Thoughts On Business Cycles, Recessions, and Financial Markets (Part 2)
On the Nature Of Recessions
- I believe the economy is an extremely dynamic and interrelated system. An economy is balancing millions of different markets, each with their own fundamental characteristics, their own lead and lag times to ramp up or ramp down production, and adapting and evolving at different rates. And each responding to incentives and stimulus to tax policy, financial markets, and geopolitics in their own ways at their own rates.
- I believe it is therefore more appropriate to view a recession as a stochastic event. That is to say, at any point in time, the economy has a certain percentage of chance of crashing into the mountains, so to speak. Risk factors that might increase the risk of a recession would be bad debt loads, overvalued assets, overbuilt capacity, geopolitical uncertainty, increasing commodity prices, etc.
- I believe the economy is at its heart, a system run and controlled by humans. Corporations are run by humans, as are stock markets, capital markets, mortgage decisions, and investment banks. And humans are, of course, subject to basic emotions of greed, fear, and a particularly nasty herd mentality.
- Accordingly recessions are unavoidable. At a micro scale you see this in every commodity sector. The boom/bust nature of oil, shipping, gas, mining. The price rises, people get overly excited and leverage up, and build out too much capacity. Supply crushes demand, firms go insolvent. The cycle continues.
- I believe capital markets are too large of a part of life for individuals, companies, and governments to ignore. A CEO who has just watched his share price fall 30% will behave differently than if his share price had risen slightly. A family of 4 who has just had their wealth cut in half will spend differently than if they had not.
I therefore have come to believe the start date of a recession is not something decreed a priori on stone tablets from Mount Sinai but is something that is itself endogenous in the system.
- If we accept that interest rates have an impact on the real economy and also have an impact on financial markets, it therefore becomes clear that financial markets and the economy are themselves correlated bidirectionally.
- I have begun to think that perhaps 2001 was like World War I. By the 1910’s, a systemic European-wide conflagration was pretty much inevitable as the arms races, the clashes of colonialism, and the German challenge to the British hegemony assured that sooner or later war would come to pass. But would it be something in Africa in 1912 that lit the spark, or something in the Middle East in 1916, or as history would have it something in the Balkans in 1914?
- By 2000, for example, the excesses had built themselves up to such an extent that recession was inevitable. But why did it have to be March 2001? Why not June 2001 or January 2001, or the summer of 2000? All of the pieces were pretty much in place throughout the late 90s.
- Indeed, the yield curve first inverted in June 1998 before recovering to invert again in February 2000, about 1 year before the recession. In December 2005, it inverts more than 2 full years before the recession. In 1988, there was nearly 2 full years before the 1990 recession. Why in 2000 couldn’t conditions have lasted an additional 1 year in line with the other recessions?
To me, therefore, the answer to the question of why does the stock market peak 6 months before a recession is not because the recession can be predicted but rather because the cause of both the stock market drop and the subsequent recession is a loss of confidence in the system and capitulation by the herd.
If the underlying decay of the economy has reached a point where any disturbance to it, be it a bank failure, some pronounced layoff, a Fed rate hike, or merely a 10 percent equity correction like the one we just had sets off the panic, then I think it plausible this not only impacts stocks but cascades into a full blown recession. A loss of confidence starts to show as projects are delayed and workers are gradually furloughed. The effect snowballs. And that loss of confidence will manifest itself in the economic data only ex-post, much as we see with the fall 2000 and early 2001 data.
Again, for clarity I am not suggesting that the stock market collapse itself causes the recession. Rather I am supposing it to be plausible that both the 2000 stock market selloff and the 2001 recession were completely unavoidable events, but were triggered by a concurrent collapse in economic confidence that occurred somewhere in the third quarter of 2000, which was when the layoffs began to turn strongly upwards, the stock market peaked, and the data got much softer.
The thing that this way of thinking solves for me is the 2011 conundrum. The prior post showed some data from the Chemical Board that the numbers in 2011 did not look good. Unemployment claims jumped 10% in the middle part of the year, and US GDP printed its worst quarter since the recession with a -1.5% Q1 number. And Europe looked to be falling absolutely apart. I think in this context there was a fairly high chance for the economy to crash into the mountains, and its not a coincidence that this corresponds to a 22% drop in the S&P between the May highs and the October lows, the most severe correction of this bull market.
To use the football metaphor, if we play that game 100 times, I think in 30-35 of those times, Europe tears apart and the world economy slides into recession. Certainly it was an event where one false move from one single leader could have sent things into the abyss, and I don’t know that type of outcome can ever be predicted.
So what, if anything, can we do about this? While I truly believe at least SOME recessions can be spotted in real time, given the personal stakes, I’m looking for a harder trigger.