With all of the turmoil happening in the world at the moment, it’s no surprise that many people are worried about a significant downturn in the economy and in the markets.
Hi everyone, Jay Pluimer here with Flourish Insights. As the director of investments at Flourish Wealth Management, I take pride in providing our clients, colleagues, and friends with resources and information that can help them make strategic and effective choices regarding their investments. Did you know we have an Alexa Skill? To listen on your Alexa device, just say, “Alexa, play Flourish Insights.”
Today, we’re talking about The Next Recession.
With all of the turmoil happening in the world at the moment, it isn’t surprising that a lot of people are worried about a significant downturn in the economy and in the markets. I have been surprised to see how many analysts and economists have been confidently predicting that a recession is imminent in the United States. As a refresher, a recession is defined as one or more quarters with negative economic growth and typically include job losses, declining real income, meaning after adjusting for inflation, and lower consumer spending. Most recessions are accompanied by a stock market correction, meaning a 10% drop, or a Bear Market when losses are 20% or greater. So why are so many people so confident that a recession is imminent? Do we share those concerns at Flourish? And what should investors do when there is so much negative sentiment?
Let’s start by summarizing the various reasons people think a recession is imminent. For the record, a recession is inevitable because historical evidence shows they happen every 3 and a half years. In this case, however, people seem very confident that the next recession will take place in 2022.
One of the recession indicators that people reference is the yield curve, noting that an inverted yield curve predicts a recession. An inverted yield curve takes place when short-term rates are higher than long-term rates, typically reflecting that investors are not confident about the current environment or the prospects for growth in the future. It is a fact that short-term rates are rising, due in large part to interest rate hikes by the Federal Reserve. The Fed has set the overnight borrowing rate at 0% since the onset of COVID in early 2020. The first increase of 25 basis points took place in mid-March with expectations that we will experience at least 4 additional increases this year, and potentially as many as 7. That would push short-term rates from basically 0% to over 2% in a matter of months. The short end of the yield curve started to move up in late 2021 in anticipation of the upcoming actions by the Fed, but medium and long-term rates have remained relatively stable.
If the trend of rising short-term rates continues it is a logical concern that the yield curve could invert. After all, an inverted yield curve has predicted every recession since 1955, with only 1 false signal during that time. The yield curve inverted in late 2019 and correctly predicted the COVID recession, although it’s hard to state that the two are directly related. Still, it’s hard to imagine that we would go from the current GDP growth rate of 7% to negative growth over the next few quarters.
Another reason people are predicting a recession is that commodity prices have skyrocketed over the past few months. The War in Ukraine and the Russian sanctions have led to significantly higher oil and energy prices, along with rising prices for wheat and other commodities. These higher prices are definitely hurting the pockets of American Citizens as household debt is spiking again and inflation rates close to 8% are wiping out wage growth. Inflation has been above 7% for almost 6 months, so it’s not exactly a new phenomenon, but there aren’t any indications that we will see lower inflation rates any time soon.
The combination of an inverting yield curve and sticky inflation with persistent supply chain issues make a compelling argument that a recession is imminent. We know that recessions happen every 40 plus months, and it’s been 24 months since our last recession, so we know that another recession is inevitable. It’s hard to argue with the evidence in favor of a recession in 2022, although a contrarian investor prefers to go the opposite direction as everybody else and look at the prevailing pessimism as a potential buying opportunity.
Assuming we are facing a combination of rising short-term interest rates with slowing economic growth and a stock market downturn, investors will be faced with some difficult choices. The environment I just described makes it hard to make money in either stocks or bonds, and with cash still earning minimal interest it’s hard to make a case for sitting on the sidelines. We have been exploring opportunities to add exposure to commodities and real assets, along with other strategies that perform well during an inflationary environment, but that approach is designed to add diversification instead of putting our head under the covers and hiding until things get better.
The fact is that nobody knows exactly when the next recession will start or when the stock market will react with a significant drop. Historical evidence shows that we will likely have a recession in either 2022, 2023, or 2024. In addition, as discussed in episode 60 of Flourish Insights, the Federal Reserve will be doing everything they can to successfully walk the tightrope to support an economic recovery with lower inflation rates without over-correcting into a recession. We also know that long-term investment returns include both the good times and the bad times, and that we’ve had a couple very good years in the stock market so a down year wouldn’t be too surprising.
All that being said, recessions and market downturns typically last about a year, so we look at the current volatility as a potential buying opportunity for investors with additional cash to invest. For those that rely on their portfolio to sustain their lifestyle, on the other hand, we have three to five years of cash flow ready to meet spending needs without needing to sell stocks at a discount. In short, we plan to stay fully invested while looking for opportunities to rebalance client portfolios, add diversification, and make sure clients are well positioned for the eventual stock market recovery. In contrast, the people using these stats and facts to scare investors out of the market will never get them back in, and unfortunately, staying out of the market is the only way to guarantee that your long-term goals will be out of reach.
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