Good morning. Here’s your Early Warning for Tuesday, 26 March 2019.
This morning, I’m going to focus my thoughts on the next recession. Tomorrow I’ll go back to the usual Early Warning format.
Several weeks ago, I received an email encouraging me to explain why I think the next recession matters so greatly. Here it goes.
Talk of recession continues to permeate economic and investment circles. I think that’s largely due to the length of this economic expansion and the surprise or terror the thought of recession brings.
We’re nearing the part of 2019 where some early predictions last year expected a recession. It appears way too early, although weak Q1 numbers are likely to fuel speculation that recession is or could be imminent. That could become a self-fulfilling prophecy, however, pending some black swan event, most watchers expect Q2 growth to bounce back in the range of 2-2.5 percent growth.
One recent prediction from Bernard Baumohl, chief global economist for The Economic Outlook Group, is a recession in early 2021. Other investors and economists, like Ray Dalio, are also revising their expectations backwards past 2020. Predictions and expectations are still all over the place, and there are a few economists who believe that we’ll skip the ‘coming’ recession entirely.
One project I’ll begin working on is a chart of prominent investors and economists and their outlook on recession. Plotted on a timeline, I think we’ll be able to get a better picture of where they stand, and that could better inform our expectations, as well.
Last week’s 10-year and 3-month yield curve inversion is a typically reliable signal of recession within 18 months. And there are numerous other leading indicators of recession that we’re watching, as well. Since December’s statement, the Federal Reserve is signaling concern over raising interest rates too quickly, as evidenced by the Fed’s 180-degree reversal on rate hikes for 2019. Not only may there not be additional rate hikes, but some investors actually expect a rate cut.
First, we have to differentiate between a recession and a financial crisis. In 2008, we had both and both were painful. The financial crisis was the result of a real estate bubble, and the recession was more painful than most. The recovery was also more muted than most. Growth after the end of a recession is usually very good. In 1932, the economy contracted by 12.9 percent. Two years later, growth was back up to 10.8 percent annualized. In 1935 and 1936, the economy grew by 8.9 percent and 12.9 percent, respectively. Those were the bounce-back years after the worst part of the Great Depression. As has been well-publicized, the Obama recover was weak — just 2.6 percent in 2010 and 1.6 percent in 2011.
Looking forward to 2020-2021, I do wonder about two major factors. The first is what the Fed’s monetary policies will look like. The second is what the president’s economic policies will look like. It’s impossible — impossible — to have accurate expectations of the next recession without knowing those two things.
Also, there are numerous signs of bubbles forming in the economy. One question that remains is whether or not we’ll see another simultaneous financial crisis (bubble burst) and recession. One argument goes that these bubbles, some or all, could smoothly deflate or not burst at all during the next recession. Anyone who believes that every bubble must pop is making an assumption, and it may be a faulty assumption. The next recession, in addition to potentially being moderate, may not last the average of 11 months, either. Pro-growth policies could mute the effects of the next recession. I’m entirely open to the idea that the next recession occurs without a financial crisis. That would mean another delay to the eventual reckoning.
There is no shortage of voices who are characterizing the next recession as, in the words of Fred Sanford, ‘the big one.’ Those people are speculating, and I think doing a disservice to readers by not considering the alternative here. I think we should consider the alternative and instead of succumbing to confirmation bias — that is, gathering data that supports your expectations at the expense of data that conflicts with your expectations — we should keep an open mind and consider each piece of information, regardless of where it points.
That said, there is the potential that the next recession could be quite bad. This would be another financial crisis coinciding with a recession. There is undoubtedly a corporate debt bubble, as there is likely a municipal bond bubble. Loose money policy means cheap loans, and U.S. corporations have accumulated some $9 trillion in cheap debt. There certainly is an argument that puts some corporations at risk of defaulting on those loans if the next recession is long enough or steep enough. To put this into perspective, the size of U.S. home mortgages in 2007 was around $7 trillion, so the corporate debt bubble today is larger than the housing bubble was in 2007.
Here’s exactly where I stand as of this morning:
I’m not an economist (potentially to my credit). I am an observer of investors and economists, and the ‘consensus’ informs part of my rationale. I weigh the opinions of successful investors and economists who have an above average track record more heavily than I do the opinions of professional pundits and doomsday entrepreneurs. I also recognize the human tendency to allow emotion, especially fear, to override rational thought.
Right now, I believe that the major financial and fiscal reckoning is farther away than a year or two. Later in the 2020s and into the 2030s, there are going to be some likely unavoidable hurdles and challenges for which state governments especially are ill-prepared, and for which the federal government is not preparing. There’s a $184 trillion shortfall in federal government spending alone over the next 30 years. For the next couple years, however, I think persistently weak growth is more likely than another Great Recession or Great Depression scenario. And if the next recession avoids any major financial crisis, then pro-business and pro-growth policies could ease an economic downturn. That, however, depends on the decisions of policy makers, and whether their decisions make things better or worse.
Our near- to mid-term economic future is less likely to hit a brick wall than it is to endure a bumpy road. Also, the magnitudes of those bumps are more likely to be regional. States will good balance sheets and growth industries are obviously more likely to fare better than those with high levels of debt. Leaving states with poor financial health would be a prudent step for those concerned about the coming state-level financial crises, which could be persistent and very disruptive (i.e., the public pension crisis). Here’s a great resource from the Mercatus Center to check your state’s fiscal health.
Regardless of where you live, however, we’re likely to see higher tax rates in the future than we do now. The federal government could be forced into some extreme measures to deal with the coming fiscal tsunami, but raising taxes across the boards is going to be the easiest and most politically palatable response. We’re likely to see the same with state-level tax rates, which is going to push a higher number of wealthy residents into lower tax and business friendly states. That’s a shift we’re already seeing (e.g., California and New York), and that problem will become self-reinforcing for states with poor fiscal health.
There’s absolutely no way to tell with any authority or certainty how bad things will be 12-24 months from now, however, a ‘preponderance of the evidence’ leads me to believe that our worst fears are more likely to come after this period, than before or during this period.
I hope that helps you understand my stance. I’m certainly open to comments, feedback, questions, disagreements and hate mail.