Business

Understanding And Preparing For Recessions – Interactions Between Sectors

My clients frequently ask, “When is the next market crash? And when will the next recession happen?” As the current economic expansion continues, I believe we are closer to the end of the cycle than the beginning. I don’t think a recession is imminent, but it’s always good to understand more about the economy. Learning about recessions, especially before they happen, can prevent worry.

To understand recession, let’s start by looking at the components of Gross Domestic Products (GDP).

Recessions

Consumer spending makes up about 68% of the economy. Business investment makes up about 16%. Federal government spending accounts for 8% (not quite half of that is defense spending). State and local government spending accounts for 11%. Finally, our foreign trade deficit subtracts 3% from this calculation of GDP. Also, in this version of GDP, Social Security and Medicare are counted as consumer spending because of the trust fund structure.

In economics class, you may have learned that recessions come from the business cycle. (There are many different variants of this business cycle theory and hundreds perhaps thousands of academic papers on it but the basic gist is the same.) As the economy grows, businesses begin investing more to meet future demand. That investment spurs the economy, creating more demand. (One business’s spending is another consumer’s or business’s income.) At some point, businesses get ahead of themselves. They may be too euphoric about how profitable the future will be, and then they invest too much. The anticipated extra demand doesn’t materialize, so they cut back on investments and lay off employees. Ta da! You have your textbook recession at the end of a textbook economic cycle.

These types of recessions are not that bad because they affect only 16% of the economy. Think about the recession at the end of the technology boom in 2002 and 2003. Around 2.2M jobs were lost before a recovery began. Yes, there was an enormous stock market bubble that deflated, but the actual economy was affected much less.

Cuts to government spending (and/or raising taxes) can also cause recessions. The deeper the cuts, the larger the recession. Take a look at what is happening in Europe for evidence of that. Greece is mired in an economic depression due to continued budget cuts and tax increases. Since 2010, Greece has been subjected to thirteen separate rounds of spending cuts and tax increases, which has left the Greek economy only 75% of its former size. Also look at the UK’s experiment with austerity at the end of 2010. Budget cuts and tax increases brought the UK economy close to a recession at the end of 2011 into 2012. Initial GDP figures say the economy shrank .3% in the last quarter of 2011 followed by a .2% drop in the first quarter of 2012. (Subsequent revisions bumped the .2% drop up to 0%, thus letting the UK avoid the technical definition of a recession.) Budget cuts and tax increases slow an economy and can cause recession if they are large enough.

Now we come to consumer spending. Consumer spending drops were the reason why the recession in 2008 was so bad. Since consumer spending accounts for the bulk of GDP growth, any big change in consumer spending can be catastrophic. Typically, consumer spending is stable since a lot of it is for necessities like food, housing, transportation, health care, utilities, and such. But problems can arise if consumers begin spending more than their income and if private sector debt grows faster than GDP.

Think back to the housing bubble. Mortgages and home equity loans allowed consumers to spend money that vastly exceeded their income. Building new houses, remodeling old houses, and using home equity lines of credit for non-real estate expenses created an economic boom. The chart below shows household debt to GDP.

Recessions

Recessions

We can see how consumer debt growth picks up around 2000 and then rockets higher. When the debt bubble burst about 2007, the economy started to collapse. Remember that consumer spending is 68% of the economy, so changes in household spending habits can have a huge effect on the economy. In the chart above, when you see the debt-to-GDP ratio going down then consumers are cutting back on spending and paying down debt. Instead of buying homes or cars, going on vacations, buying more shoes or purses, or a new video game system, they are paying back the banks.

Interactions Between Sectors

It is also important to remember that different sectors can balance each other’s effects. Think about a few years after 2008. We had consumers retrenching and paying down debt and businesses not investing because consumer demand was down. Governments (not just the US, but most developed countries) enacted some type of stimulus by increasing spending and cutting taxes. This was enough to get the economy growing but not enough to get it back to its pre-recession level quickly.

Now, think about Bill Clinton’s attempts to balance the budget during 1998-2001. He raised taxes and cut spending. Why didn’t we have a huge recession? Several reasons. First, we had a huge amount of business investment due to the tech bubble. Second, households took on more debt. On the household debt-to-GDP chart, you can see household debt growth starting to accelerate. This papered over the contractionary effects of the government’s fiscal policies.

How about the sequestration agreement and budget cuts in 2013 and 2014? Thankfully, US consumer spending was healthy enough to keep the economy afloat. Although notice that during those years household debt to GDP stopped falling. Thus, consumers stopped paying down debt and started spending. That spending helped. It also helped that the budget cuts were generally not large.

Summary

When trying to predict and prepare for a recession, it is important to look at what is going on in each sector of the economy. Different sectors have different levels of impact on the economy. Remember that recessions vary in severity. I focus the most on government spending trends and household debt levels. Data that’s almost instantaneous is available to track government spending levels, so it’s easy to analyze. Household debt trends are what could lead to another enormous recession like 2008. Such recessions are what my clients, especially those nearing retirement, are most keen to avoid. Recessions caused by changes in business investment are much harder to predict but much more benign. When you learn what is happening with an economy, then you have a better understanding of when to worry and when to stay calm.

You can relax, knowing that I am monitoring the data for you and taking the best care possible of your investments. You can sleep easy at night.

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Article by Ben Strubel, Strubel Investment Management