Is it easy to predict a recession?

Learning to live with recessions

For about a year now, the fear of a recession in Europe and the USA has increased steadily. But fear and panic are of no help in recessions. Smart investors should count on them and put their portfolios together in such a way that they can sleep soundly even in stormy market phases.

It's back, the fear of a recession. Wherever you look or hear, the augurs are largely in agreement: economic growth will weaken worldwide. At the international level, ongoing trade disputes, especially between the USA and China, increasing protectionism, the still unresolved Brexit procedure and other geopolitical factors are burdening the economy. In Germany, the shortage of skilled workers, delivery bottlenecks and difficulties in the auto industry are also slowing the economy.

Economic growth: forecasts for 2019 are falling

At the beginning of April, the leading German economic research institutes stated in their 2019 spring report that the global economy is currently developing only weakly; they expect growth of 2.7 percent this year. The German economy has lost momentum since mid-2018 and is in a phase of economic slowdown. The real German gross domestic product (GDP) is expected to grow by only 0.8 percent in 2019. The research institutes had already dubbed their autumn report in 2018: "The upswing is losing momentum - the global economic climate is getting rougher". However, last September they still assumed that the German economy could grow by 1.9 percent this year. For the world economy, they expected an increase in GDP of 3.0 percent at that time.

Despite the significant reduction in growth forecasts, it can be said that even low economic growth is still growth and not a recession. Economists usually only speak of a recession if the GDP of a country or region has not grown for two consecutive quarters. So far, no such thing has been said in the official forecasts for Germany or the global economy. “The long-term upswing in the German economy has come to an end. So far, however, we consider the risk of a pronounced recession to be low, ”emphasized Oliver Holtemöller on the occasion of the publication of the spring report. Holtemöller is head of the Macroeconomics Department at the Leibniz Institute for Economic Research Halle (IWH) and one of the authors of the report. However, there is one downer: the current forecasts by economists assume that a hard Brexit can be avoided. Should the British leave the EU without a contractual agreement, economic growth this year and next is likely to be significantly lower than forecast.

Recession indicator: yield curve

In the US, fears of an economic downturn are even more widespread this spring, although growth forecasts for the US economy are consistently better than for Europe. This is primarily because the US uses a kind of oracle to predict future recessions: the yield curve. This curve is obtained by plotting the interest on government bonds in relation to their term in a graph. Since investors generally take higher risks with long-term investments and therefore also demand higher risk premiums, the interest rates for bonds with longer terms are usually higher than for paper with short terms - the yield curve rises as the term increases. If the interest rates for short-term bonds are higher than for long-term bonds, one speaks of an inverse interest rate structure - and economists see this as an alarm signal.

In the US, the yield curve has proven to be an astonishingly reliable indicator of recessions over the past few decades: each of the past nine phases of downturn was preceded by an inversion of the yield structure. Conversely, almost every inversion of the yield curve was followed by a recession within a year or two. The yield curve has not sent a single false signal in this regard since 1977. The Federal Reserve Bank of San Francisco described it as a "reliable indicator of recessions" in a research report published at the end of August 2018. However, the high correlation between the two events does not allow any statements to be made about the fundamental causes of economic downturns, which is why it is difficult to interpret this relationship. In any case, a mere flattening of the yield curve is not an indicator of a recession, emphasized the authors of the Fed study. That should calm the mind, because short-term interest rates in summer 2018 were still slightly lower than long-term rates.

Fears of recession fueled by the inverse yield curve

That has now changed: at the end of March 2019, the interest rate for three-month Treasury Bills (“T-Bills” for short) fell slightly below the interest rate for ten-year US Treasuries for a few days. At the beginning of April, ten-year-olds were already yielding slightly higher returns than T-bills, but discussions about an impending recession in the USA had picked up speed again. The so far only brief and slight inversion of interest rates has lured various prophets of doom and disaster out of their hiding places and since then has repeatedly made headlines, especially in the US media.

Numerous economists, analysts, asset managers and fund companies publicly oppose this (see, for example, the detailed article “Don't Be Fooled by the Yield Curve” by Laurence Siegel). Some experts fundamentally question the informative value of the yield curve in the current environment: In the end, less economic factors were responsible for its development than the various activities of the US Federal Reserve. The latter actively contributed to a flattening of the interest rate curve not only through its most recent rate hikes, but also through its massive bond purchases, which, beyond the usual market forces, would have led to lower interest rates on long-term bonds. As long as other indicators, such as the unemployment rate, did not point to a downturn in the economy, fears of a recession seemed out of place. However, if the interest rate structure reverses longer and more clearly, caution is advisable in any case.

Adjustment Reactions in the Business Cycle

Of course, investors should also exercise a certain degree of caution, especially since recessions are usually accompanied by upheavals in the financial and capital markets. However, there are good reasons to remain calm in the face of discussions about yield curves and speculation about a downturn in the economy. The most important: Such phases occur frequently and obviously cannot be avoided. In the United States, there have been a total of 47 economic downturns lasting at least six months since the Articles of Confederation were passed in 1777. There have been five recessions in the United States since 1979 - the shortest lasted six months and the longest a year and a half. Even with an investment horizon of 20 years, investing in the US is highly likely to have seen at least two recessions during this period. The situation is similar in other countries and regions.

Obviously, not only are recessions an integral part of our current economic system; they can also have positive effects. "One can learn from history that recessions are adjustment reactions in the business cycle that put a disturbed market back in order," said economic historian Werner Abelshauser in an interview with the Süddeutsche Zeitung in May 2010. Only then would the situation become dangerous when a recession turns into a depression that the economy cannot find its way out of for a long time.

In addition, recessions have the unpleasant characteristic that their beginning and duration cannot be foreseen. Even the inverse yield curve, the supposedly reliable indicator of the downturn phases in the US economy, only gives a very rough time frame for their possible beginning. John Cochrane, an economist at the Hoover Institution at Stanford University in California, put it in a nutshell in his blog at the end of May 2018: "We know one thing for sure: recessions cannot be predicted." analyze exactly which basic assumptions are behind it.

Surviving recessions without major damage

As with entrepreneurs, however, the real challenge for investors is not to understand or predict recessions, but rather to survive them without causing major damage. You can deal with recessions in a similar way to earthquakes or other natural events that you can neither prevent nor predict. If you want to build a house in a region where earthquakes occur every now and then, you should ensure that it is earthquake-proof or suitable. Analogously, investors can and should construct their securities portfolios in such a way that they do not offer any reason to panic even in stormy market phases. If your own portfolio is put together sensibly and fits your individual risk tolerance, it is usually the best and easiest method to simply sit out economic cycles. In practice, supposedly intelligent solutions and products that are supposed to protect against downward movements in the markets often use their providers rather than investors. Charly Munger, the congenial partner of Warren Buffett, once said: "It is remarkable how much long-term benefit people like us have got from trying to avoid stupidity consistently instead of trying to be particularly intelligent."

Prudent investors anticipate recessions and their consequences, so don't panic if they do occur. Fear is known to be a bad advisor and unnecessary or excessive action can easily lead to your own long-term investment goals taking a back seat. Provided that you have proceeded rationally in the construction of your portfolio and have not made any major mistakes, an inverse interest rate structure in the USA or speculation about an economic downturn in Europe should not be a reason for major shifts. Concrete signs of an imminent recession can certainly provide an opportunity to check whether the current composition of one's own investment portfolio also fits the individual risk tolerance if expectations of an economic downturn should trigger a bear market in the stock markets.

The next recession is coming. Nobody knows when they will start, how long they will last and how difficult it will be. But one thing is almost certain: until it is there, the media will regularly publish speculations about the next downturn and its consequences. Such reports sometimes stir up fears and encourage hectic actionism, which can have a greater negative impact on long-term investment success than the recessions or bear phases themselves. As an investor, one should learn to live with these cycles and to deal with them as rationally as possible. In stormy market phases in particular, it is important to proceed with caution and not lose sight of your long-term investment goals.