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  • Writer's pictureThe Student Investor

Opinion: Weighing the Risks of a Recession

Updated: Nov 14, 2022

Written By William Meng

Only two years after the deepest economic plunge since WWII due to the pandemic, yet another recession may be just around the corner. With inflation, continuing supply-chain woes, and more recently lockdowns in China and the Russo-Ukraine war dampening growth expectations, there are indications for a possible global downturn. And while central banks around the world embark on the most aggressive tightening campaigns in decades, economies might just be in for a hard landing.

Key Takeaways

· The yield curve is signalling a recession

· Inflation is weighing on consumers

· Central banks are tightening into weakening economies

· Employment is a lagging indicator

The Yield Curve Recently Inverted

Investors and economists make a lot of noise about the yield curve. Although it is seemingly insignificant, all ten recessions in the U.S. since 1955 were correctly signalled by an inversion of the yield curve. Investors have learned from history that the yield curve is something to pay close attention to.

The yield curve simply refers to the different interest rates that bonds of equal risk yield depending on the duration. Investors and economists typically follow the yield curve of U.S. Treasuries, which often serve as a global benchmark for interest rates. A normal yield curve is upwards sloping, with longer term bonds yielding higher rates than short-term ones as investors demand higher interest as compensation for investing their cash for a longer duration. A yield curve inversion occurs when yields on the short end go higher than long-term rates, and the yield curve becomes downwards sloping.

In late March of this year, the yield curve inverted and the yield on the 2-year treasury went above the yield on the 10-year. When the yield curve inverts, recessions typically follow within 6-18 months.

Spread between 2 and 10-year treasuries with shaded areas indicating recessions. Note the frequency of recessions following a spread of less than zero, or an inversion.

Elevated Inflation Weighing on Consumers

With inflation rates at multi-decade highs around the world, consumers and businesses have been getting squeezed. Many economists like to point out the solid balance sheets of households and strong spending from the consumer as cases for continued growth. However, it is more likely that high consumer spending is a result of inflation rather than economic activity. Recently released Q1 earnings from retailers such as Walmart and Target missed expectations by a wide margin, with soaring input costs being to blame. Walmart noted that many consumers were budget-strapped and spending more on fewer items. This is in line with the University of Michigan’s consumer sentiment index, which came in at a 10-year low for May. Moreover, personal savings rates in the US hit a new low of 4.4 percent in April - the lowest since 2008.

Indeed, food and energy have seen year-over-year inflation rates approaching the double-digits, forcing consumers to cut discretionary spending as more and more of their budgets go towards essential expenditures. This bodes particularly badly for consumption-based economies such as the US, where consumer spending accounts for nearly 70 percent of GDP. Thus, it is inflation that is driving high consumption, which more likely points towards a recession and not growth.

Central Bank Tightening and The Reverse Wealth Effect

With such high rates of inflation, the Fed and other central banks around the world have begun to tighten monetary policy as they look to bring inflation under control. In fact, having already delivered the largest rate hike in 22 years of half a percent, the Fed is expected to raise rates much further and embark on Quantitative Tightening. However, this tightening occurs despite signs of slowing economic growth and a yield curve that only recently inverted. This is the most aggressive tightening by the Fed for the past few decades, and there is a real chance that the Fed may be tightening into a recession. Policy makers have stated their goals for a “soft landing”- in which inflation comes down towards the target of 2 percent while avoiding a recession. However, in recent statements, even Fed chairman Jerome Powell discussed the difficulties of achieving such an outcome, and that the soft landing may only be “soft-ish”.

Elevated inflation and the Fed tightening that is expected to follow has left investors and the markets nervous, and there has been a major decline in the stock market. The S&P 500 recently skirted bear market territory and the NASDAQ is already deep in a bear market. Since the start of 2022, it is estimated that Americans lost $5 trillion in wealth from stock market losses alone. As wealth evaporates, the economy may go down with it.

Consumers tend to be more confident in spending more when their wealth is elevated from a strong stock and real estate market. This is known as the wealth effect, and it is something that the Fed even targeted in their policy response following the Great Financial Crisis. However, with asset prices that are now falling, there is a reverse wealth effect and consumption is likely to fall. And as mentioned previously, soaring prices will continue to curtail spending and amplify this effect.

Q1 GDP Is Already Negative

The recently released GDP estimate for the first quarter shows that the US may already be halfway in a recession. According to the Bureau of Economic Analysis, the US had an annualized contraction of -1.5 percent for Q1 2022. Many investors seemed to have brushed this off - attributing the contraction to increased imports and restocking of inventories. However, it is worth noting that Q1 GDP was still far below analyst expectations for a 1 percent gain. With a recession being defined as two consecutive quarters of declining GDP, if Q2 GDP is also negative, the US will technically be in recession.

What About Near Record Low Unemployment?

The labour market is still very tight as employers struggle to find workers to fill job vacancies. The headline unemployment rate in the US sits at a near record low of 3.6 percent, and jobless claims remain low. Many point out that labour market conditions such as these are not synonymous with recessions. However, it is also worth noting that unemployment is usually very low prior to recessions and when unemployment levels rise, it does so quite rapidly. Employment is a lagging indicator - by the time it signals a recession the economy is already in one. With inflation eroding the purchasing power of consumers and diminishing business margins, employers may begin to layoff workers. Additionally, the recent market sell-off has already led to layoffs in tech companies such as Netflix and various other start-ups.

Headline US unemployment rate since 1950 with shaded areas indicating recessions. Historically, when unemployment rises it does so rapidly, and recessions typically start before the rise in unemployment.

Why The Upcoming Recession will be Different

The mounting recession risk occurs under the backdrop of multi-decade high inflation rates in numerous countries around the world. Given the environment the world is currently in right now, it is unlikely that it will drop back anywhere near the 2% level that is typically targeted by central banks. The war in Ukraine has triggered supply shocks in food and energy which will apply upwards pressure on the price of these necessities. Covid related lockdowns in China will only lead to further supply shortages. Geopolitical tensions between the US, China, Russia, and other nations have added to supply chain disruptions and deglobalization, as countries re-shore supply chains for national security. Finally, given the high levels of debt in developed markets, central banks have very little room to tighten monetary policy to fight inflation. With a tightening cycle that has barely even begun, economies are already showing signs of weakness and real interest rates are still negative - adding to inflationary pressures. Therefore, the real risk is not just a recession but stagflation - which as shown in the 1970s is a nightmarish scenario for policy makers and the economy.

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