It’s official – we’re experiencing the longest economic expansion in U.S. history. Since the Great Recession, the U.S. has experienced approximately 130 months of growth. Of course, with any bull run, one begins to ask themselves, “when does the music stop”? No one wants to be left without a chair, yet I constantly hear of wealthy, intelligent individuals preparing for the next catastrophe. While I certainly am not Pollyanna about the economy, I apparently hold a vastly different belief than the majority of people. In this post, I’ll explain why we absolutely will not see a major downturn and why the next recession will more closely mirror other minor recessions that we’ve had over the last 100 years.
The Great Recession
First, let’s define what the Great Recession actually was. At this point, it’s been labeled as the worst economic decline since the Great Depression that started in August of 1929 and ended around March 1933. Here are some important metrics that will help you understand just why the Great Recession was so painful for Americans:
- Real Gross Domestic Product (GDP) fell $650B or 4.3% of total GDP of $15T
- Household net worth fell $11.5T or 17.3% of $66.4T
- Unemployment spiked at 10% with 8.6M or 6.2% of the work force losing their jobs
- The financial system seized up with banks unable and refusing to lend because they were unsure of their own financial strength
One of the major stories of the Great Recession was that ~10M Americans lost their homes to foreclosure. At the risk of oversimplifying the issue, this is what really caused the Great Recession (yes, some of this was in the Big Short, but you really need to dig into the details of it):
- Collateralized debt obligations (CDOs) that were once used to hedge risk on commercial debt were almost entirely replaced by mortgage backed securities which were tainted with toxic mortgage products.
- CDOs were granted high rating status by ratings agencies which gave the appearance of security, even though they didn’t know what comprised the CDOs.
- Based on these high ratings, pensions, governments, and other safe investment vehicles invested in CDOs in the hopes of achieving higher returns for the portfolio.
- Because CDOs had mutated and become so complex and convoluted, investors had no idea what they actually owned and how much was toxic. This uncertainty caused the financial markets to seize up.
- Once the economy began to falter in 2007 and 2008, these underlying mortgages proved to be disastrous because the homeowners could not handle the payments that the mortgages required. Because they could not refinance out of these mortgages due to home values declining and banks freezing up, home owners began to default.
- This daisy chain of defaults, and institutions not knowing exactly what they were holding on to, resulted in the financial crises as banks refused to lend and assets worth billions of dollars became worthless or lost massive value.
Where Are We Today?
It’s a bit shocking to see where the U.S. economy is today compared to a decade ago. By several measures the economy is on sound footing:
- As of November 30, 2019, the U.S. unemployment rate is at 3.5% compared to 10% during the Great Recession (more on this in a later post)
- Household net worth stands at $113.5T as of the last report
- Gross Domestic Product has grown at 2% to 3% even in the face of a struggling housing economy. Estimated GDP at the end of Q3 was $21.54T
- The Dow Industrial Average sits at ~28,500
- Home prices have largely recovered to surpass the highs set just prior to the crises. Every market will differ.
- In 2019 alone, U.S. workers have experienced wage growth of ~4% which has been increasing over the last few years. Not as much as needed to allow the economy to go gangbusters, but steady.
By every indication we’re at the market high, poised to drop and possibly drop hard and fast. But why?
Are We Poised For a Recession?
I hear it nearly every day now from a number of different places.
- “I’m stockpiling cash to get ready.”
- “I don’t want to buy in this market and regret missing out on deals that will come when prices fall.”
- “Is now a good time to buy? I can’t find any deals.”
- “This cycle is the longest in history. It’s just bound to come unraveled.”
Really, the underlying theme here is that we’ve been recovering for too long. The stock market is too high. Prices for real estate are too high. Everything is too high. But, is that reason enough to cause a recession? And not just a recession, but a really bad recession? One that mirrors the Great Recession? Because no one I speak with thinks it’s going to be a minor pull back. Everyone is convinced that we’re about to have another major crises.
Every time I hear this, I ask why? What is going to cause not a minor recession, but a major recession?
What is a Recession?
The most basic definition is that a recession occurs once GDP retracts for two consecutive quarters. That means that the economy has to actually contract for a full six months before we call it a recession. That’s a major lagging indicator and can make it very difficult to tell when we’re actually starting down the path of recession and whether we’re in a full-blown recession. There are other helpful indicators, but for purposes of this article, let’s just stick with the most basic definition.
So, we’ve got six months of declining GDP. Keep in mind, that’s not slowing GDP, but actually reversing GDP. The economy is shrinking.
The United States is a bit unique compared to the rest of the world. Our economy is primarily driven by consumer demand and purchases by consumers. This includes purchases for t.v.s, cars, clothes, computers, iPhones, etc. When a recession occurs, consumers are purchasing less and thus businesses begin laying off workers or reducing payrolls. When companies reduce staff or the income of its remaining staff, this puts additional pressure on consumers being able to purchase goods to help fuel the economy. Thus, we have a vicious cycle of retraction. This is why you’ll see the federal government offer tax cuts and outright tax rebates/refunds to consumers to help spur the economy. The U.S. economy needs consumers.
Are We In For a Recession in 2020?
I’ll go ahead and deliver the punchline since you made it this far.
No, we’re not going to have a recession in 2020.
And no, we’re not going to have a major crises for the next downturn.
In the near term, there are simply too many positive variables working to prevent a recession in the United States. Employment is at an all time high, workers are making more each year, there’s positive innovation at work, banks and other creditors are still lending with little reservation, and the housing sector is even showing signs of new life. In addition to these factors, the Trump administration appears to have prevented a full blown trade war with China and those headwinds which were at play in 2019 hopefully will dissipate for 2020. There’s clear evidence that the trade war with China caused uncertainty for businesses which prevented them from deploying capital and taking business risks which would have further grown the economy.
Ok, great, the economy is on steady footing now, but what’s lurking in the shadows? Real estate is too high, so we’re clearly going to have a repeat of the Great Recession, right? Bank balance sheets are full with commercial and residential loans, so they’re over leveraged, right? Student loans outstanding are a ~$1.4T and when they default, that’s going to trigger a crises, right? The stock market is at an all-time high, so that’s going to trigger a recession, right?
- Yes, real estate prices have largely recovered and even exceeded pre-crises levels, but why should that mean that they’re over inflated and bubbly? This is related more to inflation, higher costs of building, low interest rates, and a lack of inventory. I predict that we will actually see a gradual slowing and leveling of real estate prices in the next few years – without a crises. Home builder confidence is at an all time high and they’re building homes as quickly as they can. Trade deals with China, Canada, and Mexico help the housing market as labor and materials can be acquired more cheaply. Low interest rates have allowed borrowers to purchase more expensive homes, but, they’ve qualified for those loans under tight underwriting requirements. No more ridiculous appraisals which helped aid in the crises. The loans being written today and over the last decade are some of the safest loans that have been made in U.S. history. I know, because I run a mortgage company. It’s safe paper. As more housing inventory hits the market, we’ll see less pressure on the existing supply and prices will cool. As Millennials continue to hit their working stride and earn more, demand for houses will increase which will spur additional building. Also, we’re going to have Boomers moving out of their homes and selling to a Millennial generation that is desperate for housing inventory. More on that below.
- Bank balance sheets concern me a bit and we’ll cover that more later. But, the loans being written have better loan to value ratios and are secured by better collateral than in the last two decades. The loans on bank balance sheets are good paper. There’s just a lot of that paper and liquidity is getting a bit tight.
- Student loans don’t scare me one bit. For a few reasons. The first and primary reason is that no one, to my knowledge, is packaging these loans up, slicing and dicing them via Collateralized Debt Obligations (CDOs), and then creating additional massive leverage on them like what happened with mortgage backed securities. The investors holding on to these loans know what they got themselves into. They’re fully aware of the risks and no one is committing massive fraud to try to hide performance. Secondly, student loans stick with the borrower no matter what. There’s no defaulting on them. In essence, they will always have value because the borrower must always perform. So, even in a wave of “defaults”, someone could provide the liquidity to the market and that investor would be made whole at some point because the loans would perform.
- The stock market is at an all-time high. I would say it is well poised for a pull-back. But this is going to be made worse primarily because of automatic computer trading and ETFs. These are new devices and instruments that have never been as popular or prevalent as they are in today’s society. We’ve already seen what happens when a “flash crash” occurs. It’s not good. But, a decline in the stock market does not trigger a recession. See the definition above. It may hurt overall household wealth, but there’s no indication to me that corporations are going to disappoint shareholders through missing earnings – at least not a major scale. The economy is doing well, consumers are doing well, and companies are doing well.
You may still be under the impression that the “next one” is going to be bad. As bad as the last one. I simply ask you this: why? What is going to trigger the financial system to seize up and collapse? What massive gamble is going to come unraveled? What financial product has the world invested heavily in without understanding the product? What assets are artificially inflated? The questions go on and on. At the end of the day, it all boils down to the fact that we as humans suffer from a bias that the most recent event is going to be the next event. It’s not a bad survival mechanism, but it’s terrible at helping us predict events.
What Am I Watching Out For?
I always want to be watching out for signs of instability. In 2018, the 10 year Treasury spiking and rising to 3.25% caused major problems in residential real estate. We don’t need that to happen again in the next few years. That will make it too expensive for borrowers to purchase homes at these higher prices without receiving larger wage increases.
I’m watching out for employment and wage growth. If wages don’t continue to grow, consumers cannot keep up with inflation. The stated inflation target and rate of ~2% is nonsense. The real inflation rate is much higher and I’m working on a post to cover that topic. It’s a major problem. Employment appears to remain strong, but the longer-term issue here is whether the jobs currently being worked are sustainable for the future. Society as a whole has a very long way to go when it comes to expansion in science and math. We’re only just scratching the surface of the opportunities in space. Opportunities in the human genome. Opportunities to reverse climate change. There are plenty of opportunities in the future. The question will be whether workers have the time, resources, and insight to make necessary changes before it becomes too late for them to pivot. We need more resources dedicated to educating the work force and preparing them for the future.
The stock market should continue to perform well through Q3 and possibly Q4 of 2020. Investors very likely have seen the best days of the stock market and should not expect to see the phenomenal returns of the last few years. This run up has been aided by the massive liquidity sloshing around in the markets after Quantitative Easing rounds. I will likely liquidate my investments around Q3 and will let the correction take place. A logical reason for a decline in the stock market is going to be corporations providing forward guidance that indicates a softness or earnings per share coming in weaker because the corporation has run out of opportunities to cut costs, expand market share, or increase revenue. A company only has so many levers it can pull.
There is a longer-term issue which has already been coined as the Silver Tsunami where the homes that Boomers own and may not be methodically selling will all the sudden start hitting the market in waves. That’s a big problem. For a variety of reasons. The first reason is that it’s never good for a glut of homes to hit the market at once. Secondly, a fair portion of these homes are in locations where Millennials aren’t located and don’t want to locate. That’s important because they’re the only generation capable of matching Boomers in terms of eligible purchasers by sheer headcount. And finally, these homes are going to be outdated and need work. If a potential homeowner is considering a 20 or 30 year home compared to a new home, they’re going to lean towards the new home. So this massive glut of homes could sit vacant in markets for a very long time. Given that the horizon of this event is 10+ years or greater, it’s difficult to assess the full impact this may have on the economy and local communities. Just know this is either an opportunity or a problem.
The final thing that concerns me is what is happening in the repo markets for large institutions. This story first broke in September where the short-term lending rate spiked as high as 10% for extremely short-term liquidity. This sparked a flurry of articles as the Federal Reserve immediately stepped in to provide liquidity and assurance to the market. Initially, this was written off as a cash crunch because companies needed to pay their taxes. At face value, that might make sense, but when you step back for a moment, you realize that would either be major financial mismanagement. Companies know when taxes are due. They know how much is going to be due ahead of time. If that was in fact the case, this would indicate that companies were suffering from not having enough liquidity. At the time, it was speculated that this was a short-term phenomenon, yet, the issue persists to today. There’s so much at play with what goes on in the repo markets, it would require a separate article from someone much smarter than me. Suffice it to say, it bears watching as these fractures could lead to a full blown break if the issue cannot be identified and mitigated.
What’s Your Prediction
Given this analysis, you should see that talks of another bad recession, this soon, are driven almost entirely be fear and short-term memory. What’s your take on what’s going to happen? I’d love to hear from you.