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Recession Watch

John Lim

I’M PLAYING ECONOMIST today, looking ahead to third-quarter GDP, the first estimate of which will be released Thursday. No, I won’t be offering a forecast. There are plenty of highly capable economists doing just that. Rather, my goal is to discuss what few in the media are talking about. Could a recession be in the offing?

According to economists Paul Samuelson and William Nordhaus, a recession is defined as “a period of significant decline in total output, income, and employment, usually lasting from six months to a year and marked by widespread contractions in many sectors of the economy.”

The job of calling a recession belongs to the National Bureau of Economic Research. While there are no strict criteria for dating a recession, a common working definition is two consecutive quarters of negative GDP growth. The most recent recession lasted from February to April 2020—the so-called COVID-19 recession.

The first two quarters of 2021 saw real GDP growth of 6.3% and 6.7%, respectively. This is undoubtedly robust. But it’s important to remember that the COVID-19 recession was one of the most severe—and shortest—in modern history, with GDP declining 19.2% from peak to trough. The rebound in GDP in the first half of 2021 was off a fairly low base.

What’s in the cards for the third quarter? According to the Atlanta Federal Reserve’s GDPNow forecasting tool, the latest estimate of third-quarter GDP growth is an anemic 0.5%. This is an annualized estimate. How accurate is GDPNow? As shown in this chart, it depends on the proximity to the release date of GDP. Within four weeks of the release date, it does a pretty good job.

Of course, there’s far greater uncertainty in economic forecasts since the onset of the global pandemic. Still, 0.5% GDP growth is not that far from zero—and third-quarter GDP could surprise to the downside.

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What about other recession indicators? Previously, I’ve written about the power of the yield curve in predicting recessions. It’s traditionally been one of the most robust tools in forecasting recessions.

The yield curve is currently upward sloping, meaning Treasurys with longer maturities have higher yields than those with shorter maturities. But I’m not so sure we can put quite as much faith in the yield curve as a recessionary predictor in an environment of near-zero interest rates. I would also argue that massive quantitative easing has distorted the yield curve in significant ways, perhaps making it a less useful indicator than it has been historically. Finally, the prospect of inflation may be causing long-term Treasury yields to be higher than they would otherwise be.

Personal consumption is the largest component of GDP and has recently surged to 69%, a multi-decade high. How are consumers feeling these days? According to the Conference Board, consumer confidence has fallen for three straight months, down 15% from the recent peak in June.

The Conference Board’s survey also looks at consumers’ appraisal of both their present situation and expectations six months out, both of which have been worsening. The deterioration of the latter is especially worrisome for consumer spending in the months to come.

I’m certainly not forecasting a recession, at least not with any degree of confidence. As the saying goes, economists have predicted 10 of the past five recessions. But what I am pointing out is that the odds of a recession are rising and are not insignificant. At a minimum, investors need to be mentally prepared for a rough stretch in the economy and the financial markets. If inflation doesn’t recede meaningfully, this raises the unpleasant specter of stagflation—stagnant economic growth plus inflation.

Should we enter a period of stagflation, where can investors hide? Bonds, especially long duration bonds, would likely suffer. Bond prices would be driven lower by higher market interest rates, while the value of the fixed payments from bonds would be diminished by inflation. Stocks of companies without pricing power would also face headwinds. Ditto for growth stocks with lofty price-earnings multiples, which tend to struggle when interest rates rise and cause investors to put a lower value on future earnings. In addition, cash would be unattractive because its purchasing power would be eroded by inflation.

Series I savings bonds, which I wrote about recently, would provide inflation protection and may serve as a good cash alternative. Value stocks may catch a break as investors flee from frothier growth names. Commodities and natural resource companies might benefit from a scenario of higher energy prices. Finally, if history is any guide, gold could be a major beneficiary of a stagflationary environment.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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Roboticus Aquarius
Roboticus Aquarius
8 months ago

The impact of the pandemic and supply chain disruptions may very well have already caused a recession this past quarter, but the economy is not the stock market.

We haven’t had a year of more than 4% inflation in almost 3 decades. People are a little shocked by inflation. However, deflationary forces are still a prime mover in the economy. Not to say we should discount the possibility of some difficulties with inflation: inflation is a retiree’s worst enemy, and one should never turn their back on an enemy.

The best way to be prepared for inflation is to maintain a long-term portfolio with equities (excellent long term hedge against moderate inflation), and include the level of TIPS and real assets in your portfolio that you feel is appropriate. TIPS is pretty straightforward, opinions vary on the value of real estate (REITS and actual RE), gold (argued over endlessly), commodities, crypto (which comes with a warning flag). I lean towards Tips, real estate, and REITs myself. A low-rate long-term mortgage is a really nice inflation hedge. Then, once decided on an asset allocation, stay the course. The most destructive force on a portfolio is performance chasing.

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