The fear of recession is mounting in the United
States.
Where do you peg the probability of a recession?
Right now? Let's say by year end, I'd say about 50/50.
It's pretty close.
In June 2022, the World Bank slashed its global growth
forecast to 2.9%, warning that several countries could
fall into recession.
I think there's a lot of fear just around how it's
going to play out, how long it's going to be, and how
deep it's going to be.
And it hurts a lot of people.
I think the pain tends to be kind of concentrated in
the victims of the recession. But none of us
can be completely sure that we or our families are not
going to be among those victims.
Recessions also often impact the valuation of other asset
classes, like the value of your house or the value of
your car.
And last but not least, it's that really most
important one, that increase in the unemployment
rate, where people really fear that they could lose a
job and thus lose income.
I do believe recessions are really inevitable.
I believe that the economic cycle exists.
But some believe that this isn't all bad news.
Some investors, they look at recessions as opportunities.
This is an opportunity to buy this asset that's now on
sale and now it's at fair value.
I think it's really important to just understand
the mechanics because I think when you do, knowledge
is power, information is power, and then you can
start to be able to seize the moment.
So why do recessions happen and are they an inevitable
part of the American economy?
The National Bureau of Economic Research defines a
recession as a significant decline in economic activity
that's spread across the economy and lasts more than
a few months. It's been synonymous with major
economic pain felt by businesses and consumers
alike. The Congressional Research Service cites three
main causes of a recession.
The first is an overheated economy.
When economists talk about the economy overheating,
they mean that demand in the economy is growing
faster than the ability of the supply side of the
economy to satisfy it.
And that can be because we just can't produce enough
stuff, or it can be because we don't have enough
workers.
A hot spike in inflation alongside a dip in the
unemployment rate could signal that the economy may
be overheating. Every recession but one since
World War II has seen an inflation hike right before
the start of the downturn.
And nearly every recession since World War II saw the
unemployment rate fall to 5% or lower.
When unemployment gets really low, it means that
there's not really very many available workers for
firms to hire.
And if firms can't find workers to hire, then they
have to start bidding up wages. As they start paying
people more, people have more income with which to
buy goods and services.
More income buying goods and services tends to push
up the prices of goods and services. So you get a
positive feedback between wages moving higher, pushes
prices higher, pushes wages higher, pushes prices
higher. And if the Federal Reserve didn't intervene by
inducing a recession and raising interest rates, that
spiral would get stronger and stronger and stronger.
And eventually you'd have inflation running away and
really getting out of control.
Asset bubbles can be another direct cause.
The recession of 2001 was primarily caused by the
dot-com bubble burst of 2000, while the Great
Recession occurred just after the crash of the
housing market.
Asset prices, whether they're stock prices or
house prices, go up a lot, and they exceed the
fundamentals, and then suddenly they come down
abruptly. That has a big negative effect on the
economy, particularly if people have borrowed to buy
those assets.
When that happens, people find out that they're not as
wealthy as they thought that they were.
And when you find out that you're not as wealthy as you
thought that you were, you cut back on your spending.
And as you cut back on your spending, that decreases
demand in the economy, and it slows the economy down,
and then enough of it can cause a recession.
In other times, recessions are caused by unpredictable
events that lead to severe disruptions.
Economists call these events black swans.
These are the things that, unfortunately, we cannot
manage. You cannot control geopolitical events.
You cannot control COVID-19.
But when they do happen, usually they're fast and
furious and have an immediate impact.
And that's what drove us into a very quick recession
throughout COVID and others that we've seen through the
course of time.
The U.S. has experienced at least 30 recessions
throughout history, dating back as early as 1857.
They may have become an inevitable part of the
economic cycle that fluctuates between periods
of expansion and contraction.
History teaches us that recessions are inevitable.
I do think recessions are part of our business cycle.
Do I believe that they're completely inevitable in a
capitalistic society?
Partly. There's so many events and external factors
that contribute to recessions, such as supply
shocks, demand shocks, geopolitical issues that
come about.
It's part of human psychology to get too
excited about things. And when you get too excited
about things, you ultimately have asset
bubbles and those ultimately lead to
recessions. It's also part of human nature that people
will continue expanding their firms and businesses
as long as the economy is good.
And as long as that keeps happening, you'll eventually
overheat, which eventually will lead to a recession.
Nonetheless, certain measures can be taken to
make recessions less likely .
As the nation's authority on monetary policies, the
Federal Reserve plays a critical role in managing
recessions.
With the right monetary policies, the Fed can
prevent a recession.
It's just very difficult to do so.
There are two things that the Fed can do to avoid a
recession. One is to steer the economy so we don't get
so much inflation that they have to slam on the brakes.
The second is to pay close attention to the financial
system so we don't have a repeat like the 2007, 2008
and 2009 recession, which was caused by too much
lending, too many mortgages, and too much
careless securitization on the part of Wall Street.
The Fed has often attempted to avoid a recession by
engineering what's known as a soft landing.
This is where precise interest rate hikes are used
to curb inflation without pushing the economy into
recession. But a successful soft landing is extremely
rare, arguably achieved just once, in 1994.
So what they're trying to do is raise rates enough so
demand slows.
So it's really a tough needle that they're trying
to thread to get our economy in equilibrium.
Now the question is, is there an amount of pressure
that they can apply onto the breaks that's enough to
control inflation, but not enough to crash the economy
? And the truth is that that's really, really
difficult to get into that really, really narrow zone.
It's the difference between trying to land an airplane
in a really wide, spacious, open field versus trying to
land an airplane on a very, very narrow piece of land
with rocks and water on either side.
Some experts argue that policies have a clear
limitation on what they can achieve against an impending
downturn.
Policy tends to operate with long lags.
I also think that increasingly we live in a
global economy where the cross-currents that are
impacting the economic dynamics are very complex.
These are dynamics that the Fed doesn't have tools to
address. And so, you know, to a certain extent, we do
think that policymakers have certainly developed
more tools to fight recessions, but we don't
think that you can rely on policymakers to prevent
recessions.
There are several early signs of recession that
investors look out for.
One tool that's commonly cited is the yield curve,
right? The yield curve inversion.
When the yield curve tends to invert, it means that
people expect that the bond market expects interest
rates to be higher in the short term than it does in
the long term. That's because the Federal Reserve
hikes rates to control inflation, and then after
inflation is controlled, it cuts interest rates back
down. So if you see that the market expects high
interest rates in the short term and low interest rates
in the long term, that's indicative that a recession
is coming, followed by an interest rate cutting cycle.
A lot of people look at some of the manufacturing indices
like the ISM Manufacturing Index.
When it tends to be above 50, that means that the
economy is expanding.
But when the ISM starts decelerating and approaches
50, a lot of people say, okay, the manufacturing side
of the economy is going to contract, that that could be
a recession indicator.
The third recession indicator that a lot of
people look at is consumer confidence and suggest that,
well, if consumer sentiment and consumer confidence goes
negative, that means consumers are going to pull
in, take the credit cards away, and not spend.
And that could cause a contraction in the economy.
A diverse portfolio can often provide the best
defense.
Diversify your holdings of assets to make sure that
you're including not only growth stocks, but more
value stocks and more defensive stocks.
Like health care, like the utilities market.
These are the companies that could manage through
this process a little more effectively than some of the
hypergrowth firms that are leveraging the credit market
more so than a company with a ton of free cash flow and
really strong balance sheets. And that's why I
think there can be some value in recessions, not too
deep and not too long, but in scenarios where we are
overheating, assets have gotten way out of whack, and
we need to get to a point where they get back to fair
value.
It also creates opportunities to be a stock
picker. It's very hard to buy stocks in a bull market,
but very often recessions and the bear markets that
come with it create brief opportunities to really
reload your portfolio, to buy the stocks that you've
wanted to own, essentially at sale prices.
But whether recessions are actually good for the
economy remains widely debated.
Look, recessions are very healthy things for the
economy because ultimately recessions flush out
excesses. So you think about it, when we have a
recession, it reduces whatever extreme bubbles may
have built up.
I think that's ridiculous.
This notion that somehow we need to cleanse the system
and the recession is a cleansing thing.
It's like saying everybody should have a heart attack
once in a while because it'll make them eat better
and exercise more.
It's just not true.
You know, recessions cause job loss and every job loss
is enormously unfortunate.
Becoming unemployed has enormously disrupted
people's lives. It causes enormous pain for families,
for households, for communities.
It's terrible.
For Americans, understanding how recession works can best
help them prepare for whatever may lie ahead.
Understanding the dynamics of a recession allows you to
potentially be more opportunistic and protective
of your wealth should these downturns happen.
Knowing that it may be coming can help you think
through decisions about: Do you want to buy a house or
do you want to rent?
Do you want to take a new job or do you want to maybe
wait because because the job market may soften up?
These are all things that, if you possess the knowledge
of the business cycle, can help you manage your
financial life in a much better way.