It is hard to open a newspaper or listen to a business report without hearing the word recession. Suddenly everybody is worried that the economy is about to go into the tank and that we will all become poor, or at best, poorer. I think it is worthwhile to look at the topic and try to add some perspective to the discussion.
A recession is quite simply a period of six or more months during which the economy shrinks rather than grows. It says something about the success of our economic system that perpetual growth is the expectation, and contraction is now seen as the rare exception. Here is a graph showing the growth of the US economy since the end of World War II. The white areas are periods of growth; the grey bars show periods of recession.
Three things are immediately obvious. Recessions are unusual, but not rare. There have been 11 in the past 70 years, an average of one every six years or so. Most recessions are short. The width of the grey bars show that on average recessions last less than a year. Finally, we can see that we have not had a recession in a long time. The very bad economic crisis of 2008-09 is now more than ten years in the past. By some measures, we are now (or will soon be) in the longest recession-free period in the post-war period. Since we expect the future to look more or less like the past, everyone expects that a recession will come along pretty soon.
A fourth thing that is perhaps not quite so obvious is that every recession is different from its predecessors, both in causes and in impact. As noted, the most recent recession was particularly severe. The downward slope in GDP is evident on the chart and is much more pronounced than the very slight dips, barely discernable, in the grey bars marking the recessions in 1991 and 2002. The 2008-09 event was the worst economic downturn since the 1930’s, and was caused by horribly imprudent lending, gross regulatory neglect and improvident management of financial institutions. Whenever the next recession comes, there is no reason to think it will be as severe as the last one, and certainly the causes will be different.
Everyone, of course, would like to be able to know when the next recession will arrive. Sadly, nobody knows, and there are no reliable prediction methods. At the moment, there is a lot of discussion, some informed and some merely inflammatory, about a phenomenon known as the inverted yield curve.
Normally it costs more in interest to borrow money for a long time than a short time. Since we cannot know what interest rates, or inflation, or economic growth may be 10 years from now, lenders want to be compensated for taking the risk that they are lending out their money too cheaply for too long, so they charge more for a long loan than a short loan. The “yield curve” simply describes the interest rates charged for loans of increasing duration, and normally it rises as the duration gets longer.
When the interest rate charged for borrowing money for a short period of time, say one year, is more than the rate paid for borrowing for a long time, say ten years, the yield curve is not behaving like it should and is said to be “inverted”. Recently the US yield curve became inverted for the first time since 2007 as ten-year money became very slightly (2/100th of 1%) cheaper to borrow than one-year money. An inverted yield curve is a fairly reliable, but hardly infallible, predictor of recession. That is why you have been hearing so much about it. (Explanations for why the yield curve inverts are pretty technical and beyond the scope of this essay).
So we have an inverted yield curve during the longest recession-free period in over 70 years. Is it time to panic? Hardly, and for a number of reasons. Here are five indicating we are in “business as usual” mode:
- In the past, when a recession has been preceded by an inverted yield curve, there has been a time lag of between 12 and 18 months. If we are in for a recession, it will likely be in 2020 or even 2021.
- As noted, each recession is unique. The US economy shows few of the signs of excess that characterized the last recession. The housing market is far from over-heated, loan defaults are in the normal range and banks are showing no signs of distress. Whatever the next recession looks like, it will very likely not resemble 2008-09 in causes, length or depth.
- Stock markets and the economy are not the same thing, and history shows that on average, stock markets do very well in the periods just before recessions. If there is a recession in 2020 (which is far from certain), being out of the market in 2019 would probably be a bad mistake.
- We know that we cannot time the market. We don’t think anyone can. We are as likely to sell too soon and buy too late as we are to do the opposite. Experience and observation have taught us that trying to anticipate the direction of the stock market is a futile endeavour. This is demonstrated quite well by our fifth point.
- Following a horrible end to 2018, the first quarter of 2019 was one of the best starts to a year in recent history. Stock market wisdom is that as goes the first quarter, so goes the year. Those who sold in despair in December lost out on significant gains in the first three months of the year, and perhaps more to come in the rest of the year.
There are three important parts of our investment process. We buy stocks and bonds based on fundamental research, detailed analysis, and serious discussion. We sell stocks and bonds using much the same process. More important than buying and selling, however, even if less obvious, is the discipline of simply paying attention. We continuously monitor what is going on in the economy, in various industries and economic sectors, and most importantly, inside the companies in which we have invested your funds. We put more faith in our diligent observations than in signs and portents. When those observations indicate that it is time to take action, we will do so; but not before.