“I think it’s a myth that expansions die of old age.” – Janet Yellen
Ten years ago, the French bank BNP Paribas froze three of their funds, thus marking the beginnings of a credit crunch that ultimately led to the Great Recession. The lookout for the next global crisis has preoccupied and paralysed many investors for much of the past decade. We’ve argued before that this preoccupation often grievously exaggerates both the recurrence of such episodes and their predictability.
In spite of the trauma of 2007-09, US recessions have been tending to become less frequent and milder over the last few decades. Of the 33 US recessions that have occurred since 1854, 21 (64%) occurred before World War 2, when the US economy was much more frequently in recession, and only 12 (36%) have occurred since.
For investors, perhaps the most important note to remember is that recessions are much shallower than expansions. In a typical recession, GDP falls by about 2% on average; in contrast, during an expansion, GDP tends to rise by almost 20%. This means that the economy is generally more likely to grow than not – it remains unwise to bet against continuing technological innovation. All of this has important implications for investments, particularly equity markets, since the profits that drive market returns are themselves a direct function of this continuing growth story.
While long term investors can be reassured by this historically reliable growth trend, those trying to call the vagaries of the business cycle have a harder job. One major problem is that recessions are heterogeneous and often still mysterious. The International Monetary Fund (IMF) has identified several key contributors to recessions across advanced economies since 1960. Of the recession triggers the IMF managed to identify, oil shocks and excessive monetary policy tightening have historically been the most common culprit. Nevertheless, the IMF’s taxonomy was only able to identify triggers for half of their sampled recessions – the remaining half were caused by idiosyncratic shocks like investment swings due to ‘animal spirits’ or asset price collapses.
As the IMF data shows, it’s precisely the wide range and variety of recession triggers that makes forecasting one so difficult. Contrary to popular belief, the economy isn’t a mechanical clock that undergoes boom-and-bust cycles with deterministic regularity. This concept of a ‘clockwork economy’ may fit certain triggers like a financial crisis, where bouts of speculative euphoria eventually sow the seeds of turmoil, but it doesn’t for other recession triggers.
Take oil shocks for example: one would be hard pressed to argue why an economy should undergo a perpetual cycle of oil shocks. Common recessionary triggers like oil shocks and excessive policy tightening aren’t fundamentally linked to how long the economy remains in expansion. Therefore, the probability of a recession occurring tends to be independent of the length of the cycle. Claiming that the economy is overdue for a recession solely because we are past the average business cycle length, is the equivalent of falling into the Gambler’s fallacy. It is as wrong as claiming that the next coin toss is more likely to come up heads, just because the preceding ten tosses yielded tails. Economic expansions do not die of old age.
The wide variety of potential recessionary triggers, as well as their unpredictability, makes it almost impossible to time/forecast a recession. Nevertheless, investors can take comfort in the long-proven fact that the occasional recessions, however deep or painful they may be, have always been outweighed by mankind’s inexhaustible ability to innovate and grow. Therefore, disciplined long term investors can afford to ride out the short-term pain associated with recessions and still come out on top.
For those trying the more hazardous job of allocating around the business cycle, most data points – not least the ISM manufacturing index – suggest that a US recession isn’t imminent. Of course, this isn’t the only consideration, but we see no more automatic recourse to pessimism on growth or investor returns now than any other time. Some asset class valuations are elevated, but not yet asphyxiate. The prospects for ongoing growth remain reliably founded on mankind’s continuing ingenuity and restlessness.