Well folks, the bad times are clearly back again. There’s a growing chance of a recession. What’s worse, there might actually be stagflation, where inflation remains high while economic output declines.
For those of you who’ve been consistently investing since 2009 or earlier, experiencing a recession is just a part of the economic cycle. Bad times follow good times. Bad times create innovation and efficiency, which leads to good times again.
But if you’ve only been working and investing since 2009 or later, then experiencing a recession may be more jolting. We actually experienced a mini-recession in 2020 during the start of COVID-19. However, that recession lasted only two months.
The next recession will more than likely be longer. The impact of a recession on your livelihood will depend on your risk exposure, job stability, number of income streams, age, and cash balance.
Signs A Recession Is Imminent
After publishing my newsletter discussion on recession signs, I thought I’d write more broadly about the topic in this post. Then I can update the post as time passes with the latest signs.
1) The Yield Curve Has Flattened
The spread between the 2-year Treasury yield and the 10-year Treasury yield has compressed to the narrowest margin since March 2020. Notice how every time the 10-year Treasury yield goes below the 2-year Treasury yield, a recession occurs within the next 12 months. An inverted yield curve is a reliable recession indicator.
In a healthy economy full of optimism, the yield curve is upward sloping due to the time value of money. A dollar today is worth more than a dollar in the future due to inflation. However, if you are pessimistic about the future, you tend to not invest in the future. Instead, you hoard cash and buy shorter duration Treasuries and other assets.
Thankfully, expectations for aggressive Fed rate hikes over the next 12-24 months have declined. However, even if the Fed doesn’t hike at all, the yield curve could still turn negative since the Fed doesn’t control the Treasury bond market, the market does.
You can track the yield curve through the St. Louis Fed, which has the best economic data around. Once the line below goes below the dark horizontal line, we have inversion.
2) Long Bond Yields Are Not Spiking With Surging Energy Prices
Energy prices are surging due to the war in Ukraine. Given Russia is one big gas station, levying economic sanctions will hurt the global supply of oil and gas.
In a surging inflationary environment, longer-duration Treasury bonds would normally increase as bonds sell off. However, the 10-year Treasury bond yield actually declined and can’t seem to get past 2%. The reason is that the fear of a recession is greater than the fear of higher inflation.
Investors would rather own safety and lose in real terms, rather than invest in risk assets and lose in nominal and real terms. In other words, wouldn’t you rather still earn a nominal 1.8% return and a negative 5.7% real return in a Treasury bond versus losing a nominal 20% in the stock market and a negative 27.5%+ real negative return?
3) Negative real wage growth is recessionary.
Although real wage growth is strong for lower-income earners, real wage growth is negative overall due to high inflation. However, unlike with negative real mortgage rates, which is great for real estate, negative real wage growth is negative for the economy.
Negative real wage growth simply means that the average wage is not keeping up with a basket of goods and services. As a result, the cost of such goods and services is getting more expensive and disposable income is declining if consumption is not cut.
BofA shows a chart that says if real wage growth is still negative by summer, the chance of a U.S. recession increases. Based on the way things are going, overall real wage growth is most certainly going to be negative for the rest of the year.
This data point is a good reminder to focus on building more income through investments, not labor. There’s more friction trying to get a raise through labor (asking for one, job-hopping, etc).
4) Drastically higher energy prices have historically preceded a recession.
Below is another chart that highlights the probability of a recession increases with surges in energy prices.
It is incredible that on April 20, 2020, the price of West Texas Intermediate crude dropped by almost 300%, trading at around negative $37 per barrel. In other words, anybody trying to sell a barrel of oil would have to pay a buyer $37.
Intuitively, we all know that rising oil and gas prices make living more expensive. We need oil and gas to heat our homes, drive our combustible engine cars, fly, and produce other end products. Here are a couple of great charts by the U.S. energy information administration.
The Chance Of A Recession Occurring In The Next 12 Months
Based on these factors above, for the U.S., I think the chance of a recession occurring in the next 12 months is 70%.
The Fed will likely still raise its Fed Funds rate by another 50 – 100 bps over the next 12 months, further flattening the yield curve. Inflation will likely continue to remain above 7.5% for longer due to a surge in energy prices. Meanwhile, even if the Russians stopped massacring innocent people, the Russians will find a way to retaliate economically.
We could certainly navigate our way out of a recession over the next 12 months. However, the odds are currently not in our favor.
In contrast, the Russians are already in a recession. But their recession will be magnitudes worse. Unless they invested overseas and fled the country, life as they knew it will never be the same again.
The Main Recession Concern: Mass Layoffs
Right now, the labor market is robust. Nominal wages are going up and the number of job openings is hitting record levels. However, as publicly-traded companies see their share prices get hit, the propensity to hire decreases. The same goes for private companies that face valuation compression from competitors and investors.
Sooner or later, managers will be told to scale back their hiring and do more with less. As fewer jobs are available, wage pressure declines. As wage pressure declines, so does consumption. In industries where a significant portion of an employee’s compensation is in the form of stock, the slowdown in consumption should be even greater.
Therefore, even if you are not concerned with losing your job, you should take steps to better solidify your job safety. Do more before being told to do more. Build stronger relationships with your managers. Have more friendly chit-chats with your competitors. Reach out to people before needing something.
If you job hop for more money and a better title, you could be the first to be let go during the next round of layoffs. Last in, first out (LIFO) is the standard way to cut. So carefully weigh the benefits and negatives before making such a move.
A Recession Might Not Be So Bad
Losing money in your investments is one thing. If we have the proper net worth asset allocation, we should be fine given recessions usually don’t last longer than a year. We can always work longer to recoup our losses. Further, time is usually our friend when it comes to investing in risk assets.
However, losing money in your investments and losing your job is a terrible combination. Without the ability to work, it becomes much harder to invest on the low and make up for your losses. Violating the first rule of financial independence in this scenario is all but a certainty. Therefore, the importance of having side hustles and passive income investments increases.
The saving grace of a terrible recession is that both federal and state government have shown to step up and help. Most recently, the U.S. government provided enhanced unemployment benefits, stimulus checks, and PPP loans for small businesses. I suspect a similar amount of financial aid from the government during the next recession.
Investment Upside Post A Recession
The VIX, or CBOE volatility index, is currently trading above 30, an elevated level. The VIX is a real-time market index representing the market’s expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.
The good thing about an elevated VIX is that the next 12-month return for the S&P 500 is generally strong. If there is a surprisingly peaceful resolution to the war in Ukraine, we could easily see a 3-5%+ rally in the S&P 500. Have a look at this chart from investment house, Schroders.
CNN Money’s Fear & Greed Index is also pointing towards Extreme Fear. This is another sign that perhaps we’re getting close to the bottom.
What I Plan To Do If A Recession Arrives
My goal is to continue living the way I want even if a recession arrives. Living the way I want means spending more time with my children and less time working online. I also plan to travel more with my family to see my parents and in-laws. I’ll just be poorer in the process.
I’m in an interesting position because I can’t get let go from a day job because I don’t have one. Well, I guess my wife could fire me!
All the work I’m doing online is mainly due to my joy of writing and connecting with like-minded people. Writing is like therapy. Writing also gives me purpose. If online revenue goes down, so be it. It has always been viewed as bonus money to help boost my passive income investments.
Although ~32% of my net worth in public stocks is getting hit, I’m still confident real estate will continue to outperform in a potential recession. I clearly remember owning several properties during the worst recession in 2008-2009. Not much happened as tenants continued to pay the rent and I continued to live in my primary residence as usual.
As a perennial optimist, I view a recession as a great time to reflect on what we want to do with our lives. The opportunity cost of building wealth and getting ahead declines during a recession. Therefore, if you can afford to, what better time to take things easier and enjoy life more?
If we have another recession, I don’t think it will last for more than a year. Nor do I believe we’ll experience greater than a 20% decline in the S&P 500. The best hedge against a recession is to continue living every day with joy and meaning. As a long-time FS reader, I’m hopeful you are prepared for whatever comes next!
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With a likely recession coming, you need to do a deep-dive analysis on your net worth now. Don’t just wing it with your finances. We’ve come a long way since the start of the pandemic. The last thing you want to do is give up all your gains.