year and 4 months, the 1990-91 recession 8 months, the 2001 (9/11) recession 8 months, the Great Recession of 2007 – 2009 18 months, and the COVID recession of 2020 only 2 months.

Historically speaking, indicators would suggest a downturn ahead, with an economy dragged downward by high inflation and high interest rates. But robust retail spending and still plentiful jobs show the economy is remaining resilient. We still need to clear a number of hurdles, but thinking critically about all of the factors above could leave us well-positioned to navigate what is coming, whether it represents a long or a short recession, or even a soft landing. A shallow and short recession could make stocks attractive, while a deep, elongated recession could prove more challenging.

In order for there to be a long and/or deep recession, something would have to break. What is out there? Well, we are now seeing a possibility of new mandates and shutdowns related to another round of COVID. This would shatter consumer confidence. This was the case when we had a huge setback in 2020. But if there is a return to more conservative spending and regulatory policy, that could pull us out of the stagflation (slow growth, rising inflation) we are seeing. Responsible fiscal policy would also boost consumer confidence. As always, politics could play a role. The incumbent party doesn’t want a recession during election season.

Bottom line – nobody really knows what’s coming. Therefore, to avoid panicking about a potential recession, remember that we still have control of our finances even when the economy falters. Thinking critically about the factors above can help keep a ‘clean mind to make it simple.’ While calmly focusing on improving your financial situation to ride out the recession more successfully.

Thanks for reading.