What is a Recession, and Are We Headed For One?
Issue LIX
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Today’s Bullets:
What is a Recession?
Yield Curves
GDP, GDI & Corporate Profits
False Confidence Signals
How to Position Yourself
Inspirational Tweet:
On one side, the White House says there will be no recession, and the Fed keeps talking about a ‘soft landing’, one that may even avoid a recession altogether.
On the other side, it seems we have everyone else.
Portfolio managers have been talking about a looming recession for months. Bloomberg agrees, as Liz Ann points out above, with 65% of economists surveyed seeing a recession in the next year. And Bloomberg’s own models give an even higher likelihood of a recession in the near future, as we will detail below.
But who’s right?
And what exactly is a recession, anyway? Seems that goalpost has moved too, recently…
But no worry, we’re going to cover all that and more, nice and easy as always, today. So, grab a big ‘ol mug of coffee, saddle up, and settle in.
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🧐 What is a Recession?
Let’s start with the basics, shall we? I mean, what is a recession, and before predicting any, how can we tell that we are, in fact, in one?
Well, using various economic definitions and descriptions, a recession is simply a period of economic decline lasting at least six months. Indicators of a recession include a decrease in GDP, rising unemployment, and reduced spending by consumers and businesses.
I know, I know, we had two consecutive quarters of contracting GDP last year. But conflicting data, like continued low unemployment, rising wages (even if they did not quite keep up with inflation—I mean, do they ever really?!?🙄), and increased spending all pointed to an economy that was not really contracting.
Yet.
But the Fed is looking to change that. By raising rates at a breakneck speed, jacking up the overnight rate by almost 5 full percent in the last twelve months, the Fed is looking to tighten financial liquidity (i.e., access to cheap money) and squash demand in order to lower inflation.
*boom*
So, even as Fed members speak out of both sides of their mouths, i.e., we need unemployment higher and prices lower, but we can still avoid a recession, they know in their dark little hearts that they must induce economic contraction in order to tackle the stickiest transitory inflation that they have ever experienced.
But why do they do this? Why do they use silly terms like ‘soft landing’—whatever that even means—when describing what they know damned well to be hurtful economic contraction.
Say it with me: recession.
Maybe a little history will helps us better understand.
See, back in the late 1970s, Cornell economist Alfred Kahn was appointed by President Jimmy Carter as chairman of the Council on Wage and Price Stability (CWPS). In short, Kahn was responsible for overseeing and managing the federal government's efforts to control inflation.
Kahn was therefore often referred to as the Inflation Czar.
However, Kahn was constantly in trouble with Carter and his cabinet lackeys for referring to the terrible economic conditions of the time as a “depression” or “recession.”
Known for his use of plain and simple English in the classroom, this annoyed Kahn to no end.
His response? He said, fine, I’ll use the word banana instead.
And so, quoted in the Washington Post, Kahn said, "Between 1973 and 1975 we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly."
Sounds like soft-landing really means banana.
If we can’t trust their words, what can we trust?
That’s right. Data.
Cold. Hard. Real.
The true indicators.
🤨 Yield Curves
Some of you have heard me talk about this quite a bit before, but one of the leading indicators of a coming recession is the inversion of the US Treasury yield curve.
It’s a leading indicator for two reasons: it is one of the earliest indicators we have, and it’s also one of the most reliable.
I’ve written all about yield curve inversions and simplified the concept thoroughly here:
For you TL;DR-ers': when longer dated Treasuries, like the 10-year, have lower yields than shorter maturities, like the 3-month or 2-year, this indicates an economy is headed for trouble.
There are a host of reasons for this that you can read all about in the article above. But suffice to say that the inversion of the 10yr-2yr and 10yr-3mo curves usually happens somewhere between 6 to 18 months before the actual onset of a recession.
Case and point, here’s the historical 10yr to 2yr spread with blue bars indicating periods of recession:
and the 10yr to 3mo spread.
Looks pretty reliable to me.
And few things I notice here.
First, the 10yr to 3mo spread (2nd chart) seems to be the most reliable indicator of the two.
Second, it looks like that curve inverted in late October/early November, and the 10yr to 2yr inverted even earlier, back in early July, which puts a recession on the table for anywhere from this spring to early 2024.
Third, the magnitude of both inversions hasn’t been this bad since the 1980’s (for those of you didn’t live through that one, it sucked. Period.)
And lastly, they appear to just be getting worse.
Lovely.
🤑 GDP, GDI & Corporate Profits
One pretty big red flag is that the Bureau of Economic Analysis’ (BEA) two main measures of economic activity diverged in the fourth quarter.
GDP and GDI.
Gross Domestic Product (GDP) is the total market value of all finished goods and services produced by an economy, and Gross Domestic Income (GDI) is the total income generated by an economy in a given period.
When these diverge, there’s a profitability issue. To simplify: cost to produce goods is rising, while income generated from that production is decreasing.
A Business 101 no-no.
Low and behold, GDP rose 2.6%, while GDI fell by 1.1% in the last quarter.
Digging deeper, let’s turn to corporate profits, as that’s an actual indication of a contraction of profitability.
In short, pre-tax corporate profits also fell 2% in the last quarter of 2022:
And, in an echo of the GDP/GDI indicator, the S&P 500’s net-income-to-sales ratio for the first quarter of 2023 also dropped steeply.
It’s therefore no surprise that 93% of CEOs are preparing for a recession in 2023, and over half believe that a recession is their greatest challenge for the year ahead, according to the Conference Board’s Measure of CEO Confidence.
OK, so it seems that companies and their executives are starting to see and feel the signs of contraction. What else?
While there are many many other places we can look, like housing, and intricate sales data, among other things, there are sometimes places we look that give us a false sense of confidence.
Let’s talk about that.
🤥 False Confidence Signals
One of the signals that I consistently hear investors key in on is employment. I mean, if people are not losing their jobs, then the economy must be ok, right?
All we hear from the Fed is: no unemployment = no recession.
Seems reasonable.
Until we look at the facts. The data.
Check out this chart, for instance, and look carefully at when unemployment rises versus when a recession starts:
Huh. Looking at rising unemployment as an indicator of a coming recession seems kind of like crossing the street and watching for cars as a bus quietly flattens you.
So, the next time you hear someone say, we’re at full employment, there must not be a recession coming anytime soon, show them this last chart.
Be sure to point out the 70’s, 80’s and that lovely dagger of 2008.
They kind of remind me of this chart, actually. Like flying a plane straight up into the atmosphere, just to watch it dive-bomb back to earth again.
Maybe that’s why Bloomberg’s own models say that there is a 100% chance of recession by the end of this year.
100%.
🤔 How to Position Yourself
If you’ve been listening to me and reading my work, then you know how I’m currently positioned for the year ahead. First, I’ve been buying metals and hard monies like gold, silver and Bitcoin, and continue to add to them opportunistically.
I also hold short term USTs and a high allocation to FDIC-insured money markets, in order to keep plenty of liquidity, dry powder, at the ready. So, I can pounce when the time is right.
Because I agree with Bloomberg’s models and I’m anticipating the inevitable:
Either we get some sort of credit event (like another run on regional banks, or worse) that causes a major market disruption and selloff, or we do in fact get the dreaded reality of a full-on recession.
Or should I call it…
a banana. 🍌
That’s it. I hope you feel a little bit smarter knowing about recessions and what to look for when predicting or anticipating one. If you enjoyed this newsletter and know someone who you think would enjoy it too, please share with them!
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✌️Talk soon,
James
I found the unemployment rate vs recession timing graph the most insightful. I never understood the relationship, and this cleared it up for me: unemployment is a lagging, not leading indicator.
Appreciate your insight .. pity i can't get down to Bedford next weekend .. enjoy your time in the UK and maybe you could help your UK followers navigate our financial climate .. are we similar to the US ? or do we have our own unique problems ? regards Philip