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  • Nate Carter

The Recession: It Will Probably Get Worse

Are We In a Recession?

In recent weeks the news has focused on whether the U.S. economy is in a recession. Unfortunately, like most issues these days the comments tend to divide along political lines. For example, the Administration said this week they do not think a recession will happen, but private sector leaders believe it will. Regardless, it is pretty safe to say we are entering a mild recession and the economic situation will likely get worse in the coming year. This article will be in two parts, the first explains some of the aspects of the current recession and the next article provides strategies to help navigate a recession.

Defining a Recession

The standard definition of a recession is two consecutive quarters of negative economic growth. That benchmark has been hit. But the U.S. economy generally relies on the bipartisan National Bureau of Economic Research to make the official call on a recession. The NBER looks at three criteria which include the depth, diffusion, and duration of the downturn as part of its assessment. As of now they have yet to conclude that the economy is in recession.

The NBER may be reluctant to call this a recession because there has been substantial new job creation, which is an anomaly for a contracting economy. However, the private sector is now starting to reduce spending which includes adding new hires. There is often a lag effect on economic data, but more negative numbers are likely to show up in the coming weeks and months. A study reported this month in Fortune found 91% of CEO's surveyed anticipate a recession and only one-third think it will be short or mild. Private sector leaders who expect a recession, tighten spending in response. This will lead to more job layoffs and less business investment. Hence, recessions can become a self-fulfilling prophecy.

Signs a Recession was Coming

There were warning signs that this recession was coming along with indicators that it might be painful. This is a very broad subject but there are a few issues to consider that help explain how we got here.

First, in the last few years the U.S. government has floored the accelerator on its excessive government spending agenda. See this article from 2020 explaining the risks of our rapidly rising national debt, which was $25 trillion at the time. Since then there has been trillions of dollars in pandemic related stimulus spent coupled with financial support for the war in Ukraine. The national debt is now $31 trillion. In simple terms our national debt per U.S. taxpayer went from $200,000 two years ago, to $247,000 today. And it is still rapidly climbing.

Now pause for a minute to think about how long it would take to pay off $247,000 in debt and the severity of the situation sets in. For many of us the sum of $247,000 might be equal to a 30-year mortgage used to buy a property. But, with our government debt you do not get a paid off house at the end. Most of this money is spent and gone, and most of it was not invested in a way that will support future growth.

Excessive Government Spending

Let me be clear that government debt does not cause a recession, but when it is at such high levels it shows a lack of fiscal discipline which hurts investor confidence. Moreover, higher debt levels may blunt some of the tools the government hopes to use to combat the recession. For example, it reduces the financial space available for the government to buy falling assets to stabilize the market.

More concerning is that there is a legitimate question as to whether our Congressional leaders have the capacity to ever spend more responsibly. This lack of responsibility over the last two decades can lead to borrowers losing faith in U.S. government issued debt instruments. If this happens, it means the U.S. government has to offer higher interest rates to make the debt more attractive, which raises the cost of servicing the debt. This could lead to a much larger global downturn.

Fiscal Irresponsibility is Not Rewarded

To illustrate this point about the cost of debt servicing, we can again use the analogy of mortgage debt. A borrower paying a 30-year mortgage on $400,000 at an annual interest rate of 4% has a monthly payment of $1,910. If a lender questions the borrower's credit worthiness and will only offer an interest rate of 7% their monthly payment would be $2,661. A difference of $751 per month. That extra $751 cannot be spent on productive means such as starting a business, paying for an education, or investing in other assets. They are just paying more to have access to credit. Now consider how rising interest rates would affect U.S. debt which is being added at a rate of trillions of dollars per year. The higher costs of servicing debt crowds out far more productive uses for this money.

The pattern of U.S. government spending over the last two decades has been concerning. The national debt reached $9 trillion in 2007 amid two expensive wars in Iraq and Afghanistan. After using quantitative easing and stimulus spending in response to the global financial crisis the debt hit a record $14.7 trillion in 2011. As mentioned above, debt levels are now $31 trillion. Our debt has more than doubled since 2011.

Low Interest Rates Fueled Asset Bubbles, Led to Inflation

The second major aspect to look at as we go into this recession is the actions of the Federal Reserve (Central Bank) and its control of monetary policy. Monetary policy is just a fancy way of saying the tools used to control the overall supply of money in the economy. In response to the global financial crisis the Fed kept interest rates low to stimulate the economy and pull us out of the recession. That made sense at the time. However, the Fed kept these rates too low for too many years. The low interest rates, combined with the government stimulus money mentioned above, flooded the market with cheap money. This creates asset bubbles in which assets like real estate or stocks become overinflated in value.

Rising prices were further fueled by supply chain problems during the pandemic. Companies could not secure the inputs they needed, like computer chips or building materials. The prices of inputs rose as supplies dwindled, which then drove up the prices of the finished products. Similarly after the 2007-08 global financial crisis many homebuilders went out of business and those that remained were more cautious in how many housing units they built. This was financially prudent on the part of homebuilders, but it reduced the supply of new housing which limited supply, which led to higher prices and eventually helped contribute to the spike in inflation we saw this year.

The Fed Slams the Brakes

As inflation skyrocketed and looked to be more than temporary, the Federal Reserve reversed course on its monetary policy. Instead of keeping interest rates low it slammed on the brakes and put the car in reverse, raising interest rates five times in 2022 to date. Rates needed to increase but it should have been done much earlier and more gradually over time. Modest increases over time are more stabilizing to the economy and less of a shock. Economies and investors like predictability, not surprises.

Asset Prices Will Decline

As the recession sets in and the economy factors in higher interest rates the desire to borrow money will decline. The goal of the Fed is to reduce inflation without damaging the economy, but they already missed this window. We can expect the economy to contract further and asset prices to fall as the asset bubbles that were created begin to deflate. Although home prices are still up significantly over the past few years, the median price of homes is slowing or declining in many markets. We will likely see home prices continue to slide.

Stock prices reacted more swiftly, with the S&P 500 index down about 25% for the year. Expect more volatility in the coming weeks and months with wide swings in the market. Recessions are also psychological, they test peoples' confidence and the fear of job losses will reduce consumer spending which will deepen the recession cycle. As asset prices fall, borrowers who are overleveraged may need to sell assets to meet their obligations. If assets are sold at a discount it will bring asset prices down further. No one knows for sure how long the current downturn will last but 2023 could be a rough year.

Despite all this doom and gloom, it is important to keep in mind that recessions are part of a normal economic cycle. Think of the Biblical story of the seven fat years and the seven lean years. Recessions are the lean periods but on average since 1945 they have lasted 10 months. This recession has some factors, particularly the excessive U.S. national debt, that make it more concerning than an average recession, but this type of downturn is still a part of the broader economic cycles.

In the next article we will look at some options to help navigate this recession along with some strategies to hopefully profit during it. For those who read Become Loaded for Life! you may have noticed that chapter 23 offered warnings of what is playing out in the economy today as well as other risks that may still emerge.

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