How A US Recession Could Change Everything by Andrew Hunt author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor.
A US recession may be imminent and could signal a radical shift in terms of stock market performance. The opening months of 2016 may have provided a taster, with deep value and emerging market linked stocks enjoying a rebound relative to the high growth and quality stocks that have led for the past few years.
A US Recession is Overdue
While predicting exactly when a recession will happen is all but impossible, there are plenty of reasons to expect one for the world’s largest economy over the next year or two.
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To start with, the current recovery is already long in the tooth. The longest America has gone without a recession over the past 150 years is ten years, and we’re already seven years into this recovery. Further, the engines that have driven the recovery may have run their course: consumer credit has rebounded strongly, real estate prices are back up, auto demand is at record levels and markets have reached new highs.
In addition, a number of important indicators are signalling a slowdown. Trucking, corporate earnings, export growth, manufacturing and industrial production have all been struggling for several months now, while Q1 growth came in unexpectedly weak.
A final contributor is the weakening relative position of the US economy. On top of the strong currency, there are many structural factors that have been getting worse as other countries have been improving. These include things like poor quality infrastructure, falling educational achievement, ageing demographics and the exploding costs of regulatory compliance.
In practice, recessions tend to begin suddenly and come as a surprise. Often a change in sentiment is the only clear catalyst.
What Might Happen if there is a US Recession?
If and when the next US recession does arrive, things could get interesting. Both of the past two downturns have precipitated a regime change in equity markets. The 2000-2002 downturn saw the collapse of high growth TMT stocks and the return of value stocks, real estate and emerging markets. Similarly, the 2008 slowdown led to a fairly short lived but no less extreme bubble in resources, energy and emerging market stocks.
In both recessions the dynamics have been broadly the same. The slowing US economy causes the Fed to ease monetary policy. This increases the supply of dollars, and the dollar weakens.
This gives other countries – especially emerging markets – cover to ease. In most economies and especially developing ones, monetary easing still has the power to drive up demand for real goods rather than just financial assets.
Moreover, when the US goes into recession, investors don’t want to invest those newly printed or newly borrowed dollars straight back into the US, so those dollars flood elsewhere into other markets. Thus when the US wants to reflate its economy, it must first reflate the rest of the world.
However, a weaker dollar combined with strengthening global demand and widespread easing would clearly be inflationary for the US economy. This in turn could become a self-reinforcing spiral, similar to what countries such as Brazil are enduring. Indeed, there is scope for a loss of confidence in the dollar because the US would have been through a full economic cycle without even getting close to controlling its budget deficits or meaningfully tightening rates.
In summary, the overall result of such a chain of events triggered by a US recession is likely to be the opposite of the past five years:
- High inflation, a weak dollar and weak relative US stock performance.
- Asset heavy value stocks and emerging market stocks outperform as demand recovers thanks to global easing, and investors look for tangible assets to protect themselves from inflation.
- High growth favorites (such as tech unicorns and internet stocks) get whacked as cheaper growth opportunities emerge elsewhere. Inflation is also a headwind for growth stocks: A rising cost of capital decreases the value of future growth, while the fact that many of these business models are deflationary becomes a problem as inflation picks up.
- Bonds and quality stocks (viewed as bond proxies) struggle as inflation bites back.
Just like the past five or six years, these trends in capital flows are likely to become self-reinforcing and run too far the other way.
Is California’s Debt the Next Big Short?
For those looking for the next big short or a way to bet against the current internet bubble, California’s state debt may provide an ideal opportunity. All the makings of a crisis are present:
- Enormous off-balance sheet liabilities
Depending on whose numbers you believe, California’s total unfunded liabilities are somewhere between $350 and $500bn. Indeed, the sums are so daunting that most policymakers simply refuse to acknowledge them. Worse still, they are growing exponentially. For example the liabilities of the Teachers Retirement Fund are increasing by $22m a day!
- Accounting gimmickry
Deferred payments, internal borrowing, reclassifying revenues and liabilities, and unrealistic actuarial assumptions are all present.
- A history of problems
California is a highly cyclical state with a fragile economy and an even more fragile funding position. It ran into major protracted budget problems after the TMT bubble and the Great Recession.
- Political Paralysis
California’s growing financial problems have been known about for some time, yet a byzantine political structure and powerful vested interests has meant that no one has been able to begin to tackle them. California has the most generous welfare benefits and among the highest public sector salaries. High poverty rates and strong unions make it impossible to cut back. This gridlock exacerbated the 2008-2012 budget crisis and will no doubt make the next one even more difficult.
- A narrow and unsustainable revenue base
The current tech bubble in both private and public markets has been an enormous boon for California’s finances. The sheer sums that people have been making are vast, and this has huge knock-on effects in terms of spending, employment, confidence, construction, real estate prices and all forms of taxation. With 1% of California’s population now paying over 50% of its taxes, the state is utterly dependent on this tiny super-rich class. However, in turn they are dependent on financial markets. If there is a bubble and it bursts, California’s revenue base will collapse.
- A nasty case of double-gearing
To make matters worse, if financial markets performed poorly, the value of California’s assets (no doubt overinvested in California-based stocks and funds) would go down, making those unfunded deficits even larger. This is what happened after the TMT bubble.
Given all these troubles, I expect California will be at the epicentre of the next US recession. A few credit default swaps might provide some comfort.