10+ years since The Great Recession and the risks of severity are only increasing for the next recession the longer the U.S. goes without a contraction in the economy.
There is a lot of talk about when this economic expansion following the great recession will end, it’s ongoing for 10+ years. Analysts all agree the factors are there for the cycle to end. The problem is knowing what will be the spark that causes the chain of events that brings a recession/contraction. Recessions happen, one cannot avoid them and they demonstrate a healthy economy, to go this long may be a building up an avalanche of economic demise or a change in the predictability of how economic cycles occur and how often.
Why has the Cycle been so long?
This is the easy part to explain. In a phrase interest rates and tax cuts, which was forced to remain low because of the tepid growth. When the current administration took office the conventional wisdom was to expect a recession sometime in 2018. The tax cuts pushed that timeline to the right and as the tax cuts for corporate begin to lose their effect the factors of debt, interest rates, inflation, and the growing trade war with China will have a greater impact because the availability of cash from the tax cuts and increased cost of borrowing taper off the ability to get cash. The pundits tend to think mid-2019 the window for a recession/contraction opens up with chances increasing from there until a recession or downturn occurs.
Fear of the unknown
Everyone is worried about recessions because the last one was so awful and hit main street as hard if not harder than Wall Street. Wall Street recovered, the market is up ~200% and had help from the Federal government with a bailout and interest rates so low it made capital easy to acquire. Main Street by some measures has never recovered, the biggest measure is a remaining lack of confidence and trust in the financial system, only 54% of Americans are invested in the markets.
The problem is now that the economy is back to a growth level normally seen during a recovery, and mechanisms used in 2008 to keep the U.S. from going into depression, instead of a recession, must also now come back to within normal operating limits. So raising the interest rate levels, the unwinding of quantitative easing and the piling on of the national debt thanks to the tax cuts will stress test the resiliency of the U.S. economy. What makes many pundits so nervous is the U.S. stock market is the only market that continues to have a positive return unlike the rest of the world, see the graphic below from Seeking Alpha.
This brings into question if the market is a house of cards and not reflective of reality.
The conventional wisdom is that when the longer this “bull market” continues the greater the risk of recession, like gravity what goes up must come down. The question on everyone’s mind is not if a recession will happen but when, how hard, and how long. Many still have the financial crisis fresh in their minds both on Wall and Main Streets because it was so traumatic and changed perceptions about what was same and what was not. The Fed continues to look at the spread between the 10 year and the 3-month bond yields as a good indicator. When the yield on 3-month treasury bond is greater than the 10-year treasury bond, called an inversion, it is usually an indicator that a recession/contraction is forthcoming. A very good video by the St. Louis Fed does a great job of explaining the Feds thought process.How Well Do Yield Curve Inversions Predict Recessions? | St. Louis Fed
The yield curve plots rates on similar assets with different maturities, such as the 10-year U.S. Treasury note and the…www.stlouisfed.org
And they have the data to back it up.
Bond Yields today are close to inverting which is one of the indicators that make the pundits think we are close.
This cycle ends when the cash flow ends
Like the last crisis will not look like the last one. The ability to get access to cash flow and credit will drive the severity of it though. On Wall Street companies are loading up on debt because it’s cheaper than trying to squeeze more out of stockholders and rounds of capital raising.
For Main Street, it is also about debt and wage growth that can’t keep up with inflation.
Main Street is getting squeezed by these 2 factors more than any other. An important factor to consider from the last recession to the future one is that currently only 54% of the U.S. population is invested in the stock market, in 2008 it was 62%. So the next drop in the stock market may not have the same effect as it did in 2008 but it will still hurt because people, in general, have still not recovered in terms of confidence.
They may have recovered economically but their confidence has not been restored. The paradox is there no required stress test on someone’s personal fiscal viability to give a person confidence. For the next recession, there will be several things tested beyond a person’s personal finances.
Passive vs. Active investing- Which will be the victor in the next downturn?
Active and Passive investing models will be tested and is debated which will handle a recession or downturn best. Passive investing is en vogue at the moment but it is a post-2008 method for investing, how the passive investing react to a downturn is unknown because it has not been tested. Active investors say the passive investing will follow the markets and head south. Those who favor passive investing argue that the advent of fintech will adjust portfolios so when the market turns south the impact will not be as severe as it was in 2008. Who is right? No one knows only time and how the stock market downturn unfolds will tell.
What else will be tested in the next recession?
Other areas that will be tested is the government response. There is general agreement what worked in 2008 won’t work in today’s environment because interest rates still remain low so what else does the government have? That is a good question to which the Fed has not really answered other than to go back to the well of dropping interest rates. The Fed this time may introduce negative interest rates. What that means for Main Street is that a person will have to pay the bank to have their money at the bank. Combine this with high student debt and credit debt translates into a quagmire that may force the U.S. government to “allow the system to reset.” In other words, depression may be the only answer to cleanse the financial system and bring it back within norms of an economic cycle. Although, that may not be the answer either, expect a weak government response because of the debt that has already accumulated on the Treasury Department’s books.
Are we ready?
No of course not, because we don’t know the spark that will cause it. There are a lot of candidates, too many to go through. However, unlike last time the possibility of a contagion is less and it may be more localized on a global scale, but no matter what the U.S. will be affected because it is center of the financial universe. Almost if not all international transactions have to touch a U.S. public or private financial entity but it is still less than in 2008.
McKinsey&Company probably lays out the argument for the risks best. They see 3 major areas of risk.
They also see some additional risks which should also be considered by clicking here. They also probably sum the current risk on the cycle by stating it this way.
The good news is that most of the world’s pockets of debt are unlikely to pose systemic risk. If any one of these potential bubbles burst, it would cause pain for a set of investors and lenders, but none seems poised to produce a 2008-style meltdown. The likelihood of contagion has been greatly reduced by the fact that the market for complex securitizations, credit-default swaps, and the like has largely evaporated (although the growth of the collateralized-loan-obligation market is an exception to this trend).
But one thing we know from history is that the next crisis will not look like the last one. If 2008 taught us anything, it’s the importance of being vigilant when times are still good.
In the final analysis, the cycle will end its just a matter of how and why. The first to figure that out will be the first to profit for the rebuilding that ensues.