When Will The Recession Finally Hit?

When Will The Recession Finally Hit?

Michael Kantrowitz, CFA 's incredibly useful HOPE framework illustrates how rising interest rates ripple across the economy. And surprise surprise, interest rates don’t impact all the sectors at the same time, which explains why some are slowing, but some aren’t (yet).

Here's a short recap of an article I wrote for Finimize a few months ago:

Housing: First to slow

Higher interest rates translate to higher mortgage rates, and add to the cost of buying a home. This reduces demand for new houses and puts downward pressure on house prices. And weaknesses in the housing market have a huge impact on the broader economy: residential real estate is the largest asset class in the world, it represents a huge share of consumers’ wealth, and directly links to key sectors like construction or financial services. So when the housing market sneezes, the rest of the economy catches a cold.?

Orders: Second to slow

Falling house prices and rising mortgage rates then squeeze consumers’ disposable income. Their confidence dips and they plan to slow their consumption. Companies anticipate that, and adjust their production as soon as they can. Business sentiment follows consumer sentiment lower, new orders slow, and sales of manufacturing and capital goods take a hit. The economic environment is deteriorating, but many companies manage to keep their profits up by delaying spending, cutting costs, or passing them on to their consumers.

Profits: Third to slow

Eventually, a slowdown in consumer spending and an increase in financing costs start to bite. Companies’ margins and revenue growth dip and companies start firing workers and abandoning their expansion plans. This further hits consumer spending and negatively feeds through other sectors. It’s generally only at this point that the economy is “officially” in recession.?

Employment: The last domino to fall

Employment tends to be the most lagging indicator of all. It’s only after house prices are falling, consumers are cutting their spending, and firms are downsizing aggressively that unemployment rises. And while this is the moment when economists and investors’ sentiment are most bearish, it’s generally when it’s time to start buying risky assets like stocks, which will start to anticipate the recovery.?

So what?

With housing and orders indicators in a free fall but companies’ profits and employment still strong, we’re arguably between the “Orders” and “Profits” phases. According to that framework, that tends to precede a more general slowdown in the economy by 3 to 12 months. Now, of course, remember that it’s a framework and not an exact recipe. But it clearly shows that if some sectors still appear strong, it’s simply because higher rates haven’t impacted them yet. By tracking closely those indicators, you’ll have a better idea of which stage the economy is at, and what might come next.?

On my end, I remain very cautious about stocks in the near term. The economy has been following the HOPE framework pretty closely so far and I expect this to continue. Investors seem overly optimistic about margins and earnings growth, but the framework shows this is likely the next domino to fall. What’s more, the Fed is still focused on employment and inflation – the most lagging indicators of all – meaning that they’ll probably keep hiking while the economy continues to slow. That’s a pretty bad environment for stocks. And while sentiment has turned more cautious, we haven’t seen any real capitulation yet. So I’m happy to wait on the sidelines, and preserve my financial and emotional capital in order to fully capitalize on the buying opportunity when it appears. Stay safe out there!