Monday, March 12, 2018

The Next Recession

Given that the current economic expansion is one of the longest on record, one has to wonder when the next recession will occur and what will trigger a cooling of what can only be described as a relatively lukewarm economy.  A recent CRS insight by Marc Labonte at the Congressional Research Service provides us with historical background on the economic cycles that have taken place since the end of the Second World War and how the current economic scenario compares to past pre-recession events.

At 105 months (including March of 2018), the current economic expansion is the second-longest in post-Second World War history as shown on this graphic:

According to the Wall Street Journal's Economic Forecasting Survey, a minority of economists are predicting a recession as shown here:

That said, economists are far better at hindsight than they are at foresight; recessions are generally not visible to the economic world until they are well entrenched.  

Additionally, despite the Federal Reserve's unprecedented and "heroic" monetary experimentation, the post-Great Recession recovery has not matched its predecessors as shown here:

...and here:

This would seem to suggest that there is underlying economic weakness that has not been present in other economic expansions.

Here are a few economic trends that often precede recessions:

1.) Rising Inflation:

In all but the 1953 - 1954 recession, inflation has increased before the recession began as you can see here:

The three most recent recessions were preceded by inflationary increases of under three percentage points compared to five of the eight preceding recessions which saw inflation increase by at least three percentage points.  The recent drop in the increase in inflation more or less mirrors the decline in the size of interest rate increases required to beat back an overheated economy as shown here:

In the case of the current economic expansion, it is entirely possible that the rise in the consumer price index from its low of zero percent to its current level of 2.1 percent could be the sign that the economy is nearing the end of the post-Great Recession expansion phase as shown here:

The doubling of oil prices from the $30 dollar per barrel range to the $60 dollar per barrel range will eventually work their way into the economy just as the rise in oil prices to over $140 per barrel acted as one factor that helped push the global economy into a recession in 2007 and 2008. 

2.) Falling Unemployment:

Since the Second World War, unemployment fell to 5 percent or lower prior to all but two recessions as shown here:

In all but the 1981 - 1982 recession, unemployment was lower than the Congressional Budget Office's estimate of the natural unemployment rate before the recession began.  You will also note that in the six previous economic expansions, the unemployment rate has only fallen as low as the current rate of 4.1 percent in the 1999 - 2000 recession when it hit 3.8 percent in April 2000.  In that cycle, the recession began 11 months later.

3.) Elevated Asset Prices:  In the 1999 - 2000 recession and the Great Recession, economic contraction was preceded by asset bubbles (technology stocks and housing respectively).  In this cycle, particularly since early 2017, there has been a rapid rise in the stock market.  Here is a graphic showing the 12-month real change in the S&P 500:

From this graph, you can see that the upward volatility of the stock market is not necessarily related to the occurrence of a recession, however, each economic cycle is different.  In this cycle, we have not seen the housing market or certain specific sectors of equity markets enter what is colloquially referred to as "bubble territory", however, all of the money that has been injected into the economy by the Federal Reserve may well be playing a role in the very high valuations in the stock market which are now at the second-highest levels since the Second World War when calculated using the ratio of corporate equities to GPD (i.e. the Buffett Indicator) with only the valuations experienced during the technology stock bubble of 1999 - 2000 surpassing the current level.

Recessions are notoriously hard to predict.  As we found in the Great Recession, the economy (at least surficially) appears to be healthy in one quarter and in contraction the next.  Trends in the three factors listed above seem to suggest that an economic contraction could occur at any time, however, as Janet Yellen said in December 2015:

"I think it’s a myth that expansions die of old age. I do not think that they die of old age. So the fact that this has been quite a long expansion doesn’t lead me to believe that it’s one that has—its days are numbered. But the economy does get hit by shocks, and there are both positive shocks and negative shocks. And so there is a significant odd, you know, probability in any year that the economy will suffer some shock that we don’t know about that will put it into recession. And so I’m not sure exactly how high that probability is in any year, but maybe at least on the order of 10 percent. So, yes, there is some probability that that could happen, and of course we’d appropriately respond, but it isn’t something that is fated to happen because we’ve had a long expansion, and I don’t see anything in the underlying strength of the economy that would lead me to be concerned about that outcome." (my bold)

As it turns out, her observations about the advanced age of the current economic expansion was rather prescient.  I suspect that her replacement will not be so lucky. 

1 comment:

  1. A recent report from JP Morgan revealed that S&P 500 companies will buy back a record $800 billion of their own shares in 2018, far exceeding the current high of $530 billion that was recorded in 2017. If indeed we are seeing the later stages of a bull market built on valuation illusions based on share "buyback alchemy" then we can only speculate as to the downside potential of this market.

    Below is the link to the second part of a two-part series. The first explored how stock buybacks have been instrumental in driving this market higher since QE fueled easy money starting in 2009. This part focuses on what is ahead and how the recently passed Trump tax plan has supercharged this trend just as it may have been reaching its natural conclusion.