How the Current Economic Climate Could Spur a Different Kind of Recession

Markets shuddered Wednesday and Thursday as the latest inflation data was released after months of concerns regarding its ongoing rise. June’s rate came in at 9.1%, up from 8.6% in May and definitively ahead of the 8.8% that had been widely expected. As CNN explains, there are a number of contributing factors to this trend:

Much of the June increase was driven by a jump in gasoline prices, which were up nearly 60% over the year. Americans faced record-high gas prices last month, with the national average topping $5 a gallon across the country. Electricity and natural gas prices also rose, by 13.7% and 38.4%, respectively, for the 12-month period ended in June. Overall, energy prices rose by 41.6% year-over- year.

The increases, however, were felt across all categories. Prices for food at home were up 12.2% over the year, with eggs up 33.1%, butter up 21.3%, milk up 16.4%, chicken up 18.6%, and coffee up 15.8%. Shelter costs were up 5.6%.

This is only one element of an increasingly precarious economic climate. Real estate is taking a hit, stocks are down, and it is being speculated that the Fed will top their historic rate hike in June of 75 basis points. The Street reports:

The CME Group’s FedWatch tool is showing an 85.8% chance of a 75 basis point rate hike late this month, as well as a 35% chance of the 100 basis point move, a bet that was essentially at 0% just a week ago.

This comes not only on the back of poor consumer confidence readings, but a number of surveys indicating that between 58 and 70% of Americans believe we’re headed for a recession – data points that have significantly increased over the past couple of months.

This raises real questions. Are we in a recession, or headed towards one? What does that mean for the economy? Most importantly, what could that mean for your portfolio?

Historical Context for Recessions in the U.S.

Ask a room full of economists what defines a recession, and odds are you’ll get a variety of answers steeped in their own views of the current climate. The U.S. Bureau of Economic Analysis states:

In general usage, the word recession connotes a marked slippage in economic activity. While gross domestic product (GDP) is the broadest measure of economic activity, the often-cited identification of a recession with two consecutive quarters of negative GDP growth is not an official designation. The designation of a recession is the province of a committee of experts at the National Bureau of Economic Research (NBER), a private non-profit research organization that focuses on understanding the U.S. economy. The NBER recession is a monthly concept that takes account of a number of monthly indicators—such as employment, personal income, and industrial production—as well as quarterly GDP growth. Therefore, while negative GDP growth and recessions closely track each other, the consideration by the NBER of the monthly indicators, especially employment, means that the identification of a recession with two consecutive quarters of negative GDP growth does not always hold.

The NBER determining factors for a recession are definitely more complex than conventional views, and technically speaking, a recession can’t be “called” until their panel of 8 economists says so. Ask your average consumer or mom-and-pop investor, though, and they might not even be able to tell you what NBER is; their perspective on recessions is defined by personal experience and visibility into traditional asset classes like stocks and bonds. That complicates matters. Their feelings can become a self-fulfilling prophecy.

Determining whether we’re in a recession is made even more difficult by the variety of factors that have spurred recessions over history. If you go back to the early 1900’s, however, nearly every major recession followed a period of heightened inflation, resulting in more restrictive monetary policy. Other common precursors to periods of contraction include diminished faith in financial systems, decreased investment in traditional industry production, and drops in domestic government spending, particularly after wars. More recent recessions have taken on a slightly different flavor at times, but we’ll get to that in a minute.

Then you have to consider the scope of the recession’s impact. Some recession periods lasted for a year or so. Some extended for nearly a decade. It is worth noting that there are a number of periods commonly referred to as recessions that were so short or mild that their status on such a list is questionable.

The depths of the recession are important, too. Recent history provides an excellent illustration of this. Many refer to the “Great Recession” of 2008 with an echo of fear in their voices, but the GDP drop was only 5.1% over a period of 1.5 years with unemployment at 10%. The recession experienced at the height of the COVID pandemic, on the other hand, while only clocking in at a technical period of two months in duration, resulted in an economic contraction of over 19% and unemployment of more than 14%.

The point is that, even with strict definitions, there is a wide array of variables that are often contemplated by people trying to beat the worst of the drop, and realistically, predicting the exact nature of a downturn can be next to impossible. To this end, as Americans prepare themselves for a downturn, the question might not be one of “if” or even “when.” The most important question might be “how?”

Examining the Economic Variables

Experts disagree about the nature of strife the markets are likely to experience in the months or even years to come. A great deal of these disagreements come from focusing on individual data points that might not directly echo the makings of recessions past. Let’s consider the parallels, though.

For instance, a number of strategists, fund managers, and economists today are pointing to relatively steady unemployment numbers as a sign things aren’t all doom and gloom. We’ve talked about why that might not be a great indication of economic stability, but you know when else unemployment held relatively steady? The Recession of 1980, which also saw GDP contraction of -2.2%.

There are those who argue that high inflation followed by periods of more restrictive monetary policy don’t always lead to a recession. They especially like to point to the Great Recession in 2008 and the recession spurred by COVID in 2020 as illustrations of how recessions can exist even with falling rates. However, going back to 1953, 8 of 11 defined recessions manifested during periods of monetary policy tightening following periods of high inflation. That’s exactly where we’re at now.

Inflation, as we mentioned, is being driven substantially by the ongoing energy crisis. This mirrors the circumstances of recessions in 1973, 1980, 1981, and 1990.

But let’s consider more modern recessions. In 2001, for example, the Dot Com bubble burst, causing significant declines in the stock market. Today, the tech sector seems to be falling in on itself once more.

In three trading sessions in May, big tech lost over a $1 trillion in value over 3 trading sessions. In June, it was reported that the sector had declined more than 22% in 2022. Google, Meta, Tesla, and Microsoft are among the big names scaling back on new hiring. The list of tech companies laying off large portions of their workforce is even longer. Bank of America is warning that tech investments – previously considered a safety play – are unlikely to serve as a defense in the face of a recession now.

Compounding matters is globalization. It’s no longer just about American tech stocks. China’s tech sector is stumbling as well. Though folks have been banging the drum about the risks involved in investing in Chinese tech stocks (see the 2017 documentary The China Hustle for context), Americans still have substantial exposure to them. As tech impacts the broader Chinese economy, major U.S. companies such as Nike and Apple – with significant Chinese exposure themselves – are at risk, as well.

American stocks in general are in trouble, though. The S&P 500 is down over 20% YTD. And our stocks aren’t the only ones. All of the major global stock indices are down YTD. When else did international financial turmoil happen like this? The year 1973 comes to mind, but so does 2008 and the COVID recession.

American memories are short, so these last two recessions are, unsurprisingly, the contrast that many analysts and journalists are using when parsing the news today. The argument advanced is that things now aren’t nearly as bad as they were then. Unfortunately, that might not be necessarily true.

In 2008, the financial crisis was fueled largely by the housing bubble bursting on top of bad mortgages and structured products coming out of previously-assumed blue chip financial companies. (If you really want a good breakdown of this, we will always recommend The Big Short and Margin Call.)

Today, real estate is once again taking a hit. While homebuilders are continuing to expand business, sales are down and buyers are cancelling at the highest rate seen since the height of COVID. This doesn’t even take into consideration the likely rate hikes coming from the Fed.

A couple of points on housing:
1. Not all housing starts actually turn into sold homes.
2. Homebuilders continuing to expand starts after new home sales has turned lower is a condition that typically leads to a more significant contraction.
3. Higher rates exacerbate this. pic.twitter.com/2TiCbHzWLn

— Tom McClellan (@McClellanOsc) July 7, 2022

Lenders aren’t feeling that optimistic, either. As Forbes reports:

In a regulatory filing released Tuesday, California-based loan Depot said it has cut about 2,800 jobs this year and expects to cut about 2,000 more by year’s end, as part of a plan to “aggressively” cut costs by about $400 million on an annualized basis; the company currently employs about 8,500 people.

“After two years of record-breaking volumes, the market has contracted sharply and abruptly in 2022,” CEO Frank Martell said in a statement about the plan, which also includes reduced marketing and property sales to return to previous levels of staffing and expenses.

Chief Financial Officer Patrick Flanagan said the firm anticipates “challenging market conditions” to continue through next year, with mortgage originations projected to decline by about half in 2021, as compared to last year, and an “accelerated” decline in the coming months.

This time around, we’re not looking at a sub-prime mortgage crisis. Instead, we’re looking at a market of high home prices (fueled in part by investment companies buying up properties to rent at sky-high rates) about to take a tumble, tightening monetary policy, homeowners putting the brakes on selling, and homebuyer wariness over economic uncertainty.

And if you think the big banks don’t have the same kind of exposure to these concerns, think again. JPMorgan’s earnings miss was largely attributed to a 45 % YoY decline in mortgage originations, and they’re not painting a rosy picture of what comes next. As CNBC explains:

Importantly, a key tail wind the industry enjoyed a year ago — reserve releases as loans performed better than expected — has begun to reverse as banks are forced to set aside money for potential defaults as the risk of recession rises.

The bank had a $1.1 billion provision for credit losses in the quarter, including the $428 million reserve build and $657 million in net loan charge-offs for soured debt. JPMorgan said it added to reserves because of a “modest deterioration” in its economic outlook.

Back in April, JPMorgan was first among the banks to begin setting aside funds for loan losses, booking a $902 million charge for building credit reserves in the quarter. That aligned with the more cautious outlook Dimon has been expressing. In early June he warned that an economic “hurricane” was on its way.

In other words, trouble is brewing in real estate. It might not look the same as 2008, but that doesn’t mean we won’t take a substantial hit.

There’s no denying that COVID played a role in this. Especially in the U.S., shutdowns came too late and inconsistent to prevent the spread and mutation of the virus while simultaneously driving unemployment higher, diminishing consumer purchasing power, and forcing companies to transform the way they conducted business – often in very costly ways.

The arrival of vaccines and boosters along with eased government restrictions has helped bring the unemployment rate down, but as inflation has soared and wages have failed to keep pace, those unemployment figures are dwarfed by the weight of underemployment. This is the backdrop we have for the latest COVID development – a new, scarier strain. CNN reports:

[T]he virus is spreading again — evolving, escaping immunity and driving an uptick in cases and hospitalizations. The latest version of its shape-shifting, BA.5, is a clear sign that the pandemic is far from over.

The newest offshoot of Omicron, along with a closely related variant, BA.4, are fueling a global surge in cases — 30% over the past fortnight, according to the World Health Organization (WHO).

In Europe, the Omicron subvariants are powering a spike in cases of about 25%, though Dr. Michael Ryan, the executive director of WHO’s Health Emergencies Program, has said that number may actually be higher, given the “almost collapse in testing.” BA.5 is on the march in China, ratcheting anxieties that major cities there may soon re-enforce strict lockdown measures that were only recently lifted. And the same variant has become the dominant strain in the United States, where it accounted for 65% of new infections last week, according to the Centers for Disease Control and Prevention (CDC).

This doesn’t take into account the phenomenon known as “long COVID” either – the experience of long-term COVID-like symptoms by those who may or may not have been infected or known about it. Early study of its impacts has been startling. Dr. Peter Hoetz, dean of the National School of Tropical Medicine at Baylor College of Medicine and co-director of the Center for Vaccine Development at Texas Children’s Hospital, explains:

There are clinically identifiable things we can see with long COVID including magnetic resonance imaging, MRI brain imaging, that was shown to us initially by the Brits by their Alzheimer’s and neurology group at Oxford. A function of their system there, is they have thousands of brain scans. For anyone who had COVID, they could come back and do a before and after brain scan. And they clearly shows this gray matter brain degeneration.

There are MRI pictures of younger people that resemble somebody else much older with cognitive decline.

And all that might be the tip of the iceberg. We still aren’t sure what the long-term impact on our cardiovascular, respiratory, and neurological systems could be, even in those who were never symptomatic at all.

The immediate and most heart-breaking cost of the situation is undoubtedly loss of life, but it’s even higher than that when you consider the consequences in terms of healthcare costs and system burdens, labor force resilience, and the potential for additional shutdowns. That fear is baking into the market – not necessarily in terms of large investors, but most certainly for other economic stakeholders, with small business sentiment hitting a 9.5 year low. 

These are extreme circumstances, to be sure, making predictions on impacts in a modern economic climate difficult to predict, but the longer-term side effects of the pandemic mirror those seen 1990 and 2001 in terms of consumer, small business, and investor sentiment.

When all is said and done, the pundits are, in a sense, right. This isn’t like the circumstances of recessions past. It’s probably more accurately depicted as a melting pot of elements from almost all of them.

What a Recession Could Mean for Your Portfolio

Just as a room full of economists will have different opinions on what defines a recession or spurs one, they are somewhat split on what it could mean for a full-blown recession to develop now – especially if its duration and depth are pronounced.

Generally speaking, though, analysts and experts are assuming this will be a run-of-the-mill recession – part of normal economic cycles. What does that mean? Mark Zandi, chief economist at Moody’s Analytics, put it this way to CNBC:

In a garden variety recession, the economy typically loses 3 million to 4 million jobs, and unemployment can get as high as 6%, Zandi said. The stock market may fall another 5% to 10% and national house prices decline about 5% to 10%, he said.

That doesn’t necessarily mean that’s what will occur if the economy does fall into recession. Right now, the fundamentals of the economy are good, Zandi said.

“There is a good chance [if] we do suffer a recession, [that] it will be less severe than a typical one,” he predicted.

In theory, that should provide comfort. No economic downturn is comfortable, but since 1953, the average GDP contraction has been -2.3% (with the exception of the COVID recession), and some have seen contraction of less than a single percent.

If you were to follow conventional wisdom in accordance with such characterizations, the answer to such a possibility would be to focus on portfolio diversification. Such a philosophy would have you allocating resources to different asset classes that are usually negatively or non-correlated, allowing gains in at least a portion of your investments to counter the decline in others. Essentially, during periods of relative market stability, there is negative correlation between safety plays (think bonds) and riskier investments (think stocks). During periods of growth, we usually see riskier investments increase in value, whereas turmoil tends to witness a bump in safety plays. This can also play out within an asset class like stocks, with strategists advising exposure to different sectors and growth-versus-safety investments.

In doing so, however, you would be overlooking two issues. The first is that contributing variables to the current economic climate make it anything but “garden variety.” The second is that you would be glossing over the way that the past two recessions exemplified shortcomings in this portfolio management strategy.

The Great Recession of 2008 was the best example of this. Those circumstances, arguably, had one specific driver. Greg Phelps of Redrock Wealth Management explains:

All of these carefully-crafted models – and all the higher mathematics – went seriously awry during the 2008-2009 downturn. During that period, every asset class – from commodities to real estate to stocks – went down seemingly in concert.

It was as if the correlation coefficients had suddenly decided to converge at exactly the wrong time.

[…]

At a recent investment conference I attended, the outlines of a possible explanation began to emerge. It was noted that all of those risk assets had one thing in common: they were financed or owned by the same small number of investment banking and brokerage institutions.

When Lehman Brothers went bankrupt and Bear Stearns was essentially folded into J.P. Morgan, when Citigroup and Merrill Lynch and Goldman Sachs suddenly had to rebuild their balance sheets, they all needed to sell assets to raise money.

The result: the world’s largest owners of risk assets were all desperate sellers at the same time. Suddenly, all those assets, no matter how different their underlying economics were, found themselves in the same boat. They had to be sold so companies could meet their net capital requirements and stave off bankruptcy.

And, of course, this caused those assets to have something else in common: they were dropping in value so fast that the average investor was scared out of his wits. Instead of a run on the banks as we saw in the 1930s, there was a run on the markets.

Now think about what happened during this correlation. While GDP shrank by just over 5%, over $10 trillion in American wealth was erased. Even with a subsequent market rebound, the recovery was uneven, with wealth inequality soaring.

Still, historically, those correlation levels could seem like an outlier. After all, the Great Recession is often referred to as a “black swan” event. This goes back to that argument that this time around is not like 2008. The banks are starting to brace for pain, sure, but they’re not in free fall. And yet, many of the market dynamics that generated high levels of asset class correlation are bubbling up from other drivers all the same.

One could argue that globalization makes it more likely for a repetition of such high correlation,. In fact, the initial COVID recession proved this out. A report from the Envestnet Institute explains:

One of the most vexing problems in investment management is that the benefits of portfolio diversification can seem to disappear just when they are needed most.

The coronavirus crisis provided a fresh example of this tendency. When global markets sold off in March, return correlations among different asset classes and sectors spiked as investors sold indiscriminately.

[…]

“Every time we get into a crisis, people seem surprised when correlations that normally are in the 0%–50% range suddenly jump to the 90%+ range,” adds Sébastien Page, head of global multi?asset.1 “This risk is very much underestimated, even by the savviest investors.”

So let’s break this down. Is this 2008? No. Nor is it the COVID recession, the Dot Com bust, the energy crisis of the 70’s, the Great Depression, or any other recession stretching back to the Civil War. What it is is a multi-layered tumultuous economic climate wherein the overall negative impact could be magnified by a more interconnected world that facilitates abnormal market correlations which undermine traditional wisdom on portfolio construction.

A mouthful? Yeah. Good news? No.

Alright. What Should You Do Next?

Brace yourselves.

That’s the general idea, at least. What that looks like depends largely on your risk tolerance.

The reason we felt the 2008 financial downturn so sharply was that it directly hit many pensions and retirement portfolios for an aging generation of Boomers and beyond. These investors, depending on their available risk capital (which is, typically, not substantial for the majority of Americans in any generation), are often advised to keep their investment strategy “safe.” That didn’t work very well in 2008 because “safety” meant blue chip stocks and bonds – both of which dipped. To that point, it makes sense for risk averse investors today to explore different kinds of safety plays with their advisors, even if that means simply reducing overall investments for a period of time before the biggest declines hit – declines that could be substantial depending on how some of the variables in play shake out in the months to come.

Younger investors, on the other hand, may have a little more room to take risks. They generally have more time to ride out the storm before their investment portfolio becomes relevant to daily financials. After all, as an example, those who had invested in the stock market as of December 1, 2008, though feeling short-term pain, would have seen a bump of more than 300% as of today.

It’s worth considering risk tolerance from a mental perspective here. Ongoing anxiety as you see portfolio performance dipping can lead to something called “chasing returns” – a reactionary investment pattern whereby people allow fear to push them out at the lows while a fear of missing out pushes them back into the markets as prices go higher and higher during periods of recovery, resulting in compounded losses with a more enduring impact on portfolio performance through erasure of available risk capital. Once again, speaking with your financial advisor can help you keep your head on straight instead.

Which brings us to another cohort: entrepreneurs. In theory, the current climate affords those looking to start a business with some significant opportunities – especially in terms of commercial real estate. A persistent appetite to support small business among government agencies and elected officials also makes the environment favorable. But risk tolerance and available risk capital (especially with tightening lending standards) plays a role here, too. It may take time for consumer confidence and subsequent spending to recover, which could lead to short-term losses off of such ventures. Speaking with a financial advisor can give you sharper perspective on risk and return dynamics.

Notice a trend here? Whether you’re a Boomer eyeing retirement, a Millennial new to the game, or an enterprising business person hoping to strike out on your own, your decision-making right now can benefit from the advice of an expert. The key is to self-advocate during those conversation. Ask questions. Ask tough questions. Ask a lot of them.

Information in these circumstances – and in most others – is power.

---

Disclaimer: The above information should not be construed as investment or financial advice and was not compiled by a licensed professional. Individuals should seek professional guidance to clarify the information therein prior to acting on it. Past performance is not indicative of future results.

---

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Personal Finance & Investing Fundamentals
• All About Asset Allocation
• Advanced Investing Topics: Unicorns and Pre-Unicorn Scalable Private Company Propositions

Additional reading:

• 3 Tangible Asset Investments to Delight Your Inner Child
• The Investment Basics for Beginners Series
• Beware Venture Capital Unicorns
• Investing in a High Inflation Environment]

©2022. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.