Recession? What's in a Name?
Written by: Larry Eppolito, CFP®
My last letter was a fairly comprehensive look at inflation – at least for those who “dared to venture” beyond the summary at the top. This letter is fairly short and is written for all. (You should see the “cutting room floor.”)
Lately, talk of a potential recession is all over the media. So, you know what that means. It’s time for me to put things in perspective. The following represents my beliefs.
What Does a Recession Mean for You?
Have you noticed that few of the talking heads (if any) have expounded on what a recession might mean for you? It was likely not written into their teleprompter. Also, they talk about “GDP” (an acronym for gross domestic product), but rarely define it for you as “economic output” – essentially how much the US economy produces in goods and services. Why not use both terms together? I believe this would resonate more with people.
GDP Growth Example
I began my career on April 9, 1984. At the time, the US economy produced about $4T in goods and services. Although past performance cannot guarantee future results, as of June 30, 2022, GDP was nearly $25T. Although economic growth was interrupted by recessions in 1990-1991, 2000-2002, 2007-2009 and most recently during the 2020 Covid-induced downturn, the economy has recovered and proceeded to grow. Although it is rarely an “easy ride,” stocks tend to follow the growth in the economy over time. (1)
We Need a Slowdown
Although we certainly needed stimulus, many financial economists believe much of the inflation is being caused by the government going a bit too far with stimulus checks. To what extent? The money supply is at historic levels – about 40% above pre-Covid levels. Money is “fuel for the economic fire.” And “too much money chasing too few goods and services” is a textbook definition of an inflationary environment. (2)
The Federal Reserve Bank (The Fed) has been raising interest rates to slow inflation. Higher interest rates raise the cost of money. As the cost of mortgages and other loans rise, the economy will face headwinds to growth. As the growth in the money supply slows, the demand for goods should continue to slow. At the same time, the supply of goods is expected to rise – bringing supply and demand back into line.
So, the Fed wants to slow the economy, but they don’t want to slow it too much. They are trying to engineer a “soft-landing” that re-sets the economy without too much pain. As I’ve written, since markets are forward-looking, the markets know what the Fed is trying to do.
What Does Recession Mean?
To commentors, a recession is two straight quarters of negative economic growth. Based on preliminary reports of economic growth, we’ve had a contraction in GDP in the first quarter this year (Q1) and in Q2. The Q2 “advance estimate” will be revised three times in the coming weeks, as data comes in. The arbiter of whether we have a recession, however, is the National Bureau of Economic Research (NBER).
First of all, the GDP measure of economic growth is a rather complicated statistic. For the NBER, the true measure of a recession is based on a much broader number of variables beyond the GDP number. Some of the variables that make up GDP have shrunk. For instance, government spending has been falling from record levels. (Does this surprise anyone?) But other variables are strong. To quote Fed Chairman Jerome Powell, there are “too many areas of the economy that are performing too well,” and although growth is slowing, “it is for reasons we understand.” (3)
According to the US Commerce Department’s Bureau of Economic Analysis (BEA), the economy added 1.1 million jobs in the second quarter. So, with unemployment near a record low at 3.6%, and savings accounts still near record levels, it’s hard to say the economy is struggling. Of course, things can change quickly for any number of reasons. And keep in mind, the Fed wants the economy to slow! …and they’re not done yet. So, we may have to endure a recession eventually, but…
It’s Not the Recession, It’s the Magnitude of Any Economic Downturn!
Recessions are like snowflakes. No two are alike. Some recessions are rather shallow. Some are moderate. Some are rather deep. This is the crux of the issue.
Recessions Are Cleansing
The silver lining is, recessions cleanse the economy of excesses. A good recent example is the real estate boom that ended with the “Financial Crisis of 2008” – a very deep recession (generally caused by an asset bubble that resulted from inadequate mortgage underwriting standards and abuses thereof). Once excesses are cleansed, the economy often has a long runway of growth in front of it.
That’s Not Down!
Peak to Recent Trough: Measuring from January 1st (which was within days of the recent high-water marks) to the recent lows made in mid-June, stocks broadly fell about 20%. The markets have since risen several percent off that bottom. Although this changes daily, as I type, stocks are broadly down about 15% year-to-date. As I’ve written many times, “That’s not “down!” Down is what happens during the average recession. During the average recession stocks have fallen about 35%, sometimes more, sometimes less.
So, stocks aren’t down much – despite all the negative news. But I still believe the bumpy ride is not yet behind us.
Percentages – Not Dollars Gained or Lost – Give Magnitude
It’s normal human emotion to look at our high-water mark statement and measure how much we’ve fallen from there. But if we do this:
- It implies the highwater mark was an end game – instead of a “mile post on the long journey.”
- Long term investors often ignore the growth that got them there.
Also, it’s normal to perceive dollars in terms of what they can buy for us. But we should not measure in dollar terms. This tells us nothing. Percentages tell us magnitude. How so?
For example, generally:
- Someone with $100,000 in a diversified stock-only portfolio would likely be down ~$20,000 if the markets broadly fell 20%.
- Someone with $1,000,000 in a diversified stock-only portfolio would likely be down ~$200,000 if the markets broadly fell 20%.
They both fell by the same amount – although the dollars involved are much different. Likewise, in this example, the portfolios would have gained the same amount – in percentage terms – on the upside. It’s easy to forget this. It’s my job to reorient you periodically.
Financial economists think in terms of probabilities. The media has a habit of talking about “black and white outcomes.” This resonates with many people, but it’s the wrong way to look at things. No one knows what an economic outcome will be. As I’ve written before, the media is often less than helpful. This does not mean “don’t read.” It means “read with caution.” I believe the only article that is any good is one that gives both sides of an argument – and which puts forth “likelihoods,” not certainties.
The following represents the mid-point of financial economist expectations from a recent Thompson Reuters Economic Poll:
- Probability of recession in the next 12-months: 40%
- This is up from a 25% probability since my last letter.
- For perspective, only 5 of the 35 contributors believe there is a greater than 50% probability of a recession in the next 12-months.
- “Headline” inflation (which includes volatile energy and food prices) falling to 5% by year end 2023. It was 9.1% in June 2022 versus June 2021.
- “Core” inflation (which excludes volatile energy and food prices) falling to 0% by year end 2023. It was 5.9% in June versus a year ago. (4)
Although beyond the scope of this letter, the bond market “makes predictions.” The markets are currently expecting the Fed to raise “their interest rate” (i.e. the Federal Funds rate – a short-term rate) by another 1% or so by year-end. Long term rates move somewhat independently of the Fed’s short-term rate.
Although things can change, I believe the markets currently either expect no recession, as defined by the NBER (i.e. Fed will be able to engineer a “soft landing”), or any recession is likely to be fairly moderate. For you, this means we may have already seen the market lows for this economic cycle, which occurred back in mid-June. But we may not have. No one knows.
A deep recession would likely mean markets would cycle much lower than the June lows. Although things can change, I currently believe there is a low probability of a deep recession.
We Have Pre-Planned for This
We deal with volatility via our asset allocation. Generally, when stocks move sharply, a portfolio with bonds will not go up as much as a portfolio of all stocks, and a portfolio with bonds will not go down as much either. We know this, but we often forget this.
In summary, I believe:
- Whether we meet the media’s technical definition of a recession is irrelevant. It’s the magnitude of any economic downturn. This is the crux of the issue.
- Market “corrections” of at least 10% down from a recent highwater mark have occurred nearly once per year on average, over the decades – with no accompanying recession. So, that’s not “down” – it’s part of the ride. Down is what happens during the average recession. (5)
- Recessions come around cyclically, but not like clockwork. Enduring a recession is the price we pay for the potential for the long-term growth in the markets as the economy expands over the years. Although often painful to endure, recessions are “cleansing.”
- We may have seen the market lows; we may not have. Because markets are forward-looking, stock market bottoms happen when you least expect them – usually well ahead of the worst news. So, smart investors deal with volatility via asset allocation.
- Dollar movements tell us nothing. We measure our results in percentage terms, which give magnitude – up and down.
- Inflation is expected to fall in the months and quarters ahead.
- Many of the shortages causing inflation are due to post-Covid-pent-up demand and will dissipate over the coming months.
- Currently there is too much money in the economy. Many economists expect the money supply to continue to slowly shrink over the coming months. (6)
- As these inflationary forces dissipate, the Fed will have to do less, in terms of raising interest rates, to slow the economy.
- Some inflationary forces will be more stubborn. Food and energy prices, in particular, are being affected by Russia’s aggression against Ukraine and will likely be stickier.
We may have to endure a “NBER-defined” recession, but we may not. I believe any recession would be fairly moderate. Regardless, let’s hope for a “long runway of growth” thereafter!
Stay safe and please feel free to call me with any questions.
As you’ve probably noticed, we don’t generally ask clients for referrals, as I don’t wish to obligate anyone. At the same time, given all of the turmoil in the world, there are a number of things that concern me and I fear many people are in need of guidance. If there is anyone you care about who could use a second set of eyes, we’d be happy to meet with them to try and help them out. If so, please let me know.
P.S. Please feel free to send this along to those who may benefit.
Eppolito Financial Strategies, LLC. is not a registered broker/dealer, and is independent of Raymond James Financial Services. Investment advisory services offered through Raymond James Financial Services Advisors, Inc.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ CFP® (with plaque design) and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
- Bureau of Economic Analysis, 7/28/2022
- St. Louis Federal Reserve. As measured by M2.
- CNBC 7/28/22
- Bureau of Economic Analysis
- Dorsey Wright, Historical 10% Market Corrections
- Raymond James Institutional Equity Strategy, 6/30/2022
- Raymond James Institutional Equity Strategy
- CNBC Professional
- Financial Advisor Magazine
- The Wall Street Journal
- New York Times
- The Boston Globe
Any opinions are those of Larry Eppolito and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change. This information is not intended as a solicitation or recommendation of any kind. Investments mentioned may not be suitable for all investors. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Diversification and asset allocation do not ensure a profit or protect against a loss.
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Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
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