Part Two: Causes of a Recession
November 2019
Causes of a Recession
Question: What causes a recession?
Answer: An adverse shock to our economic system.
Some examples of adverse shocks include, asset values deflating (Tech stocks in 2001); commodity price spikes (Iraqi invasion of Kuwait in 1990); and aggressive Federal Reserve policies (Fed tightening in 1970).
Of-course these are simplified examples, but for our purposes, I’m just identifying the storm’s direction, not plotting its coordinates or calculating when it might make landfall.
Here’s an illustration of how a recession develops:
Imagine a fictitious manufacturing plant – the only one of its kind, it produces all the goods and services made in the United States – and it represents the U.S. economy.
Every quarter, our manufacturing plant (aka, the U.S. economy) calculates its total output – what we call Gross Domestic Product (GDP) – which is the value of all the goods and services produced by our plant.
Investors use these GDP figures to determine the growth prospects of our economy and their collective opinion is expressed in yield rates. For example, high yield rates indicate that investors believe economic growth will be greater in the future; whereas, low yield rates indicate investors believe economic growth will be lower. And when yield rates invert, it’s because investors believe a recession will occur in the foreseeable future.
Technically, our manufacturing plant could produce the same GDP every quarter without much consequence to our economy. Our plant could even have a deceleration in GDP and still operate. Of-course this isn’t desirable, but it won’t cause a recession because as long as our plant can balance its debits and credits it will continue operating.
But, if an unexpected shock occurs that inhibits our plant’s ability to balance its debits and credits, and therefore renders it unable to operate, then a recession occurs.
Here’s an example:
Imagine an entire section of our manufacturing plant is dedicated to making all the houses in the United States – we call this sector “Residential Fixed Investments.” Like every other sector in our plant, this department’s output expands and contracts every quarter, but the changes are small and the impact to GDP is minimal. For example, during the 20-years between 1980-2000, the biggest expansion during any 5-year period was a mere 6%.1
But suddenly between 2000 and 2006 big changes occurred.
Within our fictitious manufacturing plant, this sector expanded the square feet it used and was eventually using more space than any other sector; in search of higher income, many employees from other departments quit their jobs to join this one; and, impressed with the easy returns, management kept increasing its investment in the department so they could make more money. And by 2006, this sector’s contribution to GDP had jumped an eye-popping 34%.2
It’s easy to look back and point-out where the problem was (we’d all be rich if we could flip this hindsight into foresight). So, with the knowledge of history, we now know that the “adverse shock” to our economy was people’s inability to pay their mortgages, which led to a recession.
Dynamite vs Fuses
It’s important for us investors to understand the difference between a shock and the cause of a shock.
A shock is what happens when a stick of dynamite explodes, but the cause of that shock is a lit fuse. On its own, a stick of dynamite might never explode but once you introduce a lit fuse (the cause) there’s going to be an explosion (the shock).
Within our economy, some causes that could ignite a shock are easy to identify. For investors, these are the risks we can keep from entering our portfolios. For example, in 2000 many investors knew that Technology stock values were exorbitant (the cause). In response to identifying this risk, many investors reduced their portfolio’s exposure to the Tech sector and thereby minimized losses when the bubble popped (the shock). Did portfolios with no exposure to the Tech sector decline? Absolutely. But the collateral damage to these portfolios was minimal compared to the damage incurred by the portfolios that suffered a direct hit from the shock.
Conversely, some causes for a recession can’t be identified. For example, how many investors had the foresight to strategically position their portfolios to minimize the risks of a recession in the event that Iraq invaded Kuwait and commodity prices spiked? Probably not many.
The Takeaway
Here’s the takeaway: Recessions happen when a shock occurs that creates adverse consequences to our economy. The causes for some (yet-to-ignite) shocks are visible in economic data (like housing’s contribution to GDP growing by 34%); while other causes aren’t visible (such-as Iraq invading Kuwait).
Therefore, as investors, we must look past yield curves – and into the economic system – to identify the risks that could cause a shock to our economy (and our portfolios). Only once we know where the risks are, can we strategically position our portfolios to sidestep these risks.
So, where are we seeing risks within the economy? Stay tuned for Part 3!
Answer: An adverse shock to our economic system.
Some examples of adverse shocks include, asset values deflating (Tech stocks in 2001); commodity price spikes (Iraqi invasion of Kuwait in 1990); and aggressive Federal Reserve policies (Fed tightening in 1970).
Of-course these are simplified examples, but for our purposes, I’m just identifying the storm’s direction, not plotting its coordinates or calculating when it might make landfall.
Here’s an illustration of how a recession develops:
Imagine a fictitious manufacturing plant – the only one of its kind, it produces all the goods and services made in the United States – and it represents the U.S. economy.
Every quarter, our manufacturing plant (aka, the U.S. economy) calculates its total output – what we call Gross Domestic Product (GDP) – which is the value of all the goods and services produced by our plant.
Investors use these GDP figures to determine the growth prospects of our economy and their collective opinion is expressed in yield rates. For example, high yield rates indicate that investors believe economic growth will be greater in the future; whereas, low yield rates indicate investors believe economic growth will be lower. And when yield rates invert, it’s because investors believe a recession will occur in the foreseeable future.
Technically, our manufacturing plant could produce the same GDP every quarter without much consequence to our economy. Our plant could even have a deceleration in GDP and still operate. Of-course this isn’t desirable, but it won’t cause a recession because as long as our plant can balance its debits and credits it will continue operating.
But, if an unexpected shock occurs that inhibits our plant’s ability to balance its debits and credits, and therefore renders it unable to operate, then a recession occurs.
Here’s an example:
Imagine an entire section of our manufacturing plant is dedicated to making all the houses in the United States – we call this sector “Residential Fixed Investments.” Like every other sector in our plant, this department’s output expands and contracts every quarter, but the changes are small and the impact to GDP is minimal. For example, during the 20-years between 1980-2000, the biggest expansion during any 5-year period was a mere 6%.1
But suddenly between 2000 and 2006 big changes occurred.
Within our fictitious manufacturing plant, this sector expanded the square feet it used and was eventually using more space than any other sector; in search of higher income, many employees from other departments quit their jobs to join this one; and, impressed with the easy returns, management kept increasing its investment in the department so they could make more money. And by 2006, this sector’s contribution to GDP had jumped an eye-popping 34%.2
It’s easy to look back and point-out where the problem was (we’d all be rich if we could flip this hindsight into foresight). So, with the knowledge of history, we now know that the “adverse shock” to our economy was people’s inability to pay their mortgages, which led to a recession.
Dynamite vs Fuses
It’s important for us investors to understand the difference between a shock and the cause of a shock.
A shock is what happens when a stick of dynamite explodes, but the cause of that shock is a lit fuse. On its own, a stick of dynamite might never explode but once you introduce a lit fuse (the cause) there’s going to be an explosion (the shock).
Within our economy, some causes that could ignite a shock are easy to identify. For investors, these are the risks we can keep from entering our portfolios. For example, in 2000 many investors knew that Technology stock values were exorbitant (the cause). In response to identifying this risk, many investors reduced their portfolio’s exposure to the Tech sector and thereby minimized losses when the bubble popped (the shock). Did portfolios with no exposure to the Tech sector decline? Absolutely. But the collateral damage to these portfolios was minimal compared to the damage incurred by the portfolios that suffered a direct hit from the shock.
Conversely, some causes for a recession can’t be identified. For example, how many investors had the foresight to strategically position their portfolios to minimize the risks of a recession in the event that Iraq invaded Kuwait and commodity prices spiked? Probably not many.
The Takeaway
Here’s the takeaway: Recessions happen when a shock occurs that creates adverse consequences to our economy. The causes for some (yet-to-ignite) shocks are visible in economic data (like housing’s contribution to GDP growing by 34%); while other causes aren’t visible (such-as Iraq invading Kuwait).
Therefore, as investors, we must look past yield curves – and into the economic system – to identify the risks that could cause a shock to our economy (and our portfolios). Only once we know where the risks are, can we strategically position our portfolios to sidestep these risks.
So, where are we seeing risks within the economy? Stay tuned for Part 3!
1
Source: National Association of Home Builders.
Housing’s Contribution to Gross Domestic Product (GDP).
2 As a point of reference, the second greatest increase to the contribution of GDP comes from State and local government spending. However, this increase (which was 30%) occurred over a 10-year period during which our GDP grew by 76%. Source: Federal Reserve Bank of St. Louis. Economic Research. Bureau of Economic Analysis, GDP-by-Industry.
2 As a point of reference, the second greatest increase to the contribution of GDP comes from State and local government spending. However, this increase (which was 30%) occurred over a 10-year period during which our GDP grew by 76%. Source: Federal Reserve Bank of St. Louis. Economic Research. Bureau of Economic Analysis, GDP-by-Industry.