Technical Review

Six Dominoes of Recession

Recessions are not random.

Anticipating Recessions Is Important

Stock values are determined by the level of interest rates and in large part by earnings. As earnings increase over time investors are often willing to pay a higher price for stocks during a bull market. This is why the Price / Earnings Ratio moves up until stocks become overvalued. This valuation process is interrupted during a recession because earnings decline and investors pay less for each dollar of earnings. In 1949 the P/E Ratio for the S&P 500 was 6 and during the 1960’s held above 18. Investor’s willingness to pay more for each $1.00 of earnings tripled from the low in 1949 illustrating how important psychology is in the stock market. The impact of psychology was highlighted when the S&P 500’s P/E fell to less than 8 in 1979 – 1982, and then soared to 32 in 1999 -2000. During the Financial Crisis the P/E Ratio soared as earnings collapsed by -93.7% and the S&P 500 ‘only’ fell by -57.0%.

The S&P 500 is more likely to experience a larger price decline during a recession when valuations are high as they were in the late 1960’s and in 2000. In the 1970 recession S&P 500 earnings only fell by -12.9% but the S&P 500 declined by -36.0%. After the S&P 500’s P/E Ratio rebounded above 18.0 in 1972, the S&P 500 plunged by -48% even though earnings were down -14.8% in the 1974 recession. In April 2000 the P/E Ratio was 34.0 and the S&P 500 fell -49.0% as earnings during the 2001 recession declined by 54.0%. As the recession began in January 2008 the S&P 500’s P/E Ratio was 22.8 which is why the S&P 500 lost -57% during the Financial Crisis. If it weren’t for the intervention by the Federal Reserve the loss would have been larger.

There have been 13 recessions since 1945 and 11 of the recessions were preceded by an increase in short term interest rates by the Federal Reserve. In 1945 the economy experienced a recession as the US demobilized from a war to peace and manufacturing shifted from making guns, tanks, and ships to building cars, appliances, and homes as soldiers came home. Monetary policy didn’t play a role in the 1945 recession. The other exception was the Pandemic in 2020 which lasted just two months after the government shut the economy down. The average duration of the 11 recessions (excluding 1945 and 2020) was 11.1 months. Here’s a quick review of the 11 recessions that were preceded by an increase in interest rates by the Federal Reserve.

Prior to 1955 the proxy for the Federal Funds rate was the Bankers Acceptance rate which reflected short term rates. Bankers Acceptance are backed by the financial strength of individual banks they carried a higher yield than 90-day Treasury bills which are backed by the full faith and credit of the US government. For instance, in September 1957 the Bankers Acceptance yield was 3.83% compared to 3.60% for 90-day Treasury bills. Prior to the recession in 1949 the Bankers Acceptance yield rose from 0.44% in April 1946 to 1.20% in December 1948. The 90-day Treasury bill yield climbed from 0.38% to 1.12%.

The recession in 1954 was preceded by an increase in the Banker Acceptance rate from 1.06% in July 1950 to 1.90% in July 1953. During the same period the 90-day Treasury bill yield rose from 1.20% to 1.89.

There were 9 recessions between 1954 and the Financial Crisis in 2008 and each recession (shaded areas on chart) was triggered by a large increase in the Federal Funds rate.

Recessions Are Bad for Earnings and Your Portfolio

As this quick review highlights recessions cause earnings to decline, the S&P 500’s P/E Ratio to fall, and the S&P 500 to lose an average of -29.2% when a recession occurs. For investors saving for retirement the losses generated by a recessionary bear market in the stock market are painful but unnecessary if one can anticipate when a recession is likely.

Large increases in the Federal Funds rate have led to each recession since 1949, but that’s not the whole story. The FOMC increased the Funds rate significantly in 1965, 1984, and 1995 but no recession followed. The size of the increase in the Funds rate and the lag time between increases and the onset of a recession has varied. That’s why an increase in the Funds rate by the Federal Reserve is the first of The Six Dominoes of Recession”.

The Six Dominoes of Recession

The first domino is a change in monetary policy as the FOMC determines that it needs to increase the cost of money. The level of inflation has dictated the speed and magnitude of rate hikes. When inflation was a big problem in the 1970’s, the FOMC was forced to jack up the Funds rate. In 1972-1974 the Funds rate was increased by 7.75% in 17 months, and by 10.25% in just 10 months in 1980-1981. The largest increase occurred in 1977-1980 when the Funds rate rose by 14.0% in 32 months. People forget that Chairman Paul Volker slashed the Funds rate in 1980 as the economy slumped only to increase it again in 1981. In 2022 inflation hit its highest level since 1980 so the sharp increase in the Funds rate was warranted. The pace of rate increases in the 2004 and 2015 cycles were much slower and modest because Core CPI inflation was near 2.0%. It is much easier for borrowers to adjust to the higher cost of money if rate hikes are slow. A slower pace of rate hikes has a gradual impact on economic activity and results in fewer unintended consequences, i.e. accidents. The pace and magnitude of the FOMC’s hikes since March 2022 have been aggressive, so the risk of unforeseen accidents is higher. The regional bank crisis that erupted in March 2023 was the result of unrealized portfolio losses from Treasury bonds and Mortgage Backed Securities due to higher interest rates. These losses led to a deposit run that forced two regional banks to cover the deposit outflows by selling bonds at a loss which eroded their capital base until they were insolvent. More accidents are likely.

The second Domino is an inverted yield curve. In the majority of economic cycles since 1947 the yield curve has become inverted after the FOMC continued to lift the Funds rate. An inverted yield curve develops when short term rates (Funds rate, 3- month Treasury bill rate, 2-year Treasury yield) rises above long term Treasury yields (10-year Treasury yield, 30-year Treasury yield). There has been a high correlation between an inverted yield curve and recessions, but the lag time is long and variable. (Average is 19 months since 1950)

An inverted yield curve has been a leading indicator for recession and increases in Lending Standards. As banks anticipate the coming economic slowdown or recession and potential loan losses, they cut back on new lending, increase the spread margin as loans come due, decide to reduce the amount of loans to existing borrowers, or simply choose not to roll the existing loan over. Since 1999 lending standards (blue) haven’t topped until they have been increased to the level of the inverted yield curve (yellow). Lending standards were up in the third and fourth quarter, well before the Regional bank crisis erupted in March. Lending Standards will continue to be increased as the economy shows more signs of slowing. The third Domino is an increase in Lending Standards.

I discussed the coming increase in Lending Standards in the November 2022 Macro Tides. “The FOMC has increased the cost of money, but the availability and access to credit is still easy. This will change in 2023. As the economy slows in 2023, lending standards for all forms of credit will be tightened by banks, representing an additional tightening of monetary policy. The Federal Reserve is the credit spigot and banks are the nozzle at the end of the credit hose. Consumers and small and medium sized businesses will find it harder to borrow and will cut back on discretionary spending and capital spending. Once the availability of credit is constrained, the slowdown in the economy will accelerate.”

A Soft Landing Isn’t Likely

After the FOMC increased the Funds rate for the first time on March 16, 2022, Chair Powell emphasized that the central bank he leads could succeed in its quest to tame rapid inflation without causing unemployment to rise or setting off a recession (Soft Landing). “The historical record provides some grounds for optimism.” During his press conference he provided a chart showing that no recession developed in 1965, 1984, and 1995 after the FOMC had increased the Funds rate (red circles on chart). The Fed tightened monetary policy by increasing the federal-funds rate significantly in 1965 (from 3.4% to 5.8%), 1984 (9.6% to 11.6%) and 1994-95 (3% to 6%) without precipitating a recession. In each of these episodes, the Unemployment Rate fell from 5.1% to 3.6% in 1965, 7.8% to 7.5% in 1984, and in 1995 to 5.8% from 6.5%.

Although the FOMC increased the Funds rate significantly in those Soft Landing years, banks didn’t increase their Lending Standards. Consumers and businesses weren’t denied access to credit and were able to borrow what they needed. This is why those three Soft Landings occurred despite the increases in the Funds rate.

As I noted in the March 2023 Macro Tides, a recession has followed whenever more than 20% of banks have tightened lending standards since 1990. In the fourth quarter, 44% of banks tightened their lending standards and more will once the economy slows. Investors who are banking on a Soft Landing are likely to be disappointed.

At the end of 2022 Lending Standards were tight enough to cause a decline in lending in 2023. The Regional bank crisis will only make it worse as small banks cut lending. The fourth Domino is a decrease in bank lending.

The fifth Domino is the onset of a recession. The Leading Economic Index (LEI) declined for the 12th consecutive month in March and is down -4.5% in the last six months. Since 1959 the LEI has never fallen this much without a recession developing. The LEI is a composite of 10 separate economic data points covering the labor market, goods production, Consumer expectations, housing, and financial markets. In March 7 of the 10 inputs were negative and the other 3 were barely positive. (0.0, 0.1, 0.2)

The LEI didn’t signal a recession in 1965, 1984, and 1995. The LEI has been below its 6-month moving average for 9 months. On average a recession has occurred 6.7 months after the 6-month average has been negative. My expectation has been that the economy will weaken significantly after mid-year and potentially enter a recession before the end of 2023. The trend in the LEI supports this view.

The Unemployment Rate is a lagging economic indicator since employers are reluctant to hire until they’re sure a recession is over and hesitant to fire employees until a recession causes revenue to weaken. Since higher interest rates and tighter Lending Standards initiate a slowing in economic growth, it only follows that an increase in Lending Standards is a leading indicator for increases in the Unemployment Rate. The sixth Domino is an increase in the Unemployment Rate.

The largest increase in Unemployment occurs after the recession takes hold. As the Unemployment Rate increases, Consumer Confidence drops and consumer spending falls as the majority of consumers curb their spending. The retrenchment in consumer spending causes the recession to deepen, leading to more layoffs, and a cutback in business spending. Once a recession becomes obvious the Federal Reserve intervenes by lowering the Funds rate.

The first three Domino’s have already fallen (Monetary policy, Inverted Yield Curve, Lending Standards). A decrease in overall Lending likely began in the first quarter and will become more restrictive in coming months. A recession is likely before the end of 2023 and the Unemployment Rate will begin to inch higher in the second half of this year and jump in 2024.

Lending Standards and the 2008 Financial Crisis

Lending Standards increased in the first quarter of 2007 and well before the Financial Crisis which erupted in October 2008. I discussed the implications for the economy and housing prices in my March 2007The Financial Commentator’ (Macro Tides predecessor). The lesson in 2007 and in 2023 is ignoring a significant increase in Lending Standards is a mistake.

Excerpt from my March 2007 ‘The Financial Commentator’

“An intense debate is raging on whether the woes in the sub-prime mortgage market will spread to other areas of mortgage lending. As far as I’m concerned, it already has spread in one important way – lending standards. As I mentioned last month, in January (2007), the Federal Reserve’s quarterly lending survey found that more institutions had increased lending standards than at any time since 1991. Let’s think about what that means in the real world. Even though the Fed has kept the Funds rate unchanged for months, monetary policy has been effectively tightened by many lending institutions. This is just the opposite of what was happening as the Fed was increasing the Federal funds rate from 1.0% to 5.25%. The drag effect of those increases did not fully impact the economy, since many mortgage lenders continued to offer consumers mortgage rates of 1% to 2%. The pendulum has now swung the other way. Lending standards are not just being raised for sub-prime borrowers, but for borrowers across the board.”

“Higher lending standards will curb demand, even as foreclosures increase. It is hard to believe that less demand and more supply will not depress home values more than we’ve already seen. When the Fed does lower rates, the higher lending standards will still be maintained for some extended time. The Fed will only lower rates, if the expected late 2007 rebound in the economy looks doubtful, or the housing market weakens sharply. If the economy warrants Fed easing, mortgage payment delinquencies and foreclosures will be rising. That is not an environment conducive to lowering lending standards, and lending institutions won’t. This means the drag on the economy from tighter lending standards will continue even after the Fed lowers rates. This also means the stimulus normally provided the economy from rate reductions will not completely pass through to consumers. Just as mortgage lenders negated the drag from higher rates between 2004 and 2006, they will limit the beneficial effects of lower rates, just as the economy will need them the most.”

Excerpt from my September 2007The Financial Commentator’Between 1968 and 2000, the ratio of the median home price to median household income fluctuated in a narrow range between 2.8 and 3.2. During this 32 year period, increases in home prices were supported by a rise in household income. This relationship provided underlying support for home prices, even when recessions developed in 1970, 1974, 1981, 1990 and 2001. However, between 2000 and 2006, the ratio rose from its long term average of 3.0 to 4.5. This means median home prices have the potential to fall 33% should the ratio fall back to its long term average.”

“In a recent analysis by Moody’s of home values, mortgage rates, tax rates and incomes going back to 1968, home values appeared 20% too high. Adding validity to this estimate, Federal Reserve Governor Frederic Mishkin recently estimated that housing prices could decline 20% in coming years. It is important to remember that these estimates are based on median home prices. In California and along the east coast, average home prices are two to three times the level of national median home prices. If national median home prices sink by 20% in coming years, home prices on both coasts could fall by 30% or more. The total value of housing in the U.S. is $20 trillion. A 20% drop in home values would slash $4 trillion from homeowners’ wealth, and maybe more if prices drop more on the coasts.” The idea that home prices could fall by more than 20% seemed outrageous in 2007. But the increase in lending standards in 2007 acted as a trip wire for a series of dominoes that led to declining home values, a financial crisis, and an Unemployment Rate of 10.0%.

These Six Dominoes of Recession discussed in this piece have significantly increased the risk of a recession and potentially a Hard Landing in 2024.

Jim Welsh

The Daily Shot
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