Impact Capital’s quarterly research report seeks to highlight the latest developments most relevant to your investments and financial planning. In this installment, we will focus on some tell-tale signs that another recession is imminent.
The current economic conditions point to a higher probability of a recession. Let’s consider the following:
- Short-term interest rates are higher than long-term interest rates, a trend which has historically preceded recessions.
- The unemployment rate is historically low. Low unemployment rates have also historically preceded recessions.
- The last time the unemployment rate was this low was at the beginning of the worst stock market performance net of inflation in history when the S&P 500 went 26 years without making any money net of inflation (1968-1994).
Could this time be different? Of course. We are working with probabilities, not certainties. These are just some of the reasons we remain concerned about the stock market this year and continue to have our portfolios positioned more conservatively than we would otherwise.
Yield Curve Inversions
The chart below shows the ten-year interest rate minus the two-year interest rate. Most of the time, longer-term interest rates are higher than short-term rates (the difference is positive and above zero).
When the opposite occurs, it is called an inversion. As you can see from the chart, inversions have preceded recessions going back to 1980 (recessions are the shaded areas). Inversions preceded recessions in 1980, 1982, 1990, 2001, 2008, and 2020. The timing is not exact, but the outcome is still the same. The emergence of an inversion suggests a higher probability of a recession than times when there hasn’t been an inversion.
The Inflation Rate (The Change in Inflation)
Inflation is the loss of purchasing power due to rising prices, which we wrote a blog about last year (you can check it out here). Inflation is usually reported in terms of the amount that prices have changed over the last few months or year. The chart below shows the annual change in prices over the last five years. The last reported Consumer Price Index (CPI) indicated an increase of 4.90%, which was hailed as a success in the markets because the increase was lower than previous increases in 2022.
Consumer Price Index Data
Inflation falling is not the same as prices falling. An inflation rate of 4.9% means prices were still 4.9% higher than they were in March 2022. Beyond that, this reporting ignores what happened before the last year. Allow me to fill this reporting gap.
Last year, in March 2022, prices were 6% higher than they were in March 2021. To say inflation is falling may technically be a factual statement, but this interpretation misses the big picture: PRICES ARE STILL RISING. A one-year look back period masks the real rise in prices we’ve seen recently, with prices now up a staggering 17.8% since May 2020.The chart below shows the U.S. Consumer Price Index over the last five years.
The Federal Reserve’s goal is for inflation to simmer down to 2%, but inflation rates haven’t fallen below 2% since January 2021.
S&P 500 Historical Returns
The S&P 500 has always been higher over a 20-year holding period. The chart below shows the price of the S&P 500 since 1950, which are shown on a log scale so percentage movements can be seen. There have been times when prices fell or went sideways. Those difficult times tend to coincide with recessions, which are indicated as the shaded areas.
Inflation-Adjusted Market Returns
The story is different once inflation is taken into account. The chart below depicts the same data as above, but has been adjusted for inflation.
Let’s step back in time to 1968: Investors who bought stocks in November 1968 had to wait until December 1994 before making any money net of inflation.
The rampant inflation in the 1970s coupled with recessions and falling stock prices was a terrible combination for investors. The late 1960s were a time when people weren’t expected to live 26 years after retirement. Unfortunately, retirees in 1968 had particularly bad luck, watching 26 years go by with no real return. The possibility of something like this happening again makes it imperative that you implement risk management as part of your investment and financial planning process.
Surely 1968 was an outlier bound to never happen again, but there is one key similarity between 1968 and now (and don’t call me Shirley). The chart below shows the unemployment rate since 1960, with the shaded areas denoting periods of recession. The unemployment rate in November 1968 was recorded as 3.4%. The most recent unemployment rate from March 2023 was recorded 3.5%. Right now, the unemployment rate is the lowest since 1969, which you would think would be great news worth celebrating!
But hold off on the celebratory bubbles for a moment! As much as we want everyone who wants a job to have a job, a low unemployment rate has historically coincided with poor future stock market returns. It may be counterintuitive, but the best time to buy stocks is when the unemployment rate is high.