Recession? Or No?

You cannot turn on the news these days without hearing hostile arguments about whether we are or are not already in a recession. With news of a second consecutive quarter of GDP decline, those who dislike the current administration declare that we are. Those on the other side of the aisle say that two consecutive quarters of decline is not the official definition of a recession. The latter point to various economics professors and the National Bureau of Economic Research (NBER), which sets the official dates of economic cycles.

My answer to this debate is "who cares?" I have two favorite quotes regarding economists:

• “An economist is an expert who will know tomorrow why the things he predicted yesterday didn't happen today.” - Laurence J. Peter
• "If all the economists were laid end to end, they would not reach a conclusion." - George Bernard Shaw

The fact of the matter is that there is no official definition of a recession, at least not that economists or the NBER committee will let you nail them down on. The answer involves many factors and nebulous considerations that economists consider in order to determine the answer to the question. The NBER waits until sufficient time has passed where they can clearly see the peak of economic activity, such as in December of 2008 when they declared the peak happened in December 2007. Often, the official dates are changed as some figures are revised. Economists will never declare that we are in a recession until the data makes it obvious, and they never know at the outset that we are going into one.

The Data

The reason I say "who cares?" is because the labels put on the present situation by these quasi-pundits don't change the task at hand for business leaders. Executives must analyze multiple trends and determine how to best insulate their organizations from potential risks. Here are some key trends to consider:

• Unemployment - Many economists and reporters point out that the unemployment rate is dropping not increasing, as typically happens during recessionary periods. In a vacuum, that is an interesting statistic; however, consider the labor participation rate. We just came through a period where massive stimulus was distributed. Many on unemployment were making more than they did at their prior job. People stayed on the sidelines in record numbers until inflation went through the roof and they were forced to go back to work. The labor participation rate is lowest it has been over the last 10 years. In the near term, unemployment is likely to drop as people return to the work force. Note - FRED stands for Federal Reserve Economic Data, published by the St. Louis Fed. The gray bars on those graphs indicate U.S. recessions.

• Consumer Sentiment - This probably does not need data justification, as most of us are aware, but consumers are hurting and not expecting things to improve in the near term.

• CEO Confidence Index - Business leaders are not optimistic about the coming year, which means they will tighten control on expenses, and possibly reduce force if things worsen to a significant degree.

• ISM Manufacturing and Services Index - The Institute for Supply Chain Management publishes several reports that track factors correlated with economic expansion and contraction, specifically the Manufacturing and Services Industry PMI. When these trends drop below 50, it is an indication that we are in a period of contraction. Both indices are headed that way.

• Inverted Yield Curve - The difference between short term and long term treasury yields is frequently a leading indicator of recession. This happens when short term yields are higher than long term ones, indicating investors' expectations about the future.

• Inflation - This is another factor that has already received much attention. Inflation is at 40 year highs, fuel prices are through the roof and other economic staples are either in short supply or have shown significant price increases. Notably, vehicle prices have increased 40 percent in the last 12-15 months.

• Other Factors - Four days ago, the Federal Reserve raised rates by 75 basis points for the second time this year, with more increases expected over the next 18 months. These steps are considered necessary to reign in inflation, but they will most likely result in economic contraction as we saw in the late 1970s. This will lead to a tightening in the money supply and available credit. Add to this a somewhat burdensome regulatory environment and the likely passage of an increase in corporate taxes by the end of the year and you have some turbulent waters ahead for business leaders.

Planning for Risk

The purpose in pointing out the above is not to advocate for a particular policy or political viewpoint. Rather, it is to illustrate that these risks exist and leaders must anticipate the impact to their business. For my friends in consumer lending, I recommend the following:

• Ensure your company has excess debt capacity. In auto lending, while sales of new and used vehicles are down, pricing is high - leading to more consumers choosing to finance their purchase. Many lenders are seeing an increase in unit and dollar volume. It is wise to retain debt capacity so as to continue funding loans, particularly if the securitization market contracts or becomes impractically expensive.
• Delinquency and losses fell 20 to 30 percent during the COVID period due to record loan forbearance, stimulus and unemployment benefits. Presently, credit performance is returning to the typical baseline (a relative increase back to normal). With the headwinds we are seeing in the economy, performance will likely worsen modestly for the most debt stressed consumers. To mitigate this, lenders should reduce the upper limit on Payment to Income Ratio (PTI) and Debt to Income Ratio in their riskiest tiers. Planning for recessionary periods doesn't mean restructuring the entire credit program, just tightening where the greatest risk is concentrated. Also consider modifying requirements for maximum amount financed, minimum down payment (and for auto lenders, capping advance rates in the lowest tiers below current levels). Modest changes can go a long way to leveling off performance volatility across the credit cycle.
• For auto lenders, pay close attention to auction values. As vehicle values decline, which is likely over the next 18 to 24 months, it will be increasingly important for credit managers to slowly offset those declines with tighter policy in the lowest tiers.

About the Author: Daniel Parry is co-founder and CEO of TruDecision Inc., a fintech company focused on bringing competitive advantages to lenders through analytic technology. He was also co-founder and CEO of Praxis Finance, a portfolio acquisition company, and co-founder and former chief credit officer for Exeter Finance. Prior to Exeter Finance, he was SVP of Credit Risk Management at AmeriCredit Corp/GM Financial. If you have questions, you may reach Daniel [email protected].

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