The R word is being thrown around by investors and the media, and for good reasons. The US is ten years into a bull market and economic expansion, which is one of the longest on record. Economic data in the US has disappointed as well, and is coupled with weak growth around the world. The 10Y vs. 2Y yield curve is close to 0 which historically preceded a recession.
Officially recessions are defined by the NBER and typically include two or more quarters of negative GDP growth (which means the start can be formally declared only retrospectively), but there’s no strict definition. Investors tend to pattern match and view any upcoming recession as a repeat of 2008 or 2001. However, there are good arguments to be made that the next recession will not happen this year, and when it does happen will be milder than the previous two recessions. As always, the future is unknown, and there’s a bull case and bear case. As investors debate the possibility of a recession, here are some important points to consider
1) Economic expansions are getting longer
How close are we to a recession? Economic conditions and common sense indicate that we are late in the economic cycle. Currently in the second longest period of expansion in US history, with the longest being the ten years from 1991-2001 before the dot-com bubble. Since 1929, expansions have typically lasted four years, but the last three expansions since 1981 have lasted six to ten years.
US recessions since 1929
2) The economic swings (up and down) are getting smaller
It’s important to emphasize that recessions are a natural part of the business cycle. In a perfectly academic world, the economy would grow at its natural rate, which is approximately equal to population growth and productivity growth. However, open economies fluctuate around the natural growth rate for many reasons, such as fiscal policy, bank lending, investments and consumption, all of which are impacted by “human” factors such as sentiment. (Ray Dalio, founder of Bridgewater Associates, created a great explainer video on how the economy works here.)
The economic swings have gotten smaller over the past 50 years in the US. Goldman Sachs recently released an excellent research report shows that the standard deviation of GDP growth is getting smaller over time. There’s no definitive explanation for this, but contributing factors include better inventory management across the economy (just-in-time inventory) and more timely economic indicators to allow consumers/businesses to react to economic conditions.
Recessions are occurring less frequently and economic swings are more muted relative to history
In addition to just-in-time inventory, the share of just-in-time workers, or the gig economy, has increased since prior cycles. Gig economy workers are flexible and can adjust to shifting demand more quickly than when companies budget and hire full time workers. The Bureau of Labor Statistics estimates that about 10% of the workforce participates in the gig economy.
3) An inverted yield curve does not always signal an imminent recession
While it is true that yield curve inversion typically precedes recession in the US, there have been many times that the curve has reached its current level without a recession immediately following. Taking the 1990s cycle as an analogy (and referring to the chart below), are we in 1995? 1998? Or 1999 (actual impending recession)? The eventuality of where we are in the cycle will depend on how central banks respond to the current weakness. Will the Fed use stimulative policy to get ahead of a slowdown? If so, it’s likely we won’t slide into a recession. If the Fed tightens, or fails to use enough stimulus, the slowdown may turn into an actual recession. There’s reason to believe the Fed will shift more dovish (see section below).
The US 10Y2Y yield curve is close to 0 as it was in 1995
Popular media reporting tends to cherry pick which yield curve to use depending on which makes the best alarmist headline: “Yield Curve Inverts! Recession Imminent!!” Typically, macro investors use the 10Y vs. 2Y as the benchmark yield curve because the 2-year is disconnected enough from the policy rate to provide a meaningful signal about the short-term outlook. And the 10-year is long enough in duration to gauge the market’s view of nominal growth. Goldman Sachs created an interesting chart which shows that a high proportion of yield curves invert before a recession, which has not happened yet. (You can follow global yield curves using the CURV dashboard in Koyfin.)
4) Balance sheet for the consumer is healthier than in previous late cycle periods.
The last recession was particularly painful because consumer balance sheets were over-leveraged, mainly due to the housing bubble. Fast-forward ten years and the consumer balance sheet has deleveraged. Corporate balance sheets are in fairly good shape as well.
Fear mongers love to highlight graphs that show the amount of consumer debt has increased — and it has. But that’s not an accurate measure of leverage. Levels of debt are only relevant when compared to income or assets. While it’s true that consumer debt has increased since 2008, consumer income has increased even faster, while interest rates have fallen.
Bears will dismiss healthy interest coverage ratios by arguing it’s low solely because of QE. While it’s outside the scope of this post to discuss QE and its effect on interest rates, the reality is that interest rates are currently low and don’t appear to be heading higher in the foreseeable future.
Household debt service payments as % of disposable income
5) Fed may shift more dovish as it considers an alternative measure to inflation
Monetary policy is evolving from prior recessions and the Fed of today is not the Fed of yesteryear. In the US, the Fed’s official dual mandate is to support maximum employment and ensure stable prices, or control inflation. In 2012, the Fed went from nebulously defining stable prices to stating that 2% is the inflation target.
Now there’s another shift and the Fed is debating how to measure how close we are to that 2%. A key sentence in December’s press conference by Fed Chairman Powell was: “We are looking for better ways to achieve the inflation goal — for example, on a symmetric basis.” Further policy speeches and interviews after that December meeting suggest that the Fed may move to measure inflation over a longer horizon rather than a short term target. In this new environment, core inflation has averaged 1.6%, so, if symmetry is really the new goal, the Fed should aim for greater than 2% inflation over the next several years to balance that. (For a good summary of this topic, see this WSJ article.)
6) Central banks globally are neutral or in easing mode
The current late cycle is different from previous cycles because almost every central bank in developed economies is either neutral or easing. In previous recessions, central banks were typically raising rates to fight inflationary pressures, which isn’t happening in any major economy. Pessimists will argue that this is negative because central banks can’t lower rates given the low level of rates globally. However, most central banks have taken the position that QE-like tools are effective even if rates are low.
Policy rate and stance of major central banks
Central banks in emerging markets have also switched to a net easing policy in February. More central banks are cutting rates than hiking rates. This has been one of the main drivers behind the emerging market rally over the past several months.
Number of emerging market central banks hiking policy rates less those cutting, measured end-of-month
7) The US fiscal drag may be less than projected
A convincing point supporting the recession argument in 2019 is that $1.5 trillion stimulus rolls off from last year’s tax cuts. This assumes that the US government will not deliver another round of fiscal stimulus. That may have been true according to the reasoning of previous administrations, but it may not be true next year.
Donald Trump is unconventional in many areas (to say the least). When it comes to fiscal stimulus, he broke a long standing precedent by using fiscal stimulus when the economy was already growing rapidly. Typically fiscal policy, along with resulting deficits, is prescribed when the economy is declining to counteract the belt tightening in the private sector.
Trump’s argument for more fiscal stimulus would be that interest rates are at record lows, so the smart thing to do is issue more debt to support the economy. Liberal economists like Paul Krugman have used this logic as well, though they advocate for spending the borrowed money on education and infrastructure. Any fiscal package next year will need to be supported by a bipartisan congress, so any fiscal spending would likely be spread across Democratic priorities as well.
Federal surplus/deficit as % of GDP
The late innings of a cycle are arguably the trickiest to navigate. Investors need to process monetary and fundamental crosscurrents to determine the timing of a cycle’s end. Every cycle is different and understanding the unique characteristics of the current cycle is key to not getting caught up in the doom and gloom discussion about the next recession.
Special thanks to Evelyn Donatelli for helping to research this report