What Might the Next US Recession Look Like?

What Might the Next US Recession Look Like?

It is naturally intuitive to look for historical parallels in economies and financial markets when seeking to predict the future. The great difficulty in doing so is that no two set of economic circumstances are ever exactly the same.

But even greater than that, many investors and forecasters seek to apply two-dimensional thinking to three-dimensional situations. Economies are three-dimensional in a biological sense, being complex adaptive systems, yet many forecasters seek to apply the laws of physics when attempting to deduce the future. Yet in understanding biological relationships, we must take into account the way the environmental elements interact with each other.

Think of an example of planting a wheat crop, where it is common for soil quality to vary within a single paddock. Yet with satellite technology, a farmer can easily determine such varying quality, and respond to it.

So, what does the farmer do in order to maximize crop yield?

He could apply more fertilizer to the less fertile areas, thus incrementally increasing the expected returns in those parts, which would seem reasonable.

In fact, he does the opposite, and applies more fertilizer to the more fertile areas, and less to the least fertile. This maximizes the yield for those areas that are more capable of producing greater returns, thus creating a biological asymmetry.

Likewise, economies consist of asymmetries due to their biological nature, and the way economic elements interact with each other, both singularly and collectively, can give vastly contrasting outcomes. Many such asymmetries do not show up under physics-based analysis. Rather, they are more easily recognized under compounding principles, as opposed to linear and constant relationship assumptions. Such compounding principles apply in both directions, and importantly, not always with mirror image outcomes.

An example of this lies in bank lending. If bank lending increased by 10% p.a. for five years, and then contracted by 10% p.a. for the following five years, would economic and banking conditions be the same in ten years’ time as they are today?

Most definitely not.

Thus, when seeking to make predictions about the US economy (or any other economy), it is important to recognize that the preconditions that got the economy to where it is now will not generate the same outcomes going forward, as nothing remains constant in a biological terms.

An example of this has been the disinflationary tailwinds behind central bankers over the past 25 years, being described for most of that time as a “Goldilocks economy”. Interest rates and bond yields were on a secular downward trajectory, leading to structurally lower unemployment and higher asset prices.

Of course, this period in financial history was not linear, and contained many crises at different intervals. Each crisis over that time saw lower lows and lower highs in official interest rates. Every time global financial markets and conditions recovered, and central banks reversed course by raising official interest rates, they were able to remain sensitive to any adverse impact of such higher rates.

This meant that due to the absence of rising inflation, they were willing and able to reduce official rates again at the first sign of trouble.

But everything has its limits, and all of the positive compounding asymmetries created and sustained over the past 25 years have now in all likelihood reached their own limitations, as inflation is resurgent.

In a global sense, the first real shoe to drop over the past year or so was the rapid evaporation of approximately USD $18 trillion dollars of negative yielding bonds, which today amounts to around $2 trillion. As these yields migrated towards and above zero, equity markets then went into a tailspin, closely followed by increased divergence in sovereign bond yields in Europe. Again, as in biology, the elements reacted in different ways with each other, and not in a mirror image set of outcomes when these markets went into reverse.

Added to this set of events is the de-globalisation of the post-COVID 19 economy, compounded by a slowing Chinese economy that has been experiencing rolling lockdowns in its most economically productive regions. There has been no uniform re-emergence of the global economy, as different regions are responding differently to COVID. Again, predicting the outcomes of this scenario will not be aided by a physics approach.

Accordingly, the immediate outlook for the US economy must be examined against a backdrop of divergence, as opposed to the convergence of the past 25 years.

So, what does the economic “biology” of the US economy look like today?

Ø  An inverted yield curve at the onset of interest rate increases compresses credit creation

Ø  High levels of inventory

Ø  The Fed would have to know that any future economic stimulus will be inflationary, thus limiting the effectiveness of any future Fed “pivot”

Ø  The US dollar at a twenty-year high constraining global and emerging market growth

Ø  The weak Yen constraining China through the Yuan/USD peg

Ø  Fertilizer, food and energy shortages

Ø  Irrevocably changing supply chains

Ø  Geopolitical tension at post-Cold War highs

Ø  Divergent European bond spreads

Ø  Increasing leveraged loan defaults

Ø  Widening junk bond spreads

Ø  Increasing construction costs with declining residential property prices

Ø  Trade conditions becoming more problematic

Ø  Bank provisioning at cyclical lows as interest rates increase

Ø  If the Federal Reserve does not arrest inflation, the US economy will likely become a “stop-start” economy if they continually pivot

Ø  Passive index funds potentially magnifying market downsides as they did with market upside, but with an asymmetrically worse outcome given their larger role than 25 years ago

Ø  If the Chinese property market is the largest asset market in the world, and is effectively not functioning, the quantum of risk is by definition unprecedented in terms of potential asset market destruction

Ø  Food and energy importers with a weak currency, such as Japan, no longer exporting deflation

Ø  With peak baby boomer retirement not expected until 2032, weaker asset valuations caused by higher interest rates and bond yields would increase the risk of pension fund drawdowns, further deflating asset prices

Ø  Corporate earnings pressure increasing as interest rates increase, thus leading to higher unemployment as costs are reduced

Ø  At the same time, increasing pressure on the many “zombie companies” who cannot service debt costs out of revenue

Ø  Developed world economies effectively fully employed, meaning that unemployment can only increase from current levels

We have no ability to predict how all the above dynamics will interact with each other, both at an individual and a collective level. Added to that is another third dimension of trying to predict how governments would respond to any adverse outcomes of this mix of risks, especially at the very time the Fed is attempting to withdraw unprecedented amounts of post-COVID 19 stimuli from the US financial system.

When the economic pendulum for most of the past 25 years swung the other way, the greatest investment risk was not being fully invested. In other words, the risk of interrupting the power of compounding that this era brought with it.

Today, we see the biggest risk is to being “timed out” through the interruption of value destruction at a time when leverage by any category or definition has never been higher.

In our view it is virtually impossible to predict with any precision the impact of such a combination of biological elements on the US economy going forward, given the unprecedented nature of many of them, let alone how they might interact with each other, and the effectiveness of any US Government responses.

But it is very likely, in our view, that the next US recession will potentially be the deepest in our lifetime, and less cyclical than typical garden-variety recessions, as there are so many excesses in the system that will not in our view be quickly resolved or washed out. While there are many great textbooks that give detailed accounts of other inflationary (and associated rising geopolitical) tensions, there is no “muscle memory” to speak of when it comes to dealing with such pressures. Reading historical accounts is no substitution for responding to chaotic events that are almost impossible to predict in advance. Other than adopting a very defensive investment mindset for longer than a few quarters of negative GDP growth.

We fear the next US recession will be secular and not cyclical.