What history teaches us about recessions in the US

The US Q2 GDP data released last week signals a technical recession in the world's largest economy. GDP shrank 0.9% Q/Q following last quarter's 1.6% contraction. Weak housing investment on the back of the Fed's aggressive rate hikes and easing consumer demand drove the contraction. 

With supply chain bottlenecks persisting and the war in Ukraine keeping energy prices elevated, it seems unlikely that this growth slowdown stops anytime soon. Case in point is the Eurozone where manufacturing purchasing managers' index (PMI) fell into contraction territory in July for the first time since June 2020 due to easing global demand. Consumer confidence is at a record low and consumers are cutting back on spending amid broad based inflation.  

We can think about the upcoming recession by taking cues from previous episodes of high inflation, supply chain bottlenecks and subsequent hit to consumer demand.  

The 1973-75 oil price shock and early 1990s gulf war are good examples of similar economic conditions.  

1973-75 oil shock: Arabic oil producers imposed an oil embargo against (primarily) Western economies for supporting Israel in the Yom Kippur War. The lack of oil imports and production cuts imposed by the Organization of Arab Petroleum Exporting Countries (OPAEC) drove a 300% rally in the price of oil between October 1973 and March 1974. 

Severe oil shortage raised US CPI towards 12% by 1974 and 14% by 1980 leading Fed chair Paul Volcker to raise rates towards a record high 20% in the early 1980s!

During this shock, US GDP contracted in 5 quarters (on a quarter-on-quarter basis) and it took 10 quarters for GDP to revert to pre-recession period. 

By gross value added, capital markets (-37%), chemicals (-20%), automotives (-11%) and natural resources (-10.3%) were the worst affected sectors.  

The unemployment rate rose from 4.6% in October 1973 to 9% in May 1975.

Employment contraction was the sharpest in construction (-9%), automotive manufacturing (-4%), chemicals for non-durable goods (-6%) and aerospace and defence (-3.4%) sectors. 

During the 70s, the global economy was facing crop failures, strong consumer demand and cuts to oil supply, quite similar to the current scenario. The challenge with supply-side shocks is that there is very little the central bank can do to control prices aside from controlling demand through interest rate hikes. The Fed chose to implement the latter in the early 80s, plunging the US (and global economy) in a recession. 

Early 1990s gulf war: Iraq's invasion of Kuwait resulted in lower oil production in the two oil producing economies and a rally in oil prices. Crude oil rose from USD 18 per barrel pre crisis towards USD 40 at its peak. 

US GDP contracted in 2 quarters and it took 6 quarters for GDP to reach to pre-crisis level. US CPI inflation rose towards 6-7% in 1991. The airlines sector was hard hit given rising oil prices as well as a decline in travel spending. 

By GVA, automotive (-23%) and energy (-11%) sectors were hard hit. By employment, industrial (-10%), aerospace and defense (7%) and automotive (-5%) were adversely impacted.

These are sectors highly correlated to economic activity through government and discretionary consumer spending. 

Imagining the upcoming recession:   

In thinking about the upcoming recession, it is important to identify the potential sources of economic pressure and how these differ from previous recessions. Similar to 1973-75 and early 1990s, this recession is likely to be triggered by elevated oil prices, transport and logistical bottlenecks and financial market tightening. What differentiates the current period is the prevalence of a global pandemic which may detract from GDP through lockdowns and restrictions. 

Another differentiating factor is the relative inability of governments and central banks to shield their economies through traditional tools today. The entrenched nature of inflation in the US, Europe and Asia will prevent central banks from cutting rates. Secondly, governments globally threw the kitchen sink at the economy during COVID. This resulted in much weaker fiscal profiles post pandemic and several government institutions are currently implementing fiscal consolidation to appease the rating agencies.

Governments will need to engineer some degree of demand destruction to improve the supply-demand mismatch in all markets globally. Indeed, the aggressive pace of rate hikes by the Fed (inspired by Volcker's courageous fight against inflation) is likely to depress business investment and consumer spending in the quarters to come. 

The Fed's policy may just drive a recession

On 16 March, the US Federal Reserve (Fed) hiked its policy interest rate by 25 basis points and started the process of monetary policy tightening after slashing rates to 0% during COVID. This move along with its plans to hike at each of the subsequent six meetings this year was expected by the market. What surprised market participants was the Fed’s terminal policy rate expectation (the highest policy rate it expects out of this rate-hiking cycle) at 2.75% by 2023 versus the estimated long-run neutral rate (the rate supporting full employment while keeping inflation constant) of 2.35%. The Fed also plans to start shrinking its balance sheet earlier than expected and as soon as in May.

What prompted this degree of hawkishness? For one, US inflation at 7.9% in February is the highest since 1982! Second, the US labour market is pretty tight with the unemployment rate at 3.8% in February, close to the pre-pandemic rate. Additionally, job gains have been widespread across leisure and hospitality, professional services, healthcare and construction.

The Fed published its revised economic forecasts for 2022–24 after the policy meeting. It was striking to see the downward revision to its US growth forecast at 2.8% in 2022 compared to its December forecast of 4.0%. The significant increase in commodity prices and economic uncertainty are expected to drive this slowdown. Simultaneously, it projected personal consumption expenditure growth at 4.3% vs 2.6% in December. The epic level of policy stimulus undertaken during COVID both from the fiscal and monetary sides had driven inflation higher throughout 2021 in the US. 2022 added the extra layer of commodity price shock arising out of the Russia-Ukraine conflict.

Following the announcement, the 10Y-5Y US Treasury (UST) spread turned negative, in other words, the yield curve inverted, signaling that the market has started pricing in an economic recession. This was driven by expectations around a global growth slowdown from elevated commodity prices and the degree of monetary policy tightening projected by the most important central bank. Thanks to the 0% interest rate in the US over the last two years, corporate America issued copious amounts of debt to stay afloat. Non-financial corporate debt rose by USD 1.2 trillion during the pandemic. Corporates will now face higher interest rates and some are bound to go bankrupt in trying to meet their debt obligation. Although the Fed did not amend its unemployment forecast for 2023 (at 3.5%), I would assume job losses starting this year as corporates restructure to raise cash and service their debt.

Despite the degree of interest rate hikes forecasted, the Fed does not expect a recession. In fact, Fed chair Jerome Powell cited three historical instances in 1965, 1984 and 1994, where the Fed was successful in cooling the economy through interest rate hikes without causing a recession. The market disagrees and between you and me, the market usually pre-empts and forces the Fed’s actions.

In this stagflation scenario — with growth slowing and inflation remaining persistently high — how should an investor think about portfolio construction? Consumer staples are an obvious beneficiary as higher prices force buyers to cut back on discretionary spending. Utilities and healthcare are other defensive sectors that could protect the portfolio. Loading up on blue-chip names is another good move. You may have come across the argument that ESG investment is inflationary as it penalizes investment in fossil fuel and metals and thereby creates an uneven supply for important commodities. I would take this prompt and add green metals that are needed for renewable energy generation to my portfolio. These include lithium and cobalt (used in batteries), copper (wind, solar PV) and zinc (wind, solar, hydro, energy storage) among others.

Some regions such as Asia have relatively dovish monetary policies compared to the West as inflation is not out of control. Here, ASEAN stocks continue to benefit from their disproportionate exposure to financials, real estate, materials and construction sectors that outperform during inflation. Please check my piece on ASEAN as an inflation hedge for this topic.

Central banks globally are struggling to juggle high inflation and easing growth. At the moment, containing inflation appears to be the number one priority. However, as monetary policy tightening weakens growth, central banks may disappoint the market’s rate hike expectations in order to protect the economy. This would create a good environment for bond investments to thrive, particularly next year.

Conclusion:

The Fed’s aggressive interest rate projections coupled with elevated commodity prices suggest the rising probability of a recession in the US and global economy.

Portfolio construction during stagflation periods should tilt towards defensive sectors such as consumer staples, healthcare and utilities.

Green metals that are used in renewable energy generation and select sectors that benefit from inflation are a good fit in the current environment.

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