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A recession is coming (and I know why) Thumbnail

A recession is coming (and I know why)

Okay, relax. That headline was just a hook. There’s nothing profound about that statement. Recessions happen. We just don’t know when they’ll happen, even when we know why they’ll happen.

And yes, we do know why an eventual recession will happen.

I recently attended a conference hosted by State Street, one of the 5 largest money managers in the world with over $2.8 trillion in assets under management. Michael Arone, chief investment strategist for State Street Global Advisors, spent some time talking about the market with a small audience of 45 local investment advisors.

Looking around, there seemed to be some horsepower in the audience – there were a lot of good questions asked, good haircuts and nice suits everywhere. I stayed in the back, hoping no one would notice the ankle socks I wore that day (a poor decision) in anticipation of a workout afterward. While keeping a close eye on my pant-cuff creep, I worked up the courage to ask Michael a question:

Me: “What’s your biggest concern with the Federal Reserve manipulating the market the way it is right now?”

Arone sighed before diving into an elaborate response. The Fed clearly weighs heavily on his mind.

For my readers, a quick lesson on the Fed: The Federal Reserve Bank (currently led by Jerome Powell with past leaders including Janet Yellen, Ben Bernanke, Alan Greenspan) is central to managing our economy with its two-pronged objective – a strong US economy and reasonable inflation. To meet these objectives the fed implements monetary policy through levers that it can pull. Those levers include:

  • The Federal Funds Rate – This is the interest rate commercial banks pay to borrow money from the Federal Reserve to lend to its customers. That Federal Funds Rate has a big impact on loans downstream from that key lending rate. As we’ve seen over the years, the economy is very sensitive to changes in interest rates as our consumption is dependent on borrowing, and our economy is dependent on our consumption.
  • Money supply – The Fed controls the abundance of money, a key driver in the purchasing power of the US dollar and the erosion of that purchasing power over time (inflation).

While the Fed is powerful and influential in the market, there are market forces at work that may compete with the Fed’s objectives. In recent history, the market has mostly supported the Fed-induced low-rate environment.

Back to Arone’s response, here are his concerns with the Fed’s actions:

  • The market continues to be propped up by the Federal Reserve reacting every time the stock market stumbles. The history of this Fed intervention goes back to 1987, according to Arone. Since then, markets have been reassured that every time the market stumbles, the Fed will step in to fix it, and because of this, it’s a managed market that is creating unsustainable imbalances in the economy.
  • In this era of slow growth, reasonable inflation and low interest rates, we’re forced to buy risk assets – you can’t grow your money in real terms (i.e. inflation-adjusted) with low-risk assets like bonds, CDs, money markets, etc., so we’re forced into risk assets (i.e. stocks, real estate, commodities, junk bonds).
  • We have a White House that spent a ton of money on a sure thing – the wealthy. Tax cuts to corporations and high-income earners flooded the market with cash, fueling demand for stock sand corporation’s appetite for buying back their own stock. Attempting to add more fuel to the fire, the President has attempted to bully the Fed into lowering interest rates, betting that this will provide further stimulus to the economy. According to Arone, this does nothing to grow the middle class. The wealth is not trickling down.
Me: “Yeah, but it appears to be working - 1987 was a long time ago” (figuring that this would provoke a more audacious response).

While Arone agreed that it appears to be working, he suggests that the Fed’s intervention and manipulation has a cumulative effect over time. At some point, it’s going to rain, and we’ll need to wait out a storm that will be a lot more severe as a result of the Fed’s intervention rather than letting the market restore equilibrium on its own.

A recession will happen as a result of the fed-fueled debt bubble we’re in. It may be 5 years from now, it may be 40 years from now, according to Arone.

No alt text provided for this image

Board of Governors of the Federal Reserve System, FRED - Board of Governors of the Federal Reserve System (US), 30-Year Treasury Constant Maturity Rate [GS30], retrieved from FRED, Federal Reserve Bank of St. Louis

The Fed has successfully kept interest rates very low. Cheap moneyis great, but the market may not support it forever and it's not hard to imagine the consequences if interest rates are forced upward.

*Cheap money = low interest rates. It means it's inexpensive to borrow money.

It’s hard to dispute that cheap money is fueling this economy. Just consider the following examples:

  • The federal government borrows money for next to nothing, allowing for more spending, bigger budget deficits, and more debt.
  • Cheap money entices corporations to buy back their stock with money they borrow, boosting their share price.
  • Growth companies are kept afloat. How successful would Tesla be if its customers couldn't borrow $60K over 8 years at 2.9%?
  • An abundant supply of money allows colleges and universities to increase their tuition at rates far exceeding inflation.
  • The real estate market loves the fact that its participants can borrow 5x their income for 3.5%over 30 years.
  • It promotes capital investment – If the cost of borrowing is lower, corporations can more easily afford to invest in revenue-generating equipment or machinery.
  • Banks stay busy and profitable as consumers and businesses borrow more.

Okay, I understand there's a problem. What do I do about it?

I would start by making a bunch of money and owning stuff…specifically assets. Cash, bonds, stocks, and real estate (your home will suffice). This is easy to do if you make good money, and if you’re reading this, there’s a pretty good chance you already own some of these assets.

That’s it? Okay, well what shouldn’t I own?

Don’t take on a bunch of debt, especially consumer debt, credit cards, excessive car loans, and student loans.

Okay, so I should just make more money, save more and pay off my debts? That’s not super helpful.

There is no silver bullet, and if someone says there is, I’d like to know what they’re selling. Like Arone says, we’re forced to buy risk assets, and that is the reality of today. The above information isn’t very actionable, but there isn't a good alternative and that is a reality you need to accept. But the choices you make today will impact your future, so think twice before buying that second home or borrowing $50,000 to buy a Tesla.

You just said that we’re in a bubble and some of those things that you said to own will be negatively impacted when the bubble pops. Why is that a good suggestion?

It’s true. Some of the assets I’m encouraging investing in (stocks and real estate) will likely be negatively impacted by a recession, but what is a good alternative? Do you hang out in a bunch of risk-free assets earning a rate of return lower than inflation? Do you try to time the market so that you make money when everyone else is getting crushed? (Hint: No, don’t do that)

Instead, use your resources today to come out ahead of everyone else. Accept that there are some things you don’t know. Accept that we don’t know the timing of this eventual recession, but we do know that those who live a highly leveraged lifestyle will get hurt worse than those who don’t. The pigs will get slaughtered, so to speak.

“When the tide goes out, you’ll see who’s been swimming naked” – Warren Buffet

Written by Justin Dering, CFP | Founder, North Country Wealth Management

This is being provided for informational purposes only, and should not be construed as a recommendation to buy or sell any specific securities. The views expressed are those of Justin Dering & North Country Wealth Management and do not necessarily reflect the views of Mutual Advisors, LLC or any of its affiliates. Investment advisory services are offered through Mutual Advisors, LLC DBA North Country Wealth Management, a SEC registered investment adviser.