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Pod: Is the US Headed For a Recession?
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Pod: Is the US Headed For a Recession?

Episode 2
2

In this episode, we cover the basics of what a recession is and how to recognize one, the Fed's efforts to induce economic contraction through raising rates, the leading indicators of a coming recession, and how to position yourself for a potential recession.

Today’s Bullets:

  • What is a Recession?

  • Yield Curves

  • GDP, GDI & Corporate Profits

  • False Confidence Signals

  • How to Position Yourself

Relevant Charts:

Fed Funds Rate
UST 10yr - 2yr Spread
UST 10yr - 3mo Spread
Bloomberg Professional

Links:

Full Transcript:

Welcome to The Informationist, the podcast that breaks down complex financial concepts into simple, fast, and easy-to-understand terms. We understand that financial jargon can be overwhelming, so we make it our mission to bring you accessible information, helping you to use financial terms and concepts to your advantage. Stay updated by subscribing to The Informationist podcast today!

In today's episode, we'll cover the basics of what a recession is and how to recognize one, the Fed's efforts to induce economic contraction through raising rates, as well as the leading indicators of a coming recession. And be sure to listen to the end, where we cover ways an investor can position themself for a potential recession.

Recession.

Are we headed for one or going to avoid it altogether? On one side, we have the White House and the Fed The White House saying there will be no recession, and the Fed insisting there will be a ‘soft landing’, or barely any recession at all. On the other side, it seems we have everyone else.

Portfolio managers have been talking about a looming recession for months. Bloomberg agrees, with 65% of economists surveyed seeing a recession in the next year. And Bloomberg’s own models give an even higher likelihood of a recession in the near future, as we will detail later.

But who’s right?

And what exactly is a recession, anyway? Seems that goalpost has moved recently, too. But no worry, we’re going to cover all that and more, nice and easy as always, today. So, let’s get to it.

Let’s start with the basics, shall we? I mean, what is a recession, and before predicting any, how can we tell that we are, in fact, in one?

Well, using various economic definitions and descriptions, a recession is simply a period of economic decline lasting at least six months. Indicators of a recession include a decrease in GDP, rising unemployment, and reduced spending by consumers and businesses.

I know, I know, we had two consecutive quarters of contracting GDP last year. But conflicting data, like continued low unemployment and rising wages (even if they did not quite keep up with inflation—I mean, do they ever really?!?🙄), plus increased spending all point to an economy that’s not really contracting.

Yet.

But the Fed is looking to change that. By jacking up the Fed Funds rate by almost 5 full percent in the last twelve months, the Fed is looking to tighten financial liquidity (i.e., access to cheap money) and squash demand in order to lower inflation.

So, even as Fed members speak out of both sides of their mouths, i.e., we need unemployment higher and prices lower, but we can still avoid a recession…they know in their dark little hearts that they must induce economic pain in order to tackle the stickiest transitory inflation that they’ve ever experienced.

But why do they do this? Why do they use silly terms like ‘soft landing’—whatever that even means—when describing what they know damned well to be hurtful economic contraction.

Say it with me: recession.

Maybe a little history will help us better understand. See, back in the late 70s, Cornell economist Alfred Kahn was appointed by President Jimmy Carter as chairman of the Council on Wage and Price Stability. In short, Kahn was responsible for overseeing and managing the federal government's efforts to control inflation. Kahn was therefore referred to as the Inflation Czar. However, Kahn was constantly in trouble with Carter and his cabinet for referring to the terrible economic conditions of the time as a “depression” or “recession.”

Known for his use of plain English in the classroom, this annoyed Kahn to no end. His response? He said, fine, I’ll use the word banana instead. And so, quoted in the Washington Post, Kahn said, "Between 1973 and 1975 we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly."

Sounds like soft-landing really means banana. If we can’t trust their words, what can we trust?

That’s right. Data. Cold. Hard. Real. The true indicators.

Some of you have heard me talk about this quite a bit before, but one of the leading indicators of a coming recession is the inversion of the US Treasury yield curve. It’s a leading indicator for two reasons: it is one of the earliest indicators we have, and it’s also one of the most reliable. I’ve written all about yield curve inversions and simplified the concept thoroughly in a recent post titled: Yield Curve Inversions: The Ultimate Signal of a Coming Recession? You can find a link to the article in the show notes.

TL:;DR: when longer dated Treasuries, like the 10-year, have lower yields than shorter maturities, like the 3-month or 2-year, this indicates an economy is headed for trouble.

There are a host of reasons for this that you can read all about in that article. But suffice to say that the inversion of the 10yr-2yr and 10yr-3mo curves usually happens somewhere between 6 to 18 months before the actual onset of a recession.

Check out the charts in the show notes.

For those who can’t see the charts, they show that a recession followed every single inversion of either spread. Super reliable, but few things I notice: First, the 10yr to 3mo spread seems to be the most reliable indicator of the two. Second, it looks like that curve inverted in late October/early November, and the 10yr to 2yr inverted even earlier, back in early July, which puts a recession on the table for anywhere from this spring to early 2024. Third, the magnitude of both inversions hasn’t been this bad since the 1980’s (for those of you didn’t live through that one, it sucked. Period.) And lastly, they appear to just be getting worse.

Lovely.

Another pretty big red flag is that the Bureau of Economic Analysis’ two main measures of economic activity have diverged in the last two quarters. GDP and GDI. Gross Domestic Product (GDP) is the total market value of all finished goods and services produced by an economy, and Gross Domestic Income (GDI) is the total income generated by an economy in a given period. When these diverge, there’s a profitability issue. To simplify: cost to produce goods is rising, while income generated from that production is decreasing.

A Business 101 no-no.

Low and behold, GDP rose 2.6%, while GDI fell by 3.3% in the last quarter of 2022 (this was revised quite a bit lower from the original measure of   -1.1%, by the way), and GDP rose by just 1.3% while GDI fell by 2.3% in the first quarter of 2023.

Not good.

Digging deeper, let’s turn to corporate profits, as that’s an actual indication of a contraction of profitability. In short, pre-tax corporate profits also fell 2% in the last quarter of 2022: And, in an echo of the GDP/GDI indicator, the S&P 500’s net-income-to-sales ratio for the first quarter of 2023 also dropped steeply. It’s therefore no surprise that 93% of CEOs are preparing for a recession in 2023, and over half believe that a recession is their greatest challenge for the year ahead, according to the Conference Board’s Measure of CEO Confidence.

OK, so it seems that companies and their executives are starting to see and feel the signs of contraction. What else? While there are many many other places we can look, like housing, and intricate sales data, among other things, there are sometimes places we look that give us a false sense of confidence.

Let’s talk about that.

🤥 False Confidence Signals

One of the signals that I consistently hear investors key in on is employment. I mean, if people are not losing their jobs, then the economy must be ok, right? All we hear from the Fed is: no unemployment = no recession. Seems reasonable. Until we look at the facts. The data.

When looking at a chart that plots unemployment versus recessions, for instance, and focus on when unemployment rises versus when a recession starts, we see something interesting. Unemployment seems to barely tick up before a recession and then spikes dramatically once we are actually in a recession. Seems that looking at rising unemployment as an indicator of a coming recession is like crossing the street and watching for cars as a bus quietly flattens you.

So, the next time you hear someone say, we’re at full employment, there must not be a recession coming anytime soon, show them that chart. It’s in the show notes. Be sure to point out the 70’s, 80’s and that lovely dagger of 2008. They kind of remind me of the Fed Funds chart, actually. The one where rates spike from near zero to over 5% in less than a year. Like flying a plane straight up into the atmosphere, just waiting for it dive-bomb back to earth again. Maybe that’s why Bloomberg’s own models say that there is a 100% chance of recession by the end of this year. Yes, you heard that right. 100%.

So if we expect a recession, how can we position ourselves?

If you’ve been listening to me and reading my work, then you know how I’m currently positioned for the year ahead. First, I’ve been buying metals and hard monies like gold, silver and Bitcoin, and continue to add to them opportunistically. I also hold short term USTs and a high allocation to FDIC-insured money markets, in order to keep plenty of liquidity, dry powder, at the ready. So, I can pounce when the time is right. Because I agree with Bloomberg’s models and I’m anticipating the inevitable:

Either we get some sort of credit event (like another run on regional banks, or worse) that causes a major market disruption and selloff, or we do in fact get the dreaded reality of a full-on recession.

Or should I call it…a banana. 🍌

The information in this newsletter is not intended to constitute individual investment advice and is not designed to meet your personal financial situation. It is provided for information purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. We strongly advise you discuss your investment options with your financial adviser prior to making any investments, including whether any investment is suitable for your specific needs.

Subscribe to The Informationist newsletter to stay informed, break down information barriers, and learn about financial concepts quickly and easily at www dot james lavish dot com.

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The Informationist
The Informationist
Welcome to The Informationist, the podcast that breaks down financial concepts into simple, fast, and easy-to-understand terms. We realize that Wall Street jargon can be overwhelming, so we make it our mission to bring you accessible information, helping you to use financial terms and concepts to your advantage.
Stay updated by subscribing to The Informationist podcast today!
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James Lavish, CFA