Why Everyone's Talking About… Recession
Concerns that the worst inflation for 40 years will remain elevated, while the economy is locked into a slow growth scenario, has cast a long shadow over many 2023 outlooks.
It’s worth considering that a large proportion of today’s working age population in developed markets will never have experienced such severe price increases, or the prospect of higher interest rates to bring inflation back under control. Indeed, there’s a whole generation that has never known a time without rising stocks, low inflation, and low interest rates.
The world has changed, and the word ‘recession’ is back in everyday parlance. Yet a recession is not necessarily a foregone conclusion. And not every investor will be impacted equally.
However, recession is more generally regarded as a significant decline in economic activity that lasts for more than a few months, according to the US National Bureau of Economic Research.
Recessions can be accompanied by many factors, including an increase in unemployment, a decrease in consumer spending, and a decline in stock prices. Additionally, there might be an increase in bankruptcies and defaults on loans.
They might be caused by external factors such as war, natural disasters, or changes in government policies. A war, for instance, can disrupt trade and reduce demand for goods and services.
Additionally, some sectors of the economy may be more affected than others. For example, during the 2008-2009 recession, the financial sector1 and the housing market were particularly hard-hit: In the US, $19.2 trillion in household wealth evaporated2, while house prices declined 40% on average3.
The severity of a recession can vary too. Deeper and longer recessions are often called ‘depressions’ – or as former US president Harry S Truman once explained it: “It's a recession when your neighbour loses his job; it's a depression when you lose yours.”
They can also cause the market to crash: In October 1929, for example, shares on Wall Street fell sharply following a speculative boom during the ‘Roaring Twenties’. Over two days, the Dow Jones industrial average fell by 25%. When it finally reached its record low in July 1932, the Dow Jones had fallen 89%, and it did not recover to 1929 levels until 19544.
But not every recession leads to a disaster in the markets. There have been a number of times in history where the US went into a recession but not a debilitating market crash.
To explain, inflation refers to the rate at which prices rise – prices of everyday goods and services we purchase, like groceries, petrol, and consumer items. Central banks can raise interest rates to try to cool the economy and bring elevated inflation back under control.
The theory being that, by raising rates, a central bank can influence borrowing costs for everything from credit cards to mortgage payments. Higher interest rates limit the amount of money available to borrow, and as the flow of cheaper debt to both consumers and companies is cut off, prices will fall because people will be spending less on discretionary goods and other non-essential purchases, while corporations cut costs via layoffs.
The Bank of England, which recently announced a 0.75 percentage point hike to 4% (its biggest such move since 1989)5, started raising rates in 2022. But the US Federal Reserve (the Fed), the central banking system of the US, had already started hiking before this – and far higher.
That’s because the US was the first major economy where higher inflation began to surface. It started in 2021, following the US economy’s injection from the government’s pandemic relief money and the spending activity it spurred.
Inflation then began to take root in other countries: with strong US demand pushing up the cost of oil, while Russia’s war on Ukraine in early 2022 disrupted energy and food markets – especially across Europe. The Fed’s response to its own inflation was to increase interest rates to the highest level in 15 years, triggering many countries around the world to follow suit.
In this way, the actions of the Fed can greatly influence the decisions made by central banks across other major economies. The crucial thing therefore is its timing: how far and fast should the Fed raise rates? And when should it pivot and roll back those higher rates – to potentially avoid causing a recession?
In the summer of 2022, economists, market strategists and business leaders were all weighing in on what they felt were a series of policy mistakes by the Fed. It largely boiled down to three things6.
- that the Fed didn’t act quickly enough to tame inflation
- that it wasn’t aggressive enough (even with a series of rate increases)
- that it should have been better at seeing the crisis coming.
Some refer to the Leading Economic Index (LEI), which The Conference Board has been publishing for decades. It aggregates a number of indicators of the way the economy is going. They include the change in the S&P 500, jobless claims, new manufacturing orders, and new housing permits.
Other notable indicators include:
- The yield curve inverts
In early 2022, yields for 2-year Treasuries moved higher than those of 10-year Treasuries – or what economists call a ‘2s10s’ curve inversion – which has, historically, signalled a recession.
To explain, the US Treasury Department issues short- and long-term securities. The yield curve compares the yields of short-term Treasury bills with long-term Treasury notes and bonds. The Treasury issues bills for terms of less than a year and notes for terms of two, three, five, and 10 years; it also issues bonds in terms of 20 and 30 years.
Typically, the longer one’s money is locked up for, the higher the yield should be – as compensation for that time risk. So, a normal yield curve slopes up with yields rising as the length of the bond grows. But, when investors are more worried about the present than they are the future, that curve can invert.
An inverted yield curve predicted all of the last seven recessions: 1970, 1973, 1980, 1990, 2001, 2008 and 20207. It is often a sign that the Fed has hiked short-term rates too high, or that investors are seeking long-term bonds over riskier assets.
- Corporate profits decline
In January 2023, the FTSE 100 – the UK's blue-chip index – fell 0.4%, with healthcare and commodity stocks leading losses after data showed British private-sector economic activity fell at its fastest rate in two years8. Share prices reflect predictions of a company’s future profits, and when profits decline, businesses cut investment, employment, and wages. A downward market trajectory can therefore be an indicator the economy is headed towards recession.
- Consumer confidence drops
When people and businesses are uncertain about the future, they tend to cut back on spending and investment. This can lead to a decrease in demand for goods and services, which in turn can lead to a decline in production and employment.
Likewise, the World Bank slashed its 2023 growth forecasts as the impact of central bank rate hikes intensifies, Russia's war in Ukraine continues, and the world's major economic engines sputter. The development lender said it expected global GDP growth of 1.7% in 2023, the slowest pace outside the 2009 and 2020 recessions since 199310.
However, not everyone agrees. Economists at Goldman Sachs no longer predict a euro-zone recession – they cite an economy that proved more resilient at the end of 2022, the fact that natural gas prices fell sharply, and China abandoned Covid-19 restrictions earlier than anticipated11.
Likewise, Jack Janasiewicz, Portfolio Manager and Lead Portfolio Strategist at Natixis Investment Managers Solutions, thinks a ‘soft landing’ is still possible in the US. Among the 12 data points he lists, Jack says that “the labour market remains robust and job gains and wage gains are moderating while not crushing the labour market”12.
Ultimately, recessions are notoriously difficult to predict. As veteran investor Peter Lynch once put it: “The stock market has a 100% record, in the last 50 years, of predicting upturns in the economy. It's never been wrong. It's less than 50-50 on a downturn.”13
In December 2022, the Fed’s chair Jerome Powell said: “I don’t think anyone knows whether we’re going to have a recession or not … It’s just not knowable.”14
Even ChatGPT – the all-knowing chatbot launched by OpenAI in November 2022 – won’t be drawn into predicting whether or not a recession will occur in 2023.
It said: “I am a language model and do not have the ability to predict future events such as whether or not there will be a recession in 2023… Additionally, the current state of the global economy is constantly changing and can be affected by a wide range of unpredictable events, making it even more difficult to predict the future.”
For example, defensive sectors – healthcare, utilities, and consumer staples – tend to perform well during a recession because they provide essential goods and services that are in demand regardless of economic conditions.
Likewise, bonds are considered a safer asset class because they provide a steady stream of income and can protect against stock market volatility. During a recession, investing in US government bonds or high-quality corporates could therefore be a sensible move.
Indeed, if central banks stop hiking rates by the end of the first quarter of 2023, it could create several opportunities in fixed income, such as an increase in duration exposure (which measures a bond’s sensitivity to changes in interest rates).
On the equities side, value companies typically have strong fundamentals, such as high cash reserves and low debt levels, which can help them weather economic downturns.
Just remember that a recession is a short-term economic slowdown, and markets eventually recover. So stay invested and, as ever, make sure you have a well-diversified investment portfolio that can weather market volatility.
Diverse minds fuel insightful ideas. And ideas mean opportunities.
- Bond – the ‘bond market’ broadly describes a marketplace where investors buy debt securities that are brought to the market, or ‘issued’, by either governmental entities or corporations. National governments typically ‘issue’ bonds to raise capital to pay down debts or fund infrastructural improvements. Companies ‘issue’ bonds to raise the capital needed to maintain operations, grow their product lines, or open new locations.
- Chatbot – Short for ‘chatterbot’, these are computer programs that simulate human conversation through voice commands or text chats, or both.
- Duration – A measure of a bond’s sensitivity to changes in interest rates. Monitoring it can effectively allow investors to manage interest rate risk in their portfolios.
- Fixed income – An asset class that pays out a set level of cash flows to investors, typically in the form of fixed interest or dividends, until the investment’s maturity date – the agreed-upon date on which the investment ends, often triggering the bond’s repayment or renewal. At maturity, investors are repaid the principal amount they had invested in addition to the interest they have received. Typical fixed income investments include government bonds, corporate bonds and, increasingly in recent years, green bonds. Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
- S&P 500 – A widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
- Short/long-term securities – Fixed-Income securities provide investors with a stream of fixed periodic interest payments and the eventual return of principal upon its maturity. The US Treasury guarantees government fixed-income securities, making these very low risk, but also relatively low-return investments. Short-term fixed-income securities include Treasury bills, which mature within one year from issuance, while longer-term Treasury-issued securities include the Treasury bond (T-bond) which matures in 30 years.
- Soft landing – A moderate economic slowdown following a period of growth. The Fed and other central banks aim for a soft landing when they raise interest rates to curb inflation. But the Fed has a mixed record in accomplishing a soft landing during past rate hiking cycles. The likelihood of a soft landing is reduced by the time lags associated with monetary policy.
- The Conference Board – A not-for-profit research organization that distributes economic information to its peer-to-peer business members. Founded in 1916, this economic think tank is a widely quoted private source of business intelligence, known particularly for its Consumer Confidence Index (CCI) and Leading Economic Index (LEI).
- Treasury note – A Treasury note is a US government debt security with a fixed interest rate and maturity between two and 10 years.
- Treasury Bill – A Treasury Bill (T-Bill) is a short-term debt obligation backed by the US Treasury Department with a maturity of one year or less. The longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.
- Yield – A measure of the income return earned on an investment. In the case of a share, the yield is the annual dividend payment expressed as a percentage of the market price of the share. For bonds, the yield is the annual interest as a percentage of the current market price.
- Yield curve – Essentially, it is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. So, the curve shows the relationship among bond yields across the maturity spectrum – this is considered ‘normal’ when the yield on long-term bonds is higher than the yield on short-term bonds. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year US Treasury debt. It is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is also used to predict changes in economic output and growth.
2 Source: blah U.S. Department of the Treasury. "The Financial Crisis Response in Charts," Page 3 of PDF, https://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf
3 Source: Federal Reserve Bank of St. Louis. S&P/Case-Shiller U.S. National Home Price Index, https://fred.stlouisfed.org/series/CSUSHPINSA
4 Source : BBC, October 2008, ‘Lessons from the 1929 stock market crash’, http://news.bbc.co.uk/2/hi/business/7656949.stm
5 Source: Bank of England, MPC minutes, February 2023, https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/february-2023
6 Source: CNBC, June 2022, https://www.cnbc.com/2022/06/18/here-are-three-things-the-feds-done-wrong-and-whats-still-not-right.html
7 Source: Federal Reserve Bank of St Louis, August 2018, The Yield Curve Versus the Unemployment Rate in Predicting Recessions
8 Source: Reuters, January 2023, FTSE 100 dips after weak data highlights recession risks
9 Source: WEF, January 2023, https://www.weforum.org/agenda/2023/01/global-recession-economic-outlook-2023/
10 Source: Reuters, January 2023, https://www.reuters.com/markets/world-bank-warns-global-economy-could-easily-tip-into-recession-2023-2023-01-10/
11 Source : Yahoo Finance, January 2023, Goldman No Longer Sees Euro-Area Recession as It Lifts Outlook
12 Source: LinkedIn, January 2023, Carve it Up
13 Source: Yahoo Finance, https://finance.yahoo.com/news/learning-peter-lynch-survive-market-181024634.html
14 Source: Transcript from press conference, Federal Reserve, December 2022, https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20221214.pdf
This material is provided for informational purposes only and should not be construed as investment advice. Views expressed in this article as of the date indicated are subject to change and there can be no assurance that developments will transpire as may be forecasted in this article.