What if a Recession is the Cure?

“Most of the time, the end of the world does not happen. “ — Howard Marks, Co-Founder of Oaktree Capital Management

As we close the first quarter of 2022, all signs point to our economy moving into a new stage of the business cycle. We are past the peak and rolling into the earliest stages of contraction. After laying the groundwork for months, the Federal Reserve Bank officially began raising interest rates earlier this year. Their goal is to dampen inflation which has now increased to alarming levels and is affecting businesses and families across the socioeconomic spectrum. The Fed has most likely taken too long to act, and they are removing stimulus that was too excessive and lasted for too long.  While the Fed’s quick action likely saved our economy from the worst possible outcomes during the pandemic, we are now surrounded by inflation that is having real world impact.  

Consumers face double digit price increases on groceries, gas, electricity, and rent. This will likely continue as global supply chain challenges promise more shortages and higher prices well into the second half of the year. Housing markets are heated, and an entirely new market distraction entered the chat with Russia’s invasion of Ukraine.  Wars are generally the harbinger of… more inflation: 

  • The military’s demand for goods is piled upon civilian demands causing prices to rise further. 
  • Sanctions and embargoes disrupt supply chains.
  • Governments finance wars by printing more money.

Russia’s invasion will keep inflation higher than it would have been and will directly impact the price of aluminum, oil, wheat, corn, and the entire food economy. 

The Federal Reserve was created to provide price stability for the U.S. by improving the flow of money and credit through the economy.  Managing inflation is one of the Fed’s primary goals. Given the pervasiveness of inflationary impact, they are already behind, and we may be witnessing the beginning of a wage price spiral. A wage price spiral occurs when consumer prices rise and workers demand pay raises to keep up, or switch jobs to seek better pay.  Employers then raise prices on goods and services to match rising costs. Eventually wages and prices become trapped in a circular dance.  We last saw this in the 1970s.   

Beyond wages and inflation, there are telltale signs indicating that we in the middle of an economic bubble that has yet to be deflated. The excesses are there: 

It’s not 1999, but the radio is playing a familiar tune.

The Fed is attempting to address the problem. My concern is that they are too focused on navigating a “soft landing,” the proverbial sweet spot where the Fed raises rates just enough to slow the economy without tipping the economy into a recession.  

But what if a recession is “the cure”?

Curing an ailment typically requires treatment. And the treatment isn’t always pleasant. Medicine tastes like… medicine.  Surgery involves discomfort, dislocation, and potentially extensive rehabilitation. But if all goes well, our bodies are better off than when we started. The problem with the soft-landing approach is that once inflation grows and begins to impact consumer thinking (consumers expect prices to rise), it can burn out of control and lead to far worse outcomes in the form of hyperinflation seen in Germany, Zimbabwe, and Venezuela. The effects can linger for decades.  

The Federal reserve is already behind.  If they consistently raise interest rates at a 50bps pace at each successive meeting, the Fed won’t reach their target rate until well into 2023.  Instead of trying to slow inflation and potentially missing the mark, the answer may be for the Fed to hold a fire hose against it and stomp it out.  And then the Fed can focus on reigniting the economy through various stimulus efforts. 

A recession is defined as two or more consecutive quarters of negative economic growth, typically measured using GDP—the value of all goods and services a country produces. When we think of a recession, we typically associate it with falling prices, extremely tight credit, bankruptcies, and high unemployment. But that is not always the case.

Recessions do not happen frequently. Each recession is unique, but they usually have a few traits in common:

  • They typically last about a year
  • There is a fall in consumption
  • International trade drops
  • The unemployment rate almost always jumps

If you consider these basic characteristics, a recession sounds uncomfortable but not ominous.  And in the case of unemployment, we need a tightening of the job market which has been artificially propped up by government support through unemployment insurance and economic stimulus.  A recession may not be that bad. Some economists think we may already be in a recession that started late last year.  

Recessions are a normal part of the economic cycle:

Recessions don’t always lead to significant job losses and typically the drop in hiring is much steeper than the number of actual layoffs. Some companies and sectors thrive during recessions.  And, on the positive side, companies are forced to become more efficient.  Money isn’t free flowing and so companies tighten their belts and find ways to do more with less. They implement technology to reduce costs. During a recession, prices regain their balance through a reverse of the spiral described earlier: employment slows, consumers cut back on spending leading to companies cutting prices to become more competitive.  As prices fall, consumers start to spend again.  We then start our ascent out of the recession and flowers begin to bloom after the rain. The risks of the current bubble reaching larger proportions and inflation growing out of control could be much more severe than a simple recession. 

The downside of proactively providing this medicine, is the potential political blowback. No one wants to be responsible for removing the punchbowl and ending the party.  

For equity markets, the process described above acts as a cleanser for stocks. (A good thing!) Questionable business models start to get questioned, valuations become more rational, and stock pickers place more focus on cash flows and profits.

Wait, don’t stock pickers always focus on cash flows and profits?

“Your vision gets blurry when it’s raining money.” – Professor Scott Galloway, NYU Stern

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