What is a recession? A recession is caused by two consecutive quarters of negative gross domestic product numbers. In effect, it is the end of an economic expansion and the beginning of a contraction. People often confuse a market drop, or a correction, with a recession. While this often happens, you can have one without the other. We can experience a good economic expansion and still have a market correction.
There are many different views on the causes of a recession and how to identify one. I view recessions as simply a normal part of the economic cycle. A strong economy causes costs to rise. For example, we are currently experiencing the lowest unemployment in 50 years! This is going to lead to higher wages, which leads to higher cost of goods. Higher prices for goods and services cause inflation, which causes the Fed to raise interest rates in order to limit borrowing and “cool off” the economy. If borrowing costs are high, then businesses are less inclined to expand, which has the natural effect of slowing the economy, which in turn leads to negative GDP and ultimately a recession. It is important to note that not everyone subscribes to this theory. Some believe they are caused by different events each time and as such can be avoided. I respectfully disagree.
So how do we (or can we at all) identify a recession except for looking in the rear view mirror after we have had two consecutive negative GDP quarters? I believe you can predict a recession before it happens! It all has to do with interest rates. When short-term interest rates (two year) rise above the 10-year rate this is known as an inverted yield curve. When the yield curve inverts, we have had a recession within 1-2 years 100% of the time in the past 50 years! Please understand that this does not imply it will always be this way, simply that it has always been this way for the last 50 years.
Also, it is important to note there has never in that time period been a “false positive.” This means that many times the yield curve has come close to inverting but if it didn’t actually invert, then we didn’t have a recession.
Other indicators of a recession include market volatility, widespread negative earnings, unemployment, housing price declines. So far we have only had 1 of the 5.
So what do I think? Is a recession coming? Is a market drop coming? I think a recession is definitely not coming in the immediate future. I also believe a major market drop isn’t either, but I do believe we will see the drop before we see the recession. Typically, the third year of a presidential cycle is the strongest due to re-election efforts. The average return in a third year is 15%. The truth is that we have no idea when a market drop will happen because they are far less predictable than recessions, in my opinion. If you are unable to tolerate a large drop in your portfolio due to a major correction (we can debate that), then you likely shouldn’t be there in the first place. The average length of a recession/market crash combination is 13 months. The 2008 crash was 17 months. A correction with a recession lasts almost twice as long on average.
The one thing that can change my opinion is not getting a trade deal with China. That could be a strong enough event that could cause a recession.
T. Eric Reich, CIMA, CFP, CLU, ChFC, is president and founder of Reich Asset Management.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation.