Recessions affect everybody in one way or another. With that in mind, I think it is important to define what a recession is and to examine if one is in the cards in the near term.
The academic definition of a recession is a contraction in the economy. This is still a fairly vague definition so the generally accepted definition is an economy that experiences 2 straight quarters of negative GDP growth.
Let us now define GDP. GDP stands for Gross Domestic Product. GDP is the total monetary (dollar) value of all the finished goods and services by a country. As you have probably heard, the GDP of the United States per year is about 20 trillion, so that means in the United States 20 trillion dollars worth of goods and services is produced per year.
I am going to take GDP one step further. At equilibrium GDP, GDP is equal to total spending. Total spending is made up of 4 categories. Using transitive property, GDP is equal to these 4 categories: consumer spending (~$14 trillion), government spending (~$4 trillion), investment spending (~$3 trillion), and net exports (~-$1 trillion). The main takeaway here is that consumer spending makes up about 70% of GDP.
With the importance of the consumer relative to the economy in mind, let us examine the current fiscal health of the US consumer. There are two ways a consumer can spend. The individual can either spend their savings, or the individual can take on debt to spend.
As you can see below, the US consumer is once again strapped for cash at ominous levels like those seen in the years proceeding the last two recessions. Recessions are marked by gray bars.
@EconguyRosie
Author of the daily economic report, Breakfast with Dave, and Chief Economist & Strategist at Gluskin Sheff + Associates Inc.
How long can the consumer continue to spend via debt then? Below you will see the year over year % change in bank credit. One can see that prior to recessions, banks tend to slow down the rate at which they provide loans to the consumer and businesses. In short prior to recessions, bank credit slowly dries up. This makes it harder for consumers to continue to spend more and more quarter after quarter.
http://www.hoisingtonmgt.com/
The mechanics of bank credit drying up make sense, since interest rates have been steadily rising. As interest rates rise, loans become more expensive. Loans, like any other good, have a price. The price of the loan is the interest rate, so as interests rates rise, less people take on debt to consume. Below you will see a variety of interest rates, which are all rising.
What are the forecasts currently predicting? The Atlanta Fed’s GDPNow is currently predicting 2018 Q4 GDP growth to come in at 2.8%. For reference, Q1 GDP growth was 2.2%, Q2 GDP growth was 4.2%, and Q3 GDP growth was 3.4%.
Making predictions on GDP can be very difficult. The main issue in my opinion with the forecast is trying to quantify the human variable. My current stance is that the statistics are not placing enough respect on the non-sustainability of tax-cut sugar highs, the trade war reaction, and the reverse wealth effect.
The theory behind non-sustainability of tax-cut sugar highs is that the Trump tax cuts created a strong earnings boost and euphoria in the economy. First, many companies were essentially given free cash flow that they had not previously expected to have, which is theoretically positive for an economy (not going to get into the fact that the tax cuts were funded with debt). With this in mind, I am taking a bet that analysts will over extrapolate the benefits of the tax cuts into the future.
The trade war overreaction means that businesses decided to get ahead on the production of goods due to the coming tariffs. If you run a business, and you know that the goods you need to produce your product are about to be subject to tariffs, then you will purchase those goods in advance to avoid the tariffs. In Q3 0f 2018, inventories could be attributed to 2.33% of GDP. This means that without the rise in inventories due to preemptive tariff reaction, Q3 GDP may have been closer to 1%.
Co-Founder 720 Global/ Partner at Real Investment Advice. Strategic Expertise: Macro-Econ, Asset Alloc, Valuation, Risk Mgt.
The last behavioral variable to hit the markets that I will speak about is the reverse wealth effect. This one can simply be defined as feeling richer or feeling poorer. For example, when your stock portfolio is appreciating, you may be more likely to spend due to the larger unrealized gains present in your portfolio. On the other hand, if your portfolio is depreciating, then you may spend less due to the fact that you will feel poorer as your unrealized gains will have fallen in value.
If we are heading towards recession soon, then Q4 GDP 2018 will need to show decline. It will be interesting to see if some of the behavioral variables end up creating a significant discrepancy of the outcome from the forecasts.