Subscribe
Share
Share
Embed
Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays), and a new monthly Q&A format called the Confluence Mailbag.
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report. I'm Phil Adler. Are investors right to downplay the risk of recession? It certainly looks like the markets have been acting that way this year. Confluence Advisory Director Bill O'Grady joins us on this day in early August to discuss whether we might have less to fear than we traditionally have assumed.
Phil Adler:Now, Bill, the title of your report is no country for recessions. You say there's evidence that recessions in The United States are less frequent than they used to be. What is this evidence? What exactly does it tell us?
Bill O'Grady:Well, to measure the frequency of recessions, I used data from the National Bureau of Economic Research, which is a private body that dates business cycles. They have measured business cycles going back into the eighteen fifties. In their data, they mark every month that the economy is in recession. So what I did was I created a dataset that first assigned a number one to each month in the economy when there was a recession. Then I ran moving some of that data over a ten year or a hundred and twenty month cycle.
Bill O'Grady:This tells us how many months the economy was in recession on a rolling decade basis. The chart in the report shows that recessions have occurred with less frequency over time. For example, from 1864 to 1940, the economy was in recession fifty four months out of every ten years or about 45% of the time. From 1941 to 1991, the incidence of recession fell to twenty one months or 18% of the time. And since 1991, the incidence has declined to ten months or 8% of the time.
Bill O'Grady:So clearly, recessions have become less frequent.
Phil Adler:Are recessions, when they do occur, tending to be shorter lasting and less severe?
Bill O'Grady:No. Not necessarily. Since 1991, for example, we've had three recessions. The two thousand one recession was very mild, but the 02/2009 recession was very deep, and the very short twenty twenty recession tied to the COVID pandemic was very deep but also the shortest on record. This idea about severity and frequency is a hotly debated topic and will be the subject of a future biweekly asset allocation report.
Phil Adler:Bill, you make the case that the number of recessions has declined for three reasons. The first is there is less concern about inventory miscalculations by corporations than there used to be. Can you explain this a little bit? What do you mean?
Bill O'Grady:Sure. When The US economy was more manufacturing based and before modern logistics were deployed, the economy was often subject to inventory recessions. Firms would overestimate demand, stockpiles would increase, and firms would then slow down production to work off the excess. During this work off period, the economy would often slip into recession.
Phil Adler:So can we say that improved technology these days has caused industry to become smarter and there is still plenty of room for growth?
Bill O'Grady:Well, inventory management has clearly improved. The whole effort to gather data on consumers is in part trying to anticipate future demand so as to further improve inventory flow. So, yes, there is some improvement for growth.
Phil Adler:The second reason is that central banks have become smarter about implementing policies designed to prevent recessions. What has changed?
Bill O'Grady:Well, keep in mind initially, central banks were created to address bank runs. Banks hold liquid liabilities but illiquid assets. If depositors demand their money in mass, the bank would fail because it couldn't liquidate its assets fast enough to meet depositor demand. Central banks stepped into the void by accepting bank assets and providing liquidity. But over time, the mandate of central banks change.
Bill O'Grady:The Federal Reserve is expected to maintain steady price inflation and full employment. Thus, it is tasked with implementing countercyclical policy. In other words, to boost the economy by cutting interest rates when economic activity declines and raise rates when the economy is running too hot and causing inflation. The change in the mandate and improved theory on how the economy works has arguably improved their performance in this role.
Phil Adler:Now Fed independence has been questioned recently. What what role does Fed independence play in this move toward effective recession prevention policies?
Bill O'Grady:Well, interestingly enough, Fed independence is less about recession prevention and more about inflation control. No political leader wants a recession on his watch, and they always lean toward easy monetary policy. Easy policy makes the odds of recession lower. It's when the Fed faces an inflationary economy where its independence matters.
Phil Adler:The third reason and the last reason that you've written about is the globalization that has contributed in recent decades to lower inflation and interest rates. This appears to be changing now, but are we still in a relatively comfortable position, at least when we're talking about the possibility of a recession?
Bill O'Grady:Well, disrupting supply chains can lead to economic slowdowns. Globalization has reduced that risk. But as The US changes its trade policy, it runs the risk that supply shocks could cause a downturn. Globalization really kicked in with the advent of the Internet and the end of the Cold War, which brought the Eastern Bloc nations into the global economy. That's part of the reason why recession frequency fell after 1990.
Phil Adler:Of these three reasons, are you least confident about whether number three, globalization will endure?
Bill O'Grady:Well, I'd I expect trade will continue, but it may not provide the same price depression effect it used to. If that forces the Fed to tighten credit, it could bring more frequent recessions.
Phil Adler:What does this reduced incidence of recessions mean for the equity markets?
Bill O'Grady:Well, it's bullish. In general, during recessions, earnings decline. If the odds of an earnings decline in any given year is less, it emboldens investors to take more risk. This, of course, leads to higher price earnings multiples and higher stock prices for each unit of earnings.
Phil Adler:So bottom line, are investors rewarded for accepting higher price earnings multiples as normal?
Bill O'Grady:In general, yes. What is unknown is when the infrequent recession occurs, it could be a deep one that brings a sharp drop in earnings. If one is holding high priced stocks, that decline could be rather unpleasant.
Phil Adler:Still, would investors be wise in the light of this evidence to ease up maybe just a little on risk aversion strategies?
Bill O'Grady:Well, you know, that depends on one's pain tolerance. In general, yes, investors have evidence that recessions occur less frequently, and so taking on more risk is defensible. But as the February showed, if a deep recession occurs, the declines can be difficult to manage. Now, if an investor is young and risk tolerant, what this research suggests is that being invested makes sense. On the other hand, an older investor may not have time to recover from a major bear market and probably should forego the excess return for a little bit less
Phil Adler:risk. Bill, I know as an investor, I'm always thinking up reasons to worry about a recession. Lately, I've been reading about how AI is allowing many companies to reduce their workforce, and I'm thinking wouldn't higher levels of unemployment impact consumer spending? This may not be your worry. But I'm wondering, is there a key worry for you that might alter the long term environment we've been discussing and ratchet up the number of recessions?
Bill O'Grady:Well, you know, Phil, this is always a worry. One key element of our asset allocation process is to handicap the odds of recession. I would say that it has become more difficult. The usual signs such as an inverted yield curve or declines in the economic leading indicators no longer work very well. Your observations about AI are important because we haven't seen it before.
Bill O'Grady:One idea I've been examining is that segments or regions of the economy may be slumping, but the declines themselves are not large enough to trigger a national downturn. We saw something like this in the late eighties. In fact, it's possible that the nineteen ninety one recession could have been avoided had the Gulf War not occurred. Every recession has its individual elements that make it hard to predict. It's also very important to note that the February initially was quite mild.
Bill O'Grady:So mild, in fact, that there was a running debate as to whether the economy was recession or not. In the full transcripts of the Fed meeting in August 2008, the FOMC was preparing to raise rates at the next meeting. Of course, Lehman Brothers failed, and the rest is history. What I am relying on more than anything is that since the end of World War II, accepting the 1945 retooling recession, we have never had a recession with fiscal deficits this large. It's just hard for the whole economy to contract with fiscal support of this magnitude.
Phil Adler:Thank you, Bill. The title of this week's report is no country for recessions, and you can find a link to the written report on the Confluence webpage, confluenceinvestment.com. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.