To The Moon

Late last year, many economists were counting on a recession in 2023, but it is now clear that the chances of such a recession this year are not so high. Europe is not having an easy time of it and there are plenty of countries with two quarters of contraction, but it is not enough to speak of a significant downturn causing markedly falling corporate profits. On top of that, due to relatively high inflation (which is what corporate profits are all about), nominal growth is still positive. In that respect, falling inflation is a bigger threat to corporate profits than two consecutive quarters of contraction. In addition to the definition of a recession and the meaning of a recession, in this article, five arguments why the likelihood of such a recession in 2024 has increased.

What is a recession?

There is no official definition for a recession. However, two consecutive quarters of declining real GDP is seen as a definition of a recession. A focus on GDP alone is too narrow in this case. It is also not used by economists to assess the state of the business cycle. Most economists take a more holistic view of data, including the labour market, consumer and business spending, industrial production and incomes. If there is a combined significant contraction that lasts for more than a few months, it is a recession. The recession begins at the peak of the expansion and ends when the economy reaches a bottom. This also means that a recession can really only be determined in retrospect.

Meaning of a recession

Normally, a recession is preceded by a period of economic prosperity. At some point then, the economy is too far ahead of the underlying developments. There has been too much investment, stocks have risen and the recession is little more than the elimination of excesses. There is a risk that companies that have taken on too much risk during the upward phase of a recession will fail. In recent decades, central bankers have done much to ease the pain of recession. As a result, many companies have not gone bankrupt when it would be best for the economy. After all, companies that fail make room for new and better companies. Now these inefficient companies inhibit innovation, productivity and hence the economy. Due to the long period of extremely low-interest rates, there are relatively many such ‘zombie’ companies. Consequently, in a coming recession, there may be above-average casualties.

Recession looming

There are at least five arguments why the probability of a recession next is higher than in the past 12 months. Each argument by itself is sufficient for a recession, but at the same time, it actually requires an exogenous shock to send the economy plunging off a cliff, so to speak. The chances of such a cliff event did increase. Here are the five arguments:

1. Up to 12 to 18 months pass before interest rate hikes have their full effect. This time, interest rate hikes went much faster than before. At the same time, consumers and businesses financed themselves for much longer during the long period of extremely low-interest rates. A normal transmission mechanism is the US housing market. A large proportion of mortgages were financed at 30-year rates below 3 per cent, while the same rate is now above 7 per cent. Companies, including those in the high-yield market, have also been financing for a long time. This has now stretched the effect to 24-plus months, meaning the full impact of this year’s interest rate hikes will not be felt until 2024. Currently, the money supply is shrinking in both the US and Europe and with that, the probability of a financial crash (a cliff event) does increase.

2. During the coronavirus pandemic, a lot of money went to consumers. Three-quarters of the unemployed in the US had a higher income during corona than when they were working. Moreover, they could not spend that money due to restrictions. Among other things, the money was used to pay off debts. Since the reopening of the economy, there has been a lot of pent-up demand, financed by this savings. That corona jar is now almost empty. It is a tell-tale sign that defaults are starting to rise in several categories.

3. The labour market is weakening. The sharply falling unemployment post-corona was a tailwind for the economy. Now, the number of vacancies is falling and so are fewer people voluntarily resigning. People usually resign only if they can get another job at a higher salary. Furthermore, the sharp fall in unemployment since its peak in 2020 has provided an additional boost, a similar boost is unlikely given the historically low unemployment rate. In the US, 000 auto workers went on strike last week. If that strike becomes as large as in 2019 (146,000 union members for 5 to 6 weeks), it scales a full percentage point of GDP. There is then a good chance that the October jobs report (published on 3 November) will show a contraction.

4. The manufacturing side of the economy has not been doing well for some time. First, this was mainly because post-corona consumers started buying fewer products and more services. Moreover, central bankers are helped in this regard by the disappointing development of the Chinese economy. Several purchasing managers of manufacturing companies are now hinting at a recession in the future.

5. Higher interest rates mean that people in debt have to pay more interest on their debts, leaving less to spend. Since the Great Financial Crisis and certainly post-Corona, the vast majority of debt has been in the hands of the government. Which does react to higher interest rates with a very long lag. Of course, the upcoming elections play a role, not the time to hold back, but now governments spend ‘like there is no tomorrow’. The budget deficit in the US has clearly widened and Europe seems completely oblivious to the Maastricht Treaty. At some point, interest charges on government budgets become so large that other items have to be cut. At the end of this month, the US government risks being locked in again if the two sides fail to come to an agreement in the budget negotiations.

Inflation recession instead of deflationary recession

Many investors fear a recession, as the last two major recessions caused the stock market to halve. Yet it is unlikely that the recession will be this big this time. The previous two times (after the dotcom hype and the Great Financial Crisis), central banks’ policies were aimed at stabilising the economy. To stabilise the economy, interest rates had to go to zero or even negative and even quantitative easing was used. This ultimately prevented deflation (narrowly). This time, deflation is not the problem, but inflation. To get inflation under control, the central bank needs to intervene much less harshly. Moreover, the moment this is achieved, interest rates can also quickly come down again.

An inflationary recession also results in a much smaller contraction of the economy and also has a much smaller effect on the stock market. After all, negative adjustments in profits are offset by falling interest rates. While in all landing scenarios (soft, hard, no or perfect) central banks can keep interest rates high for longer, that is not the case when there is a recession. Moreover, interest rates are not too far from zero, making interest rate cuts exponentially much more effective than negative earnings revisions. Therefore, in the past, the start of such a recession proved to be a good entry point for investors.