There has been much doom and gloom predicted for the stock market looking ahead to 2019, at least in some corners of the investment world. Much of the volatility in the market that we witnessed at the end of 2018, and the ensuing pessimism from investors, is predicated on a potential economic recession for the U.S. and global economies. And there is no doubt that if a severe recession were to be anticipated in the United States, that the stock market would suffer.
As wealth advisors, part of our role is to remain laser focused on the direction of the economy—here in Colorado and across the US. The health, or lack of health in the global economy, has a direct impact on the investments in our clients’ portfolios. Understanding what causes a “bear market” in stocks is critical. And in the case of a bear market in stocks, we can reliably look to financial history that an economic recession is the typical cause.
But it is important to separate fact from fiction as we begin the New Year. While economic growth has slowed somewhat on a global scale towards the end of 2018, economic fundamentals actually remain fairly strong in the New Year. According to Goldman Sachs and Haver, global purchasing manager indices remained solidly positive through year-end 2018. In other words, the global economy continued to expand, even in the face of stock and bond market volatility in Q4.
Notably, recessions are not all created equal. Some recessions are much worse than others. The Global Financial Crisis of 2008 was the most severe economic event since the Great Depression. It was a financial recession that shook our country to its core. So perhaps more important than whether or not we eventually do have a recession in the US, is whether we have a severe recession or a mild recession. So the question becomes: what can we expect from our next recession?
It is likely that the next economic recession in the US, whenever it does arrive, will be relatively mild. There are two key reasons why this is the case.
Not a Financial Recession
Financial recessions are the worst recessions by far. Academic research confirms that financial crises exacerbate recessions, leading to a much greater degree of severity and a slower recovery. Academics Carmen Reinhart and Kenneth Rogoff published an oft-cited analysis in 2011 that attempted to provide context for the 2008 financial crisis.* In their assessment, the bursting of a financial bubble is what leads to not just a garden variety economic contraction, but to economic crisis.
It does not appear that we are about to face another financial recession. According to Goldman Sachs, there is actually very little excess across financial indicators today. US consumers are borrowing much less as a percentage of their net worth and cash flow today, relative to 2007. US Banks are under-levered due to increased capital ratio requirements and greater government scrutiny. Heightened underwriting standards have made securing a home mortgage much more difficult. Indeed, the average credit score today for Americans today, as measured by their FICO number, stands at 704—the highest average ever recorded.
The bottom line here is that the American economy is not over-leveraged like it was in 2006 and 2007. As a result, the likelihood of a financial crash is quite low.
A More Aware Federal Reserve
Financial historians often argue about former Fed Chairman Alan Greenspan and his role in creating the 2008 financial crisis. While Greenspan was aware of potential excess and bubble-like aspects of the US economy during his tenure, he kept interest rates artificially low for much of the 2000’s. The result was a residential housing boom the likes of which few had witnessed. And the end result of the housing boom was the sub-prime mortgage crash of 2008. Greenspan did not act quickly enough in the face of mounting evidence that interest rates were far too low.
Today we have almost the opposite reality of the Greenspan era: a hyper-aware fed that is almost too afraid of creating the next bubble. Current Fed Chairman Jerome Powell has continued to raise short term interest rates through 2018, while simultaneously letting the Fed balance sheet shrink from the maturing bonds purchased during quantitative easing. The result has been a marked increase in monetary tightening in the past twelve months. While the growing US economy is healthy enough to absorb higher interest rates, our current Fed has demonstrated its desire to normalize monetary conditions. The punchline: today’s Federal Reserve is trying actively to reduce the potential for future bubbles in the system.
While the probability of a recession in the United States remains somewhat elevated over the next 3 years, the type of recession that we are likely to experience—a milder economic contraction compared to 2008—is an equally important consideration.
We continue to refer to our latest proprietary method, The Recession Prep Checklist™. Please reach out to us directly to discuss the specific steps that you can take, regardless of what the next downturn may look like.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All performance referenced is historical and is no guarantee of future results. Investing involves risk including the loss of principle.
* Reinhart, Carmen M., and Kenneth S. Rogoff. “From financial crash to debt crisis.” American Economic Review 101.5 (2011): 1676-1706.