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.
