The Next US Recession

0 433

Whenever there is a drop in the US stock markets, commentary about a potential recession is normal. However, the markets have been trickling down since October, which is an extended period if we were talking about a ‘buying the dip’ opportunity, and well within correction territory (defined by a drop of 10% since the latest high).

It’s been close to 10 years since the US was in a recession, well above the average 7-8 year frequency. Concern about a recession is understandable given the circumstances, but how likely is it? Let’s talk about that, and maybe uncover some factors that aren’t getting enough attention in mainstream discussion.

Join our responsible trading community - Open your Orbex account now! 

The Liquidity Problem

There is plenty of public debate about the potential effects that Fed policy is having on the markets – with the disagreement being whether it has more or less impact than the trade war.

Most people are talking about rate increases, but few are focusing on the Fed reducing its balance sheet and draining liquidity from the market. Although it’s not presented as such (euphemisms like “normalization,” “unwinding,” etc. are used) it is a monetary tightening policy.

In November, the Fed pulled $54B out of the market. At the same time, the US Treasury stepped up short-term issuance. The Fed is also reportedly telling banks to focus on cash reserves over treasuries.

How much of the Fed’s balance will be “normalized” is still an open question for the market, with some speculating it will come to an end as early as summer next year. So far, the Fed has pulled $374B out of the market since the program began, and it’s structured in such a way that the tightening will increase over time.

Financial crises come from a lack of liquidity, and while traders have been able to find enough to margin, total margin debt is 50% higher than it was at the start of the 2007 subprime crisis that rolled over into the 2008 recession.

Last month, margin debt fell by 6.5%, with increasing capital costs and poor market performance making it less appealing. This started happening in October, right after the rate hike by the Fed, with the market taking a turn downwards.

The International Scenario

The US might be the largest economy in the world, but it’s still open to effects from overseas. For example, Europe is in worse straights. While the US’ markets peaked in October, Europe’s markets have been trickling down since January.

Last quarter Germany’s economic growth slipped into negative territory. The annualized GDP growth for the whole Eurozone peaked in Q3 of 2017 and has since slumped to 1.6%. China has also seen its markets sliding lower after peaking in January.

If we were tempted to blame the current market doldrums on the ongoing trade war, then some explanation has to be made as to why the markets started to slip months before tariffs were implemented in July. While Chinese business confidence started to keel over in July, American business confidence actually jumped in August, and later slipped in October (though it remains high.)

Financial markets are not everything

Aside from financial markets, another important aspect of recessions is inventories. As the economy grows, it can lead to an imbalance between supply and demand. There is usually an accumulation of a product, and the market drops to correct to the “real” value.

Last recession, the product was housing. Prior to that, we had tech stocks, and so on. However, to produce the effervescence needed to cause the imbalance, there has to be a concurrent amount of economic growth, and the US economy has barely breached 3.0% on a handful of occasions in the last ten years.

We’ve already discussed a couple of the potential areas of excess inventory, such as the auto loans industry and the housing market. But the reality is that finding the excess inventory ahead of time is quite tricky. Usually, it’s a post-mortem exercise.  Those who were able to spot the problem of excess housing ahead of time were able to make out pretty well.

It’s not all doom and gloom

Of course, just because the markets enter correction territory, that, by no means, implies that a recession is imminent. Liquidity tightening is not unusual and should have been expected even as the Fed was being accommodative – that money would eventually have to go back. It was also to be expected that the boost from the tax cuts would wear off by the end of 2018.

The stock market had a streak of record highs since late 2016, with the p/e ratio for the S&P 500 staying above 22 for the duration, and it has since fallen back to a little over 20. Over that period, the DJIA had a growth spurt of 49%… if it pulls back 10%, it shouldn’t be too shocking. That being said, such an expansive growth in the stock market might be a sign of that excess inventory mentioned earlier.

If we ignore the stock market, underlying fundamentals remain positive. Third quarter corporate earnings were seen as broadly positive, bankruptcies are near an all-time low, and business confidence is off peak, but still well within positive territory.

What’s next?

Immediately after the holidays, we get Christmas sales data, which will give us some good insight into the economy, and we will be scrutinizing fourth-quarter reports that start in the third week of January to see how businesses are performing, as well as CEO commentary.

As always, it’s vital to keep an ear to the ground when evaluating the market. Recessions are part of the normal economic landscape, and routinely catch markets off guard. We’ll do our best to keep you informed so you can make the best trading decisions in 2019.

Happy holidays and merry trading!

START TRADING

or practice on DEMO ACCOUNT

Trading CFDs Involves high risk of loss

Leave A Reply

Your email address will not be published.