Is There A Recession Around The Corner?

Some of us are trying to become informed citizens, so we can make financial decisions accordingly. One of the things that one should determine is the direction the economy is taking. 

That can be very challenging. It requires a lot of analysis, and it is very confusing because in the financial media you can find arguments that justify all possibilities.

Regardless, one should still try to make sense out of things and get through the noise. Decide what is the direction the economy is headed and plan ahead. 

Since we are not making this for a living, we most likely will get it wrong, but the goal here is to end up better than if we wouldn’t try at all. So with that reasonable low benchmark, I will tell you why I think the US is heading to a recession.

Is There A Recession Around The Corner?

In my head, I imagine the economy as a three piece puzzle: Companies, consumers and the Government. 

If we want to form an opinion, we need to take a look at how those are doing, and whether the trend is positive or negative.  So here we go.

Companies

As you already know, we are in the middle of an inflationary period. This translates into higher production cost, and employees demanding higher wages to make up for their increase in cost of living. This situation is difficult for companies , if they want to overcome it , they have very limited options.

Those companies with pricing power, they can pass the additional cost to the consumers. Completely avoiding the situation, and passing the full weight of the problem to their consumers.

Others are not that well positioned. Those which do not have enough pricing power, cannot increase their prices. This leads to reduction in profit and margins. And If things get too ugly, they have to cut costs. Starting with no essential purchases and ending laying off people. These types of companies and their employees get naturally hurt by inflation.

In addition to inflation, the Federal Reserve has been raising rates at the fastest pace in history. Interest rates dictate the cost of borrowing money. Which is essential for a company to function. Imagine a company borrowing X amount of money at 1%, if the interest rates rise to 3% their cost of borrowing increases 3 times for the same amount of money.

In just one and a half years the Federal Reserve has raised rates from 0% in March 2022 to 5.33% in August 2023. Increasing exponentially the cost of borrowing.  This situation adds on top of inflation, and the weaker companies in the economy are under threat. 

So companies are getting hit from two directions, inflation and higher interest rates. This is clearly negative for this component of the economy.  And one way we can monitor this part, is by checking the amount of bankruptcies.

See below a graph from S&P Global up to August 2023, the Corporate bankruptcies have hit their highest point since 2010.

In conclusion, inflation and the high cost of borrowing is hitting companies hard. And corporations start shutting down. Eventually, if the trend continues, this will lead  to layoffs, spreading to the consumer.

I think that inflation is here to stay, and the Federal Reserve says they want to keep interest rates elevated. So as I think what is hurting companies will remain I judge this part of the economy as negative.

Let’s see the other parts. 

The Consumer

First, I don’t need to tell you that inflation has shrunk everyone’s budget. That is something you can see at the supermarket. The question is how hard those budgets have shrunk. So let’s get a sense of it.
 

No one likes to reduce their standard of living, whichever that is. So the first thing that people tend to do when things get more expensive, is to burn through their savings. Changing habits is difficult, and if people still have the choice to keep their lives as they are, most likely they will take their hands on their savings.

Below you can see how the Americans in 2020 had almost 6 trillion dollars in their accounts. Now they have 687 billion. The difference has been spent.

In the case of the US, they have a big culture of credit cards. So those who don’t have savings anymore and want to keep their lifestyle would use the credit card as an alternative.

In the graph below, you can see how credit card debt has hit an all time high. And keeps rising up.  See how the decline from 2020 to 2021, matches the increment on savings during the pandemic.

This dynamic ends with people maxing out their credit cards. By this point, people have to cut down expenses, or if they go beyond their capacity, they will default on their credit card loans.

That is what the graph below shows. The number of people defaulting on their loans is increasing. We are still at a low level in comparison with 15 years ago. But the trend is clearly upwards.

In conclusion, the US consumer is making up for the rise in cost of living, by using their savings and their credit cards. The amount of people defaulting is also rising.

This situation is unsustainable, and eventually, they will have to cut expenses.

When that happens, companies will see their earnings declining. If people don’t buy what companies sell, they see their profit reduced. This dynamic will reinforce the bankruptcy loop.

In my opinion, the consumer is not doing well and the trend seems to go into a negative direction.  What about the last piece of the puzzle? Let’s see.

The Government

If the companies and the consumers are not doing well. We should expect less economic activity happening.  If so, then we should expect that the government is collecting fewer taxes, which is the main source of income for a government.

Remember, that companies get tax on their profits. So if the profits are shrinking, so will the taxes they pay. The same happens with the consumers, they get taxed on their consumption. So as soon as they can no longer use their credit card, they will cut expenses, and the government will see their income reduce dramatically.

See below, how the tax revenue for the US Government just started declining.

The government is similar to the consumer, changing habits is hard for them too. That is why the  government borrows money to finance themselves.  See the US debt below, and notice how the speed and increase accelerates since 2020.

Adding to that, the US government is directly affected by the raise of rates. Below you can see how their cost of borrowing has increase almost a 100% in the last year an half.

Summarizing, companies and consumers are being pressured and that seems to be worsening. Consequently, the government is not able to collect as much taxes, and has to finance itself through debt, at a higher cost due to elevated interest rates.

This feeds the inflation loop, which hurts companies and consumers, and forces the government to issue more debt to finance itself because of the tax receipts reduction. A circle that only has one possible outcome, a recession that will bring stock prices down.

The three parts of the economy are screaming downturn ahead.  So now that we have determined the direction of the economy, what should we do?

How Can We Take Advantage?

I think this is time to prepare. Save as much as you can for the times that are ahead, and if you are fortunate enough to save some on the way, wait. 

Wait until this whole dynamic unravels and the stock market plunges. Then you will get advantage of the cheap stock prices that are coming.

In this blog, we like gold, oil and uranium stocks. Just think of what you like, make your list, and when the time comes, buy it at a lower price.

But what if Am I wrong?

As I mentioned at the beginning of this post, I will be most likely wrong in one way or another. There is a lot of room for error.  That is why I am not going all in with this thesis.

Just consider you do not have to put all your eggs in the same basket. You can still invest part of your money, or keep it invested if you already are, and leave some on the side. 

Being wrong here would mean your stocks would do well. Also it would mean that you missed out the opportunity to buy more with the money you saved.

Being right would mean that your stocks will take a big hit. And you would have the chance to buy cheap assets that will make up for the loss of your stock.

That is what I am doing, I haven’t sold my stock and at the same time I’m building up my savings, because I cannot see how the economy will improve without getting worse first.

Regardless if you agree or not, let me know what you think and share your strategy. Also subscribe to know when the next post is out to get your almost monthly economic pill.

Image by jcomp on Freepik