Avoiding a Recession

Welcome to The Shift, a weekly newsletter where I provide thought-provoking ideas to help you think differently about your career and money.

Last Week + This Week = It’s All Connected

I’ll make this quick.

Last week I wrote about my affection for big business. Read here if you missed it. This week I will talk about how those institutions could potentially play a role in saving the economy.

Too Smart for Our Own Good?

We’ve been waiting for this looming recession for what, a year now?

The anticipation is palpable. You’d probably never guess that the economy has actually grown at a solid 2-3%¹ clip this year.

Here’s the thing, recessions aren’t something you plan for. They usually just “happen.” The reason we are obsessed with this topic is because we have more information than we’ve ever had before.

With access to more data, we’ve gotten smarter.

We know where to look for clues that a recession is coming.

So when one of the most accurate recession indicators (will explain what this is at the end) started flashing red just over a year ago, recession chatter started.

Avoiding a Recession

We (collectively- companies, governments, federal organizations, American citizens, et al.) are trying to both prepare for a recession and avoid it all at once.

The ideal outcome, avoidance, may be an impossible task. But kicking the recession can down the road (as far as possible) could be a possible outcome.

The best path to that outcome might not be what economists and the financial markets anticipate.

Yet, it could be hidden right under our noses.

Lazy Thinking & Corporate Responsibility

The most obvious way to avoid a recession may be lazy thinking.

That would be to rely on government intervention and the Federal Reserve Board (the Fed) to save us. It’s the easy way out. It probably has unpleasant long-term consequences for the economy.

There’s another way.

Corporations could potentially shoulder the responsibility.

Traditional vs. New Ideas

Most economists see high interest rates as the biggest risk to economic growth ahead. If the price of loans – business loans, personal loans, mortgages, auto loans, credit cards, etc. – become too expensive businesses and individuals will reduce their spending, which reduces economic growth.

With many mortgages locked in at historically low rates² and corporate cash balances 20% higher³ than in 2019, high interest rates might take longer to lead to an economic slowdown than in the past.

Instead, financial stress on the consumer is likely the greatest risk to a recession in the year ahead. That’s because wages haven’t kept up with inflation, and every dollar earned is being stretched further.

Meanwhile, corporate profit margins expanded and cash was returned to shareholders at record rates⁴ . More recently, cost pressures from supply chain snarls have eased and pricing remains elevated, though pricing power is diminishing. Cash balances and cash flow yields reached multi-year highs³ .

Perhaps corporations could lend a helping hand?

Their current position seems clear that, as a group, support of a greater cost of living wage increase across organizations is possible. That could go a long way in avoiding a recession in the near-term.

Another benefit would be increased employee morale and loyalty. 😉 

Yet, that is way easier said than done.

Complex World, Complex Solutions

While in a simplistic world, this proposal makes sense. Unfortunately, we live in a much more complex world.

Two issues with broad-based cost of living wage increases are that 1) it dents profitability which isn’t 2) ideal for shareholders or stock prices. It can also lead to more inflation.  

Most important is the impact the recession signal mentioned earlier has on corporate spending. This indicator is so well known at this point, it actually leads to more conservative cash management by companies. Think less hiring, less spending on projects or equipment.

What might be the best solution is a combined effort by the Fed – who is in charge of how high or low interest rates go – and corporate action.

There’s probably not one solution for pushing out the timing of a recession.

The goal should be to do it with as little negative impact as possible.

Let’s make The Shift!

Lindsey

What is the most accurate recession indicator, you ask? It is called an “inverted yield curve.”

This happens when the bank has to pay more for its deposits than it can make by lending money out via loans.

In the formal definition (I will explain in layman terms in next paragraph), an inverted yield curve occurs when short-term bond yields are higher than long-term bond yield. Specifically, this indicator looks at the difference between the yield on the U.S. government 3 month Treasury bill and the 10 year Treasury bond.

Think about it like this: As a consumer you might earn something like 4.2% on the cash you have at your bank. At the same time you only pay 3% on your mortgage. That means the bank is paying you more to hold your cash than they can make on your mortgage.

It’s a losing situation for the financial services sector, which means they make less loans, which stalls economic growth.

Every single time a recession has occurred in this country, the yield curve has inverted ahead of time. The track record of this indicator is spotless (8 for 8).

The man that identified this phenomenon is economist Campbell Harvey.

I got to see him speak recently in Charlotte. Which sparked the idea for this newsletter. He talked a lot about what causes the yield curve to invert. The Federal Reserve Board (The Fed) is often to blame as they move interest rates higher during periods of economic strength to try and keep inflation at bay. The Fed also bares the responsibility of lowering interest rates if the economy slows or goes into a recession to encourage spending and return growth to normal.

It got me thinking that given the current environment, maybe the Fed shouldn’t be the only one responsible for saving the economy.

Mr. Harvey is more than an economist, he has the job of teaching economics a Duke’s Fuqua School of Business as well. I enjoyed listening to him talk about what the yield curve inversion is, how he identified it and when a recession really will happen.

He’s very well spoken and easy to understand. He even has a sense of humor, which I didn’t expect from an economist 🙂.

You can watch the in-depth discussion he had with my pals, the always entertaining, Josh Brown and Michael Batnick of The Compound & Friends here.

Sources:

1. U.S. Bureau of Economic Analysis.

2. Redfin.

3. S&P Global Market Intelligence.

4. Yardeni Research.