The Next Recession

Context
Recessions occur for various reasons. As I commented on my post about the US stock market, doom calls are useless unless they actually predict things within acceptable timeframes. I can tell you now that there is a VERY high chance of a major crash within 30 years from now… but do you care? Although predicting markets and recessions requires a careful analysis of lots of information and the building of a clear, overall picture of economic and market conditions, the general “setup” of a recession is simple: 1) the “output gap” is zero or positive, which generally means the labor market is tight; 2) inflation starts creeping up; 3) a past buildup of certain “abnormal economic or financial conditions” (case-by-case) becomes more and more apparent; 4) a trigger happens; 5) expectations shift very fast and general panic gains stock markets and other markets; 6) and down we go, with varying levels of complexities and retroactions between countries, institutions, and markets.
 
The usual trigger is super easy: monetary tightening, which itself generally comes from rising core inflation or a forecast of rising inflation, which causes the first domino to fall, and the recession dynamics to kick in. Conditions in stock markets, forex, housing, corporate debt, household debt, government debt, money markets, and several others generally then follow a somewhat predictable path, offering opportunity for those having the knowledge, and risk for the clueless. Since one of the main missions of this website is to help the clueless become less clueless, let’s have a look into this a bit, and try to clarify things for those of us who have money in stocks, forex, housing, and other markets. Ready? Go!

​The output gap and why it matters a LOT for you
The output gap is a fancy word to describe “where the current economic activity is relative to what is normal for this economy”… something like this:

​Estimating at least qualitatively the output gap is important for you, because when the gap starts to close and GDP might go above potential, it means that the central bank might step in to contain inflation by raising the interest rates, and this has important repercussions across all markets, including stocks and currencies, especially when large central banks make moves.
 
To oversimplify somewhat, and barring supply shocks, you can see the central bank like the driver of a car: if the car is “overheating” (inflation) or at risk of overheating in the next year or so, the central bank will “hit the brakes” (increase interest rates), which generally slams the brakes on stocks and housing (depending on other variables) and has effects on forex market conditions. The same logic applies when the car is slowing down: the central bank will hit the gas (decrease rates and/or outright “print money with QE) to accelerate the economy.
 
The crucial aspect is to know when to get out and step into a market. This can’t really be done perfectly, but the powerful combo of good macroeconomic analysis with a few simple tools of technical analysis can go a long way. But one thing is clear: you must at least always have some idea of where the economy stands relative to potential.
 
So how do we know at least approximately where the gap stands? It boils down to looking into many economic and financial indicators, but here are very straightforward ones:
 

1. Core and total inflation;
2. Labor market conditions: unemployment rate relative to the “natural rate”, employment rate relative to what we think will be, and participation rate relative to what we think will be;

 
There are MANY other indicators to look into, and there are complexities to add about leading and lagging indicators, expectations and market information, monetary stance and level of liberalism/orthodoxy, and many others, but I don’t want to get into that here. Suffice to say that high and increasing inflation with a tight labor market generally imply increasing interest rates soon, and maybe a recession and market corrections, with consequences on global capital flows and currencies.
 
The USA now as an example
Since we don’t really know what the output gap is, we can estimate it with the proxies of inflation and labor market indicators, and that is where things get interesting…
 
US inflation is on the low end (0-2%) since 2012 and dropped in 2015 in part due to the appreciation of the USD, which caused a drop in import prices and inflation. Right now, total inflation stands around 1% and core inflation at about 2%. There is no inflation threat right now.
 
The US labor market is the interesting part… The unemployment is roughly close to a “normal” rate of 5%, which might suggest that Y = Yp (GDP would be on potential, and interest rates would soon start increasing)… BUT… The employment rate and the participation rates were at an all-time high in 2000, then dropped a bit due to the mini recession of 2000-2001, then started slowly rising again from 2004 to 2006, but this short-lived recovery was brutally reversed in 2007-2009, and they bombed and never seemed to suggest a return to more normal levels until recently. This is VERY important my fellow stock and forex friends!
 
Why is this important? Because if both the ER and PR have lots of room to grow going forward, it means that the current output gap is more negative than most people once thought, and that means lower inflation going forward (because we would still be in negative gap), looser monetary policy than we thought, more room for momentum in stocks, and less appreciation of the USD than we thought (I don’t want to explain why in detail here), hence a bit more support than we thought for gold and oil (and the CAD). Of course, my fellow colleagues in big hedge funds and investment banks have caught onto this and most of this is priced in… I tried to hint at all this on my website way back – hopefully you got the hint!
 
So what about the next recession?
Hint: keep an eye on inflation and labor market conditions, and keep visiting this website for hints ;) If there is lots of room for extra workers to join the labor force, it means there is still plenty of “slack” in the economy, which means stocks would still have some room to run… but that depends on how the Fed sees all this, and how the market perceives what the Fed is doing and will do… interesting times ahead :)
 
You have to keep the basics in mind and build a clear picture of global markets, domestic markets, economic and financial conditions, and link that to your trade decisions! Combining a solid economic analysis (accessible to you – yes) with simple technical analysis will put you ahead of 80% of retail traders in forex and stocks! There is an “initial cost” to get the knowledge, but just like a sport that you start doing and is hard at the beginning, you eventually get good at it and it becomes easy, fun… and lucrative!
 
I hope you enjoyed this post and that things are a bit clearer now! Feel free to comment, share, and to contact me. Cheers!
 
YourPersonalEconomist
 
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