The Fed is credited for softening the blow of the last financial crisis and leading the economy on the path of recovery – albeit a slow one. However, citing historical precedence, analysts at MKM partners believe that the Fed’s action of reducing the size of its balance sheet might push the economy into a recession.
- The current economic expansion is the third longest in history
- The present cycle, however, is one of the weakest since World War II on a few fronts
- Fed is planning to shrink its mammoth balance sheet
- Previous exercises to reduce balance sheets have ended up in a recession
- With a recession, more often than not, the equity markets enter into the bear territory
- While experts are divided on the next recession, it is worthwhile to be prepared for it
A talk of recession, especially after the strong second quarter growth of 2.6% might sound irrelevant, however, a few data points warn us to pay attention to them. Let’s understand them in-depth.
Third longest stretch of economic expansion
The US economy reached a milestone on July 28, of being recession free for the past eight years. The current recovery cycle is the third longest in the history. The largest recession free period lasted 120 months, from March 1991 to March 2001, followed by a 106-month long streak that ran from February 1961 to December 1969.
Nevertheless, the current recovery has been the weakest since World War II on fronts like pace of growth and wage gains.
The US GDP has grown a measly 19% in the last eight years. Relatively, in the same span, the GDP had grown 34% during the 1991-2001 expansion, whereas, the growth was much stronger in the 1961-1969 period when the GDP grew by 51%.
Though the jobs growth has been robust, at 12%, they lag the previous two expansions in the same time span. In the 1991-2001 period, jobs grew by 18%, while the job gain in the 1961-1969 period was a whopping 30%.
There is no direct comparison of wage growth – which has been a major eyesore during the ongoing recovery cycle – as the government did not collate data on hourly pay for private-sector workers until 2006. Notwithstanding, a study by the Economic Policy Institute shows that pay for the rank-and-file workers, adjusted for inflation rose a paltry 3.5% from 2009 to 2016, whereas, in 1991-1998, it had risen 6% and during 1961-1968 it had risen by an impressive 13.5%.
However, it is not all gloom and doom because it also has a few credible achievements to its name.
A few records created in the current recovery cycle are – job addition for 81 straight months, the longest streak ever and the number of citizens applying for first-time benefits has been below 300,000 for 125 consecutive weeks, the longest stretch since 1970.
Agreed that the current economic recovery has been weak, but the length and the weakness are no reason to suspect that it is about to end. Is there any reasonable data that points to a looming recession in the near future?
What happened when the Fed reduced its balance sheet on previous occasions
As a result of the quantitative easing programs during this economic cycle, the Fed’s balance sheet has ballooned to $4.5 trillion. Now, the Fed Chair has said that the economy is strong enough for it to consider shrinking its bond portfolio.
However, historical results of such an exercise have ended up with a recession most of the times.
According to a research by Michael Darda, chief economist and market strategist at MKM Partners, five of the six past balance sheet reductions – in 1921-1922, 1928-1930, 1937, 1941, 1948-1950 and 2000 – have ended up in a recession.
Not only that, the Fed’s tightening (rate hike) has also led to a recession 10 out of 13 times.
The Fed is likely to announce their plan in September. They are expected to let a specific size roll off every month and reinvest the rest. It is likely to be a slow roll off that will be raised quarterly until it reaches $50 billion a month. The Fed plans to continue the roll off until the balance sheet size shrinks down to $2 to $2.5 trillion. The whole process can take about four to five years, if it runs without any breaks in between. Though the Fed is confident that the slow process will be painless, the experts are not convinced.
“Against this historical portrait, a pressing question arises: will credit markets and equity volatility remain quiescent moving into the second half of next year when balance sheet reduction and rate hikes — a double-barreled tightening — begin to move along at full force?” Darda said, as reported by CNBC.
Peter Boockvar, chief market analyst at The Lindsey Group believes that historically, the tightening cycles have led to a recession and this time is not going to be any different. The communication from the Fed is not going to limit its impact.
Everyone doesn’t believe that a recession is around the corner
The S&P Global Ratings firm recently reduced the risk of a recession in the US from 20%-25% to 15%-20%. S&P believes that the economy will chug along slowly at a growth rate of 2.2% for the rest of this year and at 2.3% in 2018.
Economists at Goldman Sachs believe that there is two-thirds chance that the current economic expansion will exceed 120 months and become the longest recovery on record. They, however, believe that the risk for a medium-term recession is rising “mainly because the economy is at full employment and still growing above trend,” reports CNBC.
Be prepared, as the recession might be nasty for people who are not ready for it
Are we the only one fearing a recession? No.
In a recent Bloomberg survey, 25 finance professionals from four continents believed that the next US recession would start in the first half of 2019. Their main concern was the coordinated tightening by the central banks. The US Fed is expected to start winding down its balance sheet by the end of this year, and the European Central Bank and the Bank of Japan are also expected to commence tapering their asset purchases.
More often than not, recessions and bear markets go hand in hand, as can be seen in the chart below.
Though it is not necessary that the next bear market is as vicious as the last one, the past three bear markets have been more vicious than the preceding one, as seen in the chart below.
Therefore, traders should be prudent while committing new money into the stock market at the current levels. Also, the existing positions should be protected with suitable stop losses. Holding some cash in the portfolio is also a good option. After all, the smartest investor among all, Warren Buffet is currently holding on to a cash chest of $90 billion, as he is not finding good bargains at the current levels.
Hence, at the risk of some underperformance, why not join the legendary investor and be ready to buy stocks when there is a SALE in the near future.