What the Business Cycle is Telling us About a Recession19 min read
If you’re looking for capitulation in 2022, it’s in the bond market. And that tells you that investors’ confidence in the global economy is very low. Inside the stock market, it’s all about defense. Defensive stocks, which include big healthcare companies and dividend-paying value stocks, have been driving the gains. An index of global defensive stocks put together by Goldman Sachs, which is heavy in healthcare giants, has climbed to more than an 18-month high relative to the MSCI AC World Index. Inside the U.S., the defensive ETF ticker DEF has been outperforming the Spider ETF SPY all last week and all year. For market watchers, this feels a whole lot like a recession trade.
While investors in the capital markets are battening the hatches for a recession, money in the private markets is also drying up. The value of venture capital deals in the U.S. dropped more than 25% in the second quarter to just $1 trillion, according to Dealogic. M&A activity in the United States plunged 40% to $456 billion in the second quarter and fell 10% in the Asia-Pacific region. Europe actually saw a rise in dealmaking, up 6.5% for the quarter. Behind most of the dealmaking this quarter? Buyout funds. They smell blood in the water and have been swooping in to buy distressed assets or public companies with evaporating market caps. Buyout funds generated transactions worth $674 billion so far this year.
Meet Lakshman Achuthan
Lakshman Achuthan is the co-founder of the Economic Cycle Research Institute and the managing editor of ECRI-produced forecasting publications. Mr. Achuthan previously served as a member of the Board of Trustees for the nonprofit Atlantic Foundation. With 30+ years of experience analyzing business cycles, he has been regularly featured in the business and financial media. Additionally, Mr. Achuthan serves on the Board of Governors for the Levy Economics Institute of Bard College, in addition to being a trustee for several foundations.
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Recessions are having their Hamlet moment across the world right now. To be, or not to be? And while we don’t know we’re in a recession until it’s over, the drumbeat surrounding this current downturn is getting louder by the minute. But instead of guessing whether we’re in a recession, about to be, or headed for one in 2023, let’s look inside the business cycle for those key leading indicators that actually give us the data we need to forecast. To do that, we’re bringing in our pal Lakshman Achuthan back aboard the Express this week. Lak is the co-founder of the Economic Cycle Research Institute, where they’re constantly collecting and analyzing data from the business cycle to forecast where global economies are headed. Welcome back, my friend. Good to be with you.
“Thank you. It’s great to be back and I think a really good time to be having this discussion.”
“Let’s stick to the U.S. for the moment, and then we’re going to go global. But it was impossible to not see a slowdown coming, given how fast the economy recovered in 2021. You were talking about this over a year ago. How have things changed since then, and Lak, are we headed into a recession, and how soon?”
“Well, the main thing that’s happened since then is that the forward-looking indicators that you mentioned continue to cycle to the downside. So, you have to start asking the question, is this slowdown going to culminate in recession? And people are starting to wake up to that. Our analysis is that the odds are really, really high that it will culminate in recession, given some of the backdrop that we’ll get into in a moment. And most importantly, because the forward-looking data haven’t turned up. And so, when we decelerate as sharply as we are decelerating, that path to a hoped-for soft landing just gets narrower and narrower. And that’s where we are.”
“Okay. Let’s talk about some of those things you’re looking at within the business cycle. Take us inside the business cycle to the metrics you track closely at the Economic Cycle Research Institute. What’s red hot, what’s getting warmer, and what is cold as ice?”
“Sure, sure. So, first, it’s important to just get our bearings. Like, what is a business cycle? It’s the co-movement of output, employment, income, and sales. Big aggregate numbers, big beefy numbers across the country. And they’re all decelerating. So, we have the slowdown: check. There’s no debate about that. There shouldn’t be, anyway. But with the tightness in the labor market, even though growth there is slowing in the jobs market, the labor market is still pretty strong. Unemployment rate is very, very low. You hear stories all the time about having difficulty hiring people. And jobs growth is quite good. Several hundred thousand a month, over 300,000 last month. That’s a solid showing, even though it’s decelerating.”
“So, that reveals that we’re probably not in a recession right now. But things change. And the thing about recessions is they happen kind of very quickly, like the realization happens very quickly. We wrote a book about the business cycle, gosh, over a decade ago. We opened it up with this imagery of the Roadrunner, the Coyote chasing the Roadrunner. And he always goes around that corner, and he shoots out over the cliff, and he doesn’t know that there’s no ground under him. And then he looks down, he goes ‘Ah!’ And he falls. So, that’s how recessions come. They always come this way. They’re usually a surprise. They’re never really forecast well in advance. And so, here we are. There’s a new generation of cycle analysts or newfound cycle analysts who are working these days. And they seem pretty sure that they’re looking out into next year or maybe even the year after, and they’re like, ‘Yeah, we’ll get a recession at some point.’ That’s just not how it works.”
“So, when we’re looking at our forward data, this is the key rate because it anticipates output, employment, income, and sales and where those go together. And those are still moving to the downside. On top of which, we all know about the Fed trying to play catch up and make up for their past mistakes and tighten quickly. We all know about the geopolitical issues and other issues that are mucking up all kinds of trade linkages. And all of those are weighing on the economy, economic growth, business decisions, consumer decisions. And so, you have a combination of cyclical weakness and kind of external shocks, for lack of another word, that that’s a toxic mix. That’s a dangerous mix.”
“Yeah, it’s a perfect storm of a lot of things happening at the same time. One, you just have the deceleration of the incredible growth we had coming out of the pandemic… still kind of in the pandemic but coming out of the worst days of the pandemic. But also, we don’t have that money going out to consumers and households anymore. That was a big part of the savings rate growing to record levels. That’s a big part of consumer spending holding up very strong. Consumer credit holding up relatively strongly as well. You have all of that going, plus the hiring cycle. But now a lot of those things are going… in fact, we’re going the other direction. Interest rates are rising. The Fed obviously raised three quarters of a basis point. They’re probably going to do that again in July to play catch up. Plus, the externalities that you mentioned. Russia’s invasion of Ukraine now entering its six month, issues in China with COVID-19, the supply chain is still a mess right now. So, when you have the externalities already impacting economies that were on the slowdown, how much more does that accelerate the slowdown?”
“It does cause the interesting thing is when the cycle analysis diverges from the kind of consensus view. And so, earlier on, I think we were raising the flag on this recession risk at the beginning of the year. We’re saying, ‘Look, either there’s going to be this major recession or the market’s going to break.’ Or the the other alternative, which we’re not going to do, is just let inflation run rampant. So, that policy choice has been taken in the last couple of months. And so, therefore, we’re looking at the market breaking and/or a recession.”
“And so, there’s some debating as to it’s probably going to be sometime next year. I would question that. I would diverge from that and say that it could happen sooner. There’s also some belief… and you mentioned it, because balance sheets are pretty good. Certainly corporate balance sheets are good, and even household balance sheets aren’t bad. At least they weren’t with all of the support they were getting, the fiscal support. And so, there is this hope that, ‘Well, it ought to be a pretty mild recession, if it’s a recession.’ That’s that’s the other hope that’s out there.”
“And I would take the other side on that. I think there’s a few things to be concerned about. One is, as I mentioned, the Fed tightening. Doing that while you’re slowing could slow things lot. you could have a harder landing than expected. Something could still break, if it hasn’t already. We don’t know exactly what’s underneath the water here. And when we look globally, and maybe we’ll get to this in a minute, there’s no clear locomotive of growth out there in the global economy. Everybody’s decelerating. Look, the Fed sets the tone for everybody. And so, other central banks kind of have to fall in line. And there’s all kinds of stuff going on globally in terms of tightening during a global slowdown that may make this a harder landing than expected. So, I would remain on guard. I think that’s the big message, if there’s a key message to take away.”
“The U.S. central bank, our Fed, does set the tone for many central banks around the world, and you’re seeing a lot of them also starting to raise rates as well, playing catch up in trying to combat inflation. The outlier, of course, being China, which does what it wants because it does control the People’s Bank of China and controls its own policies. But it’s also dealing with COVID-19 issues over there just the same and the things we don’t even know about. When you look around the world, what’s the cleanest dirty shirt in terms of economic health, so to speak, if a we’re looking into the hamper right now.”
“Gosh, that… the answer to that has been, and it may continue to be, the United States. As rough as the road is in front of us, a recession is not the end of the world. We’ve had 47-some-odd recessions, and we survive them, and we come out the other side typically a bit stronger. The key thing is: what is necessary to get inflation back down? And that’s an open question. Our forward-looking data on inflation cycles, while not running up the way it was last year. Look, in September of 2021… it’s a long time ago is when we were saying, ‘Inflation cycle upturn, this is not transitory, this is persistent, and you better move.’ And we know what happened. It took until last fall for the Fed to wake up.”
“So, here, when we look at inflation going forward, the odds are that as far as we can see, it’s going to remain elevated, uncomfortably so. So, one example that people will look to is the ’70s into the early ’80s as to what kind of monetary policy was required to break the back of inflation. And just to recall, we had the 1980 recession, and it did knock inflation down. But when that recession ended, Volcker took his foot off the brake for a moment. The recession ends, inflation hiked right back up. And so, the Fed, Volcker, engineered a second recession, the 1982 recession, and that was a more severe recession. It was a global recession (some of the words that I’m using earlier in discussing what’s going on right now), and that ultimately broke the back of inflation and set up a great deal of good growth and prosperity. So, recessions, I just want to be clear, they are part and parcel of a free market economy.”
According to the latest University of Michigan Surveys of Consumers, consumers expect inflation to rise at a 5.3% annualized rate as of the end of June. That’s down from the 5.4% clip in the preliminary reading released just a few weeks ago. That’s a tiny change, but a notable one. And it’s exactly the kind of data point the Fed is looking at as it considers the next interest rate hikes in July.
“They’re not bugs in the system. They are a feature of economic cycles. Just like bear markets are a feature of market cycles.”
“A hundred percent. I think people really get mixed up on this. It’s important to know the water you’re swimming in, and policymakers sometimes will look at recessions as something that is Armageddon, practically, and do crazy things to try and control them. And it’s not always the best policy to do that. And then you’ll see market participants get into… they’ll twist themselves into all kinds of fantasies about the cycle and recessions and stuff.”
“And it wasn’t even a year ago that if you looked at the headlines, there was a lot of talk (and I guess this is when crypto was kind of running pretty high) about these kind of cascade… because we were in the upswing, right? Or the early parts of the slowdown. Everything was very heady, market was doing great, all these things. And so, I think you heard all of this stuff about cascading technological advances, exponential change in the way economies and finances were set up, and, wait for it… that would crush the economic cycle. It would rewire the way the economy works. That would bring about the ‘death of macro.’ That was not that long ago. I mean, I know people don’t want to talk about it today, but that was where a lot of thinking was just a few quarters ago.”
“And we’ve seen this movie before. Many times in history, the death of the business cycle has come up. It’s very, very seductive. The underlying point here is that market economies have cycles. We’re in one. It’s not the end of the world unless you were presuming that there was no cycle, which I think a lot of people were and may still be holding out hope. Now, once you know that, ‘Okay, we’re in a growth rate cycle downturn, that’s likely going to turn into an actual outright recession and that recessions do eventually kill inflation.’ You know we’re going to come out the other side. The thing is, how do you navigate this so you can make it through it? That’s the key.”
“That’s what I want to get to. So, let’s talk about it from the consumer angle. U.S. consumers, we know it’s going to be a period of belt tightening, but how should consumers prepare for this? There’s all kinds of things you could say, ‘Oh, drive less, buy less at the supermarket, do a financial audit, know where your subscription money’s going, know where you’re spending your money.’ All of those things are the basics that you should do in whatever cycle we’re in. It doesn’t matter. But as we’re facing this… and there’s a generation or two that have never been through anything like this, Lak, and you know it well. How should they be thinking about this? And how should we, as overall U.S. consumers, be thinking about a possible recession?”
“I want to get to consumers, but I want to point out they’re not alone. I was talking to a client who’s really turned on to cycles, and we’re talking about the recession coming up a few months ago. And he’s like, ‘98% of the people who work here at this fund haven’t traded through the Great Recession. They don’t know what it looks like in real time.’ So, people just do not have a clue as to what it should feel like. The early stages, it’s not clear that you’re in a recession. It may not feel that way.”
“And in particular, as we said at the beginning of the podcast, at the beginning of the interview, in this current cycle downturn, employment remains tight. So, that may make you feel like, ‘Oh, there is no recession.’ I would not draw that conclusion. But it is an opportunity at the same time for consumers. Either… if you don’t have your dream job, look for it because the getting is still good in the jobs market. If you have your job, you’re happy where you are, solidify it. Don’t take it for granted. Solidify it. That is the most important thing going into the recession because that keeps the cash flow.”
“Now, separately, there’s… the term is discretionary and non-discretionary spending. So, your non-discretionary stuff you’ve got to do: You’ve got to eat. You pay your rent or your mortgage and you’ve got to pay the basics for your household. And you want to make sure that you can you can do that. That’s job number one. Then the discretionary stuff you have to manage. Recessions, the really long ones, have been a year and a half or so. They can be as short as six months. The severity, I think, is an open question right now. We do not know. Anyone who says that they do know is unaware that they don’t know. And when we get to investments and things like that, there’s a couple of things… probably the safest thing to do, if you’re not already, is to have some cash and otherwise for investors, consumers in particular, they can get inflation index bonds now.”
“The Treasury Inflation-Protected Securities are called TIPS. Did okay as as inflation was burning up here but really, again, performance is not something… we’re not we’re not looking for outperformance because no asset class, except for oil stocks right now, is doing very well.”
“No, I’m not recommending… I’m not an investment advisor or anything. I’m just saying, ‘Where can you, with the cyclical backdrop of high inflation and a recession… basically, recession means risk-off. Even simpler growth rate decelerations mean risk-off in the broad sense. Now if you have a supply disruption, even if demand is easing, the cost of something can go up. But in the very general view, a deceleration in demand is going to mean more of you’re leaning toward risk-off. And so, generally speaking, your fixed income stuff is going to be a safer place.”
“And in the context of a Fed that is behind the curve and trying to make up for it, you’ve got to be careful. One of the more careful ways of doing that might be inflation indexed. So, having said that, you will hear a lot of people say… and I don’t mean to step on anyone’s toes here, but you will hear a lot of people say, ‘You’ve got to stay invested. You can’t “time the market.”‘ And I get why they’re saying that, but I think they’re not entirely informed. There are basic risk-on risk-off relationships with economic cycles and risk assets.”
“And in 2020, we wrote in April for Investopedia in an op-ed, ‘Hey, there’s going to be a short recession. This COVID-19 recession’s going be short. It’s going to be over soon.’ Now the implication is that risk-on when the recession is over. I mean, the headlines are disastrous. There was nothing good to say about the second half of 2020 in the headlines, but the business cycle is moving up, and so it’s a risk on. And I think we even we went on to talk more, in June of 2020 on and Investopedia op-ed, about why the rise in stock prices made sense given just where we were in the cycle, forgetting about COVID-19, forgetting about all the nastiness that was happening otherwise in the economy with weak jobs and all those things. And so, there will come a time. Recessions all end. These things turn. Turning points happen. So, when the recession, when this current downturn begins to bottom and end, that is going to be a great time for risk-on and most people are going to be freaked out. I mean, this is the way of the world, at least for the last century, that I’ve kind of looked at it very closely. And and I suspect it will happen again.”
“As Buffett would say, and a lot of other sage investors, that’s the time to buy. When everybody’s so fearful and it looks like there is no light at the end of the tunnel, that’s probably the time to buy. So hard to do because our animal spirits are in our heads all the time, telling us it’s going to get worse, it’s going to get worse, or it’s going to stay better, it’s going to stay better. But Lak, something very important here is that, if we go into recession (and I also believe we likely will), we don’t know the severity, the depth, or the duration. That would be great to know, but we can’t know that in advance. When we come out, we’re not going back to the way things were. We are not going back to the 0% to 0.25% interest rates. We’re not going back to a Fed that is accumulating corporate bonds and mortgage-backed bonds. They are, in fact, selling them. And rates are going to rise until they normalize to where the Fed wants them, somewhere between 3% and 4%. This is a different type of environment for the economy and for investors. How key is that to recognize that, to know that no matter what, we’re not going back to the way things were? This is a different dynamic.”
“The human brain needs a story, and it likes analogies, it likes stories. And so, we can say, ‘It reminds us of this and reminds us of that.’ But to your point, that was then, this is now. We’re doing something different going forward. And our only presumption is that we’re continuing in a free market economy. Now, if that presumption gets truly shaken, then cycles can get weirder than they are. But with an economy that is dominated… it doesn’t have to be fully free market, but dominated by free market activity. Then we’re going to have cycles, then we have our indicators, and we can at least know if there’s a directional change.”
“And so, the directional change, you can simplify it. You don’t have to be too complicated. When there’s an upturn (and there will be an upturn at some point), relatively speaking, each person’s situation is different, you want to be more risk-on. And then when the next downturn comes (and another one will come), relatively speaking, you want to be risk-off and so on and so forth. This is not frequent trading of your job or your homes or your portfolio or whatever, but it is being aware of which way the wind is blowing. I think that would put a lot of people in in a position to focus on the things that they care about and that they’re good at and that they have fun doing and not worry so much about the business. Like, leave that to you and me.”
“These are part of the natural cycle of a free market economies. This is the way the world works. Just good to understanding it and get your explanation of it. Because if we’re not informed or if we’re not educated, it’s just one big terrifying thing looming over us. So, always good to get your perspective. Lakshman Achuthan, the co-founder of the Economic Cycle Research Institute and a good friend of Investopedia and mine. Thanks so much for coming back aboard the Express.”
“It’s great to talk, Caleb.”
Term of the Week: Rebalancing
It’s terminology time. Time for us to smarten up with the investing term we need to know this week. And since the end of the quarter and the first half of the year are upon us, we’re going to go with the readers’ pick this week and dig into portfolio rebalancing. According to my favorite website, rebalancing is the process of realigning the weightings of a portfolio of assets. It involves periodically buying or selling assets in a portfolio to maintain an original or desired level of allocation or risk. While there’s no required schedule for rebalancing a portfolio, most recommendations are to examine allocation quarterly or at least twice a year. Rebalancing gives investors the opportunity to sell high and buy low, taking the gains from high-performing investments and reinvesting them in areas that have not yet experienced such notable growth.
It also allows investors to do some tax-loss harvesting. If you’ve taken losses in your portfolio and want to use those losses against other gains. Rebalancing can help you do that. A more responsive approach to rebalancing outside of calendar rebalancing focuses on the allowable percentage composition of an asset in a portfolio. This is known as a constant-mix strategy with bands or quarters. Every asset class or individual security is given a target weight and a corresponding tolerance range. If several of your assets veer from that range, rebalancing can put you back on track. Finally, there’s Constant Proportion Portfolio Insurance, CPPI rebalancing. It’s basically a type of portfolio insurance in which the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that decision. That’s a little more complex and is more commonly used by professional mutual fund and index managers. Anyway, it’s a good time to examine our portfolios, rebalance, and set ourselves up right for the back half of what has been a pretty intense 2022 so far.