- A recession usually takes everyone by surprise.
- The current environment is ripe for a recession, we just need a trigger.
- The stock market will react as investors react, which is usually completely irrationally. Be prepared.
The latest FED meeting didn’t give us much news.
The monetary policy remains accommodative with the interest rate between 1% and 1.25%, while the balance sheet normalization program is purely cosmetic with minimum monthly asset sales.
We shouldn’t expect anything else from the FED as their objective is to maintain full employment and stability. As long as there isn’t significant inflation, the low interest rates help lower the unemployment rate.
However, there’s no historical precedent for our current environment and no one can know what the long-term result of this 9-year accommodative monetary experiment will be. The only thing we can look to determine the risk for the economy and our portfolios is natural economic forces. The natural behavior for an economy is cyclicality, something that’s easy to forget after 8 years of economic growth.
Let’s look at 5 charts that clearly indicate where the economy is now and what the medium term, highly probable risks are.
Unemployment, Can It Go Any Lower?
Figure 1: U.S. unemployment rate since 1950 with recessions in gray. Source: FRED.
Toward the end of 2005, the unemployment rate dropped below 5%. The recession started just 3 years later.
Unemployment also dropped below 5% in 1997, and a recession arrived by the end of 2000.
The unemployment rate fell below 5% at the end of 2015, so I’ll let you make your own conclusions.
How Much More Debt Can We Take On?
Figure 2: Consumer debt payments as percent of disposable personal income. Source: FRED.
We all know that this economy has been driven by consumer spending as the its the biggest factor in the anemic economic growth of the last 8 years. Therefore, if consumers load up on debt, at some point it will be too risky to lend them more money and consumption will fall, leading toward a recession.
The current consumer debt payment as a percentage of disposable personal income is quickly approaching 2007 levels. If the FED increases interest rates any further, service payments will quickly jump up and severely hinder future consumption.
Let’s now take a look at interest rates and recessions.
How Far Will The FED Go With Raising Interest Rates?
Figure 3: Federal funds effective interest rate. Source: FRED.
The red arrows on the chart above show how interest rates always rise just before a recession.
Central banks usually raise interest rates to prevent the economy from overheating. This time, there is no sign of an overheating economy which further reenforces how weak the economy is. Nevertheless, the FED has started raising interest rates with only one goal in mind: allow for more maneuvering space when the next recession actually comes as there isn’t much space if interest rates are kept at zero.
I hope we see many more interest rate hikes, but I also wouldn’t be surprised if we don’t see more of them in this economic cycle.
When Did You Last Buy A New Car?
Figure 4: Vehicle sales. Source: FRED.
It’s highly probable that you have a relatively new car in your driveway. This unfortunately means that you won’t be needing a new car any time soon and that you probably aren’t thinking about buying a new car as long as you’re still making payments on your current car.
As the car cycle evolves, declining car sales show how close we are to a recession. Again, the red lines in the chart above show how car sales have declined just prior to all other previous recessions, just as is the case now.
The Most Useless Indicator Of All? A Recession Indicator
I’ve read a lot of strategies that tell people to stick to stocks and sell just before a recession starts. Let me tell you the truth here, that’s impossible as we could already be in a recession, but we have to wait for quarterly GDP figures to come out to confirm that.
Further, if you take a look at the recession indicator from the Federal Reserve Bank of Atlanta, you’ll see how their best recession predicting index shows the economy is in a recession only after the fact.
Figure 5: Atlanta FED recession index. Source: FED.
Consequences For Your Portfolio
After 8 years of economic growth, a recession would be a good thing for the economy as it would make it more efficient in the long term and allow it to grow. As long as inefficient businesses are kept alive thanks to low interest rates and credit, we aren’t creating long term sustainable value.
No one likes recessions, especially market participants. The problem is that what everybody is doing now and will increasingly try to do later, is to time the markets. This is fine when markets go up as nobody is selling, but when the tide shifts, people start fearing a loss and try to avoid it.
The problem is that when the first selling starts, many others will follow as nobody likes to watch the value of their portfolio decline. So investors’ irrationality is the main thing to watch, not a recession. However, a recession is usually the trigger for a stock market sell-off. The S&P 500 fell around 50% in the last two recessions, and there is a high likelihood the same will happen again next time.
To conclude on the macroeconomic side, the longer an economic environment is kept stable artificially, the worse the crisis afterward will be as the entities controlling the environment, i.e. central banks, lose control. The environment is ripe for a recession now and all we can do is wait for a shock to trigger the fall, though nobody knows what that trigger will be.
Therefore, try to assess how whatever can happen will impact your lifestyle. That is the most important thing. Nobody can time the market exactly and sell their complete portfolio the instant things head south, so being prepared for anything will help you tremendously.