The New Recession

Recessions and business cycles have been a staple feature of the post-war economy. Recessions have typically occurred when economic and financial imbalances topple the economy into contraction.

Some recessions are driven by household spending and debt (such as the 2007-09 crisis), while others are sprung by imbalances in the corporate sector. Financial bubbles can also cause recession.

In the early stages of a business cycle (i.e., expansion and contraction), a strong economy gains momentum as it rebuilds itself after the preceding recession. But as the business cycle ages, excesses in one or more sector force central banks to raise interest rates and cool economic activity. The primary reason for this strategy is to control upward pressure on inflation (as the 1970s illustrate the costs of high inflation). Higher rates then start to weigh on growth and eventually the economy tips into recession.

It is worth mentioning that central banks have a horrible track record when it comes to predicting recession. In fact, the Fed has failed to predict even a single recession!

Financial markets are usually the first to sniff out recession, which is why strategists often point out that stocks lead the economy.

So why is this time different?

Several points:

-         First, interest rates were already at or near zero when it became clear to policymakers that a recession was coming. Before each recession over the past fifty years, interest rates were at least 5%. This means that the central bank could gradually ease policy by cutting rates. Today that option is unavailable.  

-         Second, central banks have already used additional tools that could help combat the impending recession. Quantitative easing would be just one example. This means that there aren’t many monetary policy options remain in the toolbox.

-         Third, central banks have been manipulating the yield curve for many years through their quantitative easing programs, blurring the signal from any future changes in the curve. Usually the government bond curve steepens before and after recession. Since central banks have been intentionally distorting the long-end of the curve, this once reliable indicator might be less useful.

-         Fourth, unlike past recessions, inflation has been dormant for a very long time. Inflation usually accelerates into recession, and peaks during the contraction. But we haven’t seen inflation in many years, making it much more difficult for investors and policymakers to estimate the outlook for inflation. The second-order effects of this point are significant, since uncertainty about the path for prices increases the probability of a policy mistake.  

-         Fifth, government debt levels are elevated and the economic costs of this upcoming recession remain unknown. This implies that government debt-to-gdp ratios could shoot upward.

-         Sixth, and perhaps most important, the recession lies ahead of us, not behind us. We still don’t know what the economic situation will look like in the next 6-12 months. Growth might continue to be weak through the year; but since central banks and governments have already deployed their main tools to combat recession, additional ways for policymakers to alleviate future pressure could become very scarce. This might lead to a negative feedback loop in the economy that becomes increasingly difficult to reverse.

-         Seventh, this recession will mark the first contraction since the Great Financial Crisis (GFC). This is an important point because the GFC might have changed household and business perceptions in ways that we do not yet understand. For instance, the scars of the GFC could put additional downward pressure on consumer spending and business investment, extending the duration and severity of this crisis.  

There are probably other reasons why this recession is different from previous ones. But I think the aforementioned points are sufficient to argue that this time is different, and not in a good way.

Nonetheless, investors should remember that some of the best opportunities arise when the economic system fundamentally changes, as seems to be the case today.

Did the GFC mark the beginning of a new era for business cycles and recession? I think so, and I think this crisis will help us answer important questions and be more prepared for future downturns.  

In terms of the current market outlook, I remain negative. Investors should stay defensive, and avoid bottom-fishing at this point. Yes, if concerns about the virus dissipate or a vaccination is discovered, there will be excessive stimulus in the economy. But that scenario does not seem likely. And furthermore, if the economy begins to improve as concerns about the virus fade, policymakers will roll back some of their emergency measures.

The valuation of companies that have suffered most during this selloff certainly look very compelling, and the overall market is visibly cheaper today. But even cheap things can get cheaper.

I struggle to see how stocks will rally over the coming months alongside very weak economic and earnings data. Will stocks rally when we start seeing massive job losses and downward pressure on income growth? I don’t think so. In fact, the slew of bad data we should expect for the coming months will likely put additional downward pressure on the household and business sectors.

Lastly, policymakers have been trigger happy with stimulus. This is a mistake, potentially a very serious one. The past thirty years of peace and prosperity have softened society’s ability to deal with crises. As a result, policymakers have become increasingly geared toward playing the lead role as a knight-in-shining amour. But sometimes you need to hold back some of the cavalry in case there is another enemy battalion over the ridge.

(Please note, the views laid out above are primarily related to the U.S. economy. In economies that have serious macro imbalances, like Canada and Australia, there will be additional and more serious consequences as this recession unfolds. The severity and duration of the recession in Canada will be deeper and longer, respectively, and therefore investors should stay short Canadian assets (aside from government bonds). A housing crisis is coming.)