The 5 W's of Recessions

The number one macroeconomic question this year seems to be: When is the next recession?  Or some variant thereof, like “What is going to cause the next recession” or “Are we in a recession” or “How do you prepare for a recession” or “My god, the yield curve is inverted!  That means recession!” or “My god, look how close the yield curve is to inverting (depending on which part of the curve you look at), that means recession!”.

Economists are notoriously good at predicting recessions.  They have accurately predicted 17 of the last 10. Plus, it’s a lot more fun to predict a massive recession than to say “menh, we’ll probably have 2% growth again this year” - it gets a lot more play in the press. Kind of like how earthquakes in California warrant more excitement (because it might fall into the ocean) than earthquakes in Oklahoma, despite the fact that there have been over 2,500 magnitude 3.0 or greater earthquakes in the last five years.  Boomer Sooner indeed.  Or how the Yellowstone volcano is more exciting than the 24 currently erupting volcanoes in the world, simply because it would destroy half the US.

So this month we’ll take a brief look at recessions in the US and see what we can glean about the next one.

What

Webster’s quite unhelpfully defines recession rather tautologically as the act of receding, so we’ll scrap the dictionary for this one.  In economic terms, a recession is defined as two consecutive quarters of negative GDP growth. Going to back to the Great Depression, there have been 14 recessions in the US in the last hundred years or so; roughly one every 7 years if you like meaningless averages.  We’re currently 10 years in to an economic expansion (read: no recession) and only a few months away from our longest ever non-recession streak. That means we’re overdue, right? Well, maybe. As an interesting data point, Australia has gone 27 years - and counting! - since their last recession.

The term “recession” then got slightly appropriated and slapped on to the end of other things that can go negative for two quarters, like an “earnings recession” or a “balance sheet recession” or a “Tesla production recession” or a “Netflix subscribers recession”.  We may have made those last two up, but you get the idea. At a certain point it gets a bit silly and hyperbolic. Like when the weather channel starts hyping the next storm as the worst one since last month.

If you’ll recall from the valuation newsletters, stock prices are basically earnings times some multiple.  In a recession, two things tend to happen: first, earnings will go down, causing stock prices to drop, and second, the multiple will also decline (for various reasons), causing stock prices to drop further.

Who

Because of the interconnectedness of the global economy, most of the attention is focused on the US.  There’s not much good going on in global stock markets if the US dips into a recession. As the second largest global economy, China is also a concern, though there are lots of issues with getting accurate data out of China.  “Europe” is also lumped together as a single entity, though the issues of concern there that make it across to our side of the pond tend to be more political than economic in nature (namely, Brexit or a future breakup of the EU).  Italy is currently in a recession, but that hasn’t stopped Europe from being up almost 10% so far this year.

When

The problem with recessions is that you can’t identify them until you are well into one.  The first official estimate of GDP for the fourth quarter last year is coming out later this week.  Yes, first, as in there are multiple. Yes, estimate, as in GDP is a bit of dodgy number in and of itself.  Consensus has Q4 GDP growth coming in at 2.5% or so, though the range of estimates is about 1.4% to 3%. In other words, all over the board.

Theoretically, imagine something happened back in October that drastically slowed economic productivity.  A sudden trade war escalation. The imposition of a massive corporate tax hike.  A balanced Federal budget.  Whatever.  But let’s say that Q4 GDP growth was actually negative.  We would get our first official notice of that negative growth basically in March of the following year, 5 months later.  Let’s further assume that said October something persisted and Q1 GDP growth was also on track to be negative. That would constitute a recession - two quarters (6 months) of negative GDP growth - and you don’t even find out that the first quarter’s growth was negative until you’re already in month 5 of 6!

That’s why people are so obsessed with forecasting recessions, because seeing into the future as a general rule tends to be more of an advantage than seeing into the now.  Knowing, you could say, is half the battle. Unfortunately, this desire for knowledge tends to lend itself very quickly to crystal ball seers and snake oil salesmen (we’ll expand on that analogy in April’s letter).

Where

People look for recession indicators in all sorts of places.  Jobless claims, various industrial/production/manufacturing indices...even completely esoteric indicators that backfit a trendline over a limited sample size.  But the holy grail of recession indicators is the yield curve spread.

In a functioning economy, the interest rate on a 10-year bond should be higher than the interest rate on a 2-year bond.  The difference between those rates is called the spread. If the spread is negative, that means that 2-year bonds yield more than 10-year bonds.  This “inversion” has called every recession in the last 50 years (typically with a 19-month lead time, but who cares about details). We aren’t currently inverted on a 2s-10s basis at the moment (only 0.16 away!), but we are inverted in that 6-mo rates and 1-year rates are higher than the 2-year rates, and the 2-year is higher than the 3-year and 5-year rates.  Which leads to things like this:

"Look at that 2s-10s trend closer each successive recession was preceded by a shallower and shallower inversion.  The 2s-10s inversion was yesterday's recession indicator, what really matters is the overall percentage of possible yield curve spreads that are actually inverted at any given time!  New and improved 2x concentrated recession indicator!"

Data doesn’t lie, but it’s incredibly easy to manipulate data into supporting a conclusion that is not true.  Some of this has a legit economic basis and can be helpful in analyzing potential future risk/return profiles of investments, but a lot of it tends to be tea leaves and fear-mongering.  As the Fantastic Mr. Box said - All models are wrong, but some are useful.

Alright, that was only 4 W’s...the “why” is all over the place, could be nearly anything, and would be complete conjecture at this point.  Here’s the takeaway: media loves hyperbole, and the financial media is no exception. But in investing, being early is the same as being wrong.  So we’ll look at the data as it comes in and respond as events warrant; however, against the current backdrop of doom and gloom, stocks have gone up for 9 weeks in a row and counting.  No need to head for the hills just yet, though it probably doesn’t hurt to have a bag packed.  Just in case.