Never was it more true – all we have to fear is fear itself. A tweet here, a twitch there, and market confidence collapses. Add in a graph of an inverted yield curve and another podium spot for Greta Thunberg, and it’s the stuff of nightmares. Here I explore the recession nightmare.
In the Summer there was a negative yield curve, and, as a result, markets braced for an instant recession. Do you know what a negative yield curve is? Don’t bother giving it too much thought. It is meant to be a recession indicator. It isn’t. And to the extent that it might be, occasionally, it doesn’t add any practical information on how to invest or whether to invest at all.
Then the negative yield curve (whatever it is) disappeared in a puff of smoke in late Summer, the tea leaves said it was safe to release the animal spirits, and the markets bounced again. For the benefit of the reader, I can confirm that there are a significant number of very very bright people immersed in this hocus pocus.
Was the much-predicted recession just deferred to 2020? Whether there might be a recession in 2020 (and the outlook for interest rates, inflation, blah blah blah) is the riveting stuff which is currently launching thousands of research pieces from the fund groups and investment banks desperate to say something – anything.
This is the intro from one “2020 Outlook” issued by a huge global fund concern:
“The continued slowdown in global growth that we foresaw a year ago has intensified during 2019, driven by a deterioration in the global industrial cycle and by escalating trade tensions. With geopolitical uncertainty and unpredictable policymaking becoming the new normal, what are our forecasts for global growth, inflation and interest rates in 2020?”
More than 40 pages of this followed!
The underlying assumptions are:
- These things are predictable with a high degree of certainty.
- That they are essential if you want to know where markets are headed in the coming year.
- And, REALLY IMPORTANTLY, a recession is the prerequisite to a bear market, and bear markets are important.
It’s easy to dismiss the first premise.
Let me make this clear – economic forecasting is a mug’s game.
In 2001, an IMF economist published a survey of the accuracy of recession forecasts by economists throughout the 1990s. He found that their record of failure was not far off 100%.
This survey was subsequently updated to also take into account the 2008/9 period. The result? As one commentator put it:
“The record of failure remains impressive”
I will deal with 2 and 3 together.
Mostly these predictions are about technical recessions e.g. 2 quarters of falling GDP.
But really these are bumps in the road.
What should concern you is a major recession, which can be defined as “a clear absolute fall in GDP between one calendar year and the next”. In plain English, an economic downturn which is deeper and longer.
They are extremely painful for stock markets and corporate bonds. But thankfully they are also rare, only six since the First World War. Usefully they do have common characteristics.
In all cases the key element was a shock on top of inherent vulnerability. This “shock” plays THE vital role. It causes the (positive) state of mind of consumers and businesses to change overnight.
Can you see the shock coming? No. That’s the point. That necessary “shock”, by definition, cannot be anticipated.
An equation created by a smart investment banker or academic cannot model what is essentially a behavioural response to a shock of unknown timing and unknown nature. And which is rare.
Nonetheless we observe daft headlines like “It usually takes a recession to bring down the stock market.”
Really? Like 1987 when the stock market fell in excess of 20% in one day?
No recession.
Or in 2000-2003 when the stock market fell by 50%? No recession.
A major recession does not trigger a bear market, nor vice versa - they are both triggered by that same rapid change in behaviour. All you can confidently identify is the extreme vulnerability to a major recession.
The extreme vulnerability is created by factors which we call amplifiers e.g. volume and quality of debt. The precise scale and shape will be dictated by certain factors which will amplify, exaggerate if you like, that recession.
These amplifiers today are derived from the suite of policy errors that originated in attempts to prevent the world economy collapsing in 2008/9.
The most important is the volume and quality of debt. This factor amplified the 2008 collapse in such a way that the world’s banking system collapsed. Today the debt picture is not precisely the same, but the volume of debt is somewhat higher and the quality much lower.
A further factor is liquidity - who will buy when you want to sell? Regulation changes mean that the role of investment banks in this regard, previously pivotal, is now very limited.
This will be further amplified by automated selling by computers which dominate market trading. They are programmed to sell on the first significant signs of trouble.
Certain parts of the fund industry, where daily dealing is assumed, will come under extreme pressure, and such problems have already become evident – Woodford, GAM, property funds. Do not ignore these early warnings.
In summary, major recessions are triggered by a shock, of inherently unknown timing, applied to an economy which is already inherently vulnerable. This rapidly changes the behaviour of consumers and businesses - confidence collapses.
We can also say these 3 things:
- Big swings in confidence, caused by some shock event, are at the heart of both major recessions and major stock market falls.
- Major recession always combines with a stock market collapse.
- But a stock market collapse does not require a major recession.
Therefore, rather than spend too much time on the ins and outs of the economy, we must concentrate on what matters – the stock market itself – with a form of analysis focussed on what drives the stock market – confidence.
FURTHER READING