Betting the Farm on Threading the Needle

By | November 9, 2018

The stock market has been a hotbed of volatility lately, swinging as much as 600 points downward between Monday and Tuesday, October 22 and 23, and then another 800 points upward between Tuesday and Wednesday, October 23 and 24. Amid earnings, this has some buzzing about the potential of a recession sometime between 2019 and 2022.

Before we delve into the likelihood, causes, and outcomes of a recession, there are a few things to keep in mind:

  1. Predicting a recession is largely guess work. In fact, economists have failed to predict recessions 148 out of 153 times. That means they’ve gotten it right about 3% of the time…not a great track record.
  2. Saying a recession is on the horizon is akin to :

In actuality, recessions are an inevitable part of the economic cycle, so another economic downturn is always just around the corner.

That being said, there are several reasons some believe we are headed for an economic downturn sooner rather than later. The economy has been experiencing a period of expansion for the past nine years, marking the second longest period of expansion in US history going back 161 years. For some, this is reason enough to believe that a recession must be imminent. For the most part though, those who believe we are headed for a recession in the not-too-distant future cite three things as the most likely culprits:

  1. An ill-timed end of fiscal stimulus
  2. A corporate debt bubble
  3. A possible trade war

It is important to note that any one of these on its own is not likely to cause economic expansion to grind to a halt. Rather, the next recession will most likely be caused by many things working in conjunction, each one compounding the effects and severity of the others to create an economic maelstrom. The best way to describe this is to think of a complex ecosystem, each organism not only playing a specific role, but dependent upon all other organisms in the ecosystem in order to live in symbiotic harmony. In such a system, seemingly unrelated disturbances can have a ripple effect with each wave getting larger than the last, wreaking more and more havoc on the entire system.

In early August, the New York Times published a great article titled What Will Cause the Next Recession? A Look at the 3 most Likely Possibilities detailing the three aforementioned potential culprits of the next recession. The article begins by examining the role the Federal Reserve could play in the next recession. The author reminds readers that for the past two years, the Fed has had a relatively easy job. For two years, inflation and employment have been moving toward healthy levels. In accordance, the Fed has eased back on keeping interest rates artificially low and has gradually increased rates. Generally, this wouldn’t be a concern, despite what the President may or may not be tweeting on the subject at any given time. However, this past year the government enacted tax cuts and spending increases, which has the potential to make the timing of further Fed rate hikes a bit tricky.

The issue is that with employment at near full levels and inflation near 2%, the Fed may have to raise interest rates more aggressively to keep inflation in check. However, as the article states, it is predicted that the economic boost from recent tax cuts and government spending increases will begin to fade sometime between 2020 and 2022. This means the Fed could be aggressively raising rates to slow the economy at the same time tax policy is also working to slow the economy. Now there is a slight possibility the Fed could get the timing just right, however as Krishna Guha, the head of global policy and central bank strategy at Evercore ISI is quoted in the article,

“There is probably some kind of perfect path where the Fed could thread the needle on this, raising the rates just enough to prevent overheating but not enough to leave rates so high as to risk a recession once the impact of tax cuts fades…But what’s the likelihood that you’ll thread that needle? It’s not one you’d want to be betting the farm on.”

In the same article, former Fed chair Ben Bernanke is quoted putting the situation more concisely as, “The stimulative benefit of the tax cut is going to hit the economy in a big way this year and the next year and then in 2020 Wile E. Coyote is going to go off the cliff.”

To compound the problem, the President’s recent tweets attacking the Fed could embolden Fed Chair Jerome Powell to stay the course and continue raising rates as expected (once more in December and three times in 2019), if only to prove to Trump that the Fed is an independent authority.

While this in itself could be dicey, the concern is that this may occur in conjunction with the corporate debt bubble bursting. To provide some background, the last two recessions started when an asset bubble burst:

  • 2001: The dot-com stocks/tech bubble burst
  • 2007: The housing bubble burst

Why is this of concern?

For the past ten years we have seen artificially low rates. As a result, corporate debt has piled up as companies have taken advantage of the rock-bottom interest rates as an opportunity to increase returns for shareholders. This is true not only at home but also abroad. According to the NY Times article mentioned above, the value of corporate bonds [outstanding] has risen $2.6 trillion in the past 10 years. The rise in debt overseas is even higher, especially in emerging markets where more debt is owed by riskier borrowers. This is concerning because although profits have gradually risen while interest rates have remained low, if either change, companies with high debt burdens may begin to struggle. Couple this with the Fed continuing to raise interest rates and a slowing of the economy as the effects of tax cuts fade, and best case scenario – debt heavy companies feel a tightening; worst case scenario – debt heavy companies begin to be driven to insolvency.

Again, while this may not be enough to send our economy into a recession, since Trump came into office, and more so as we have continued to implement tariffs on goods imported from China, the increasing threat of a trade war combined with the aforementioned reasons could be the proverbial straw that breaks the camel’s back. The NY Times article referred to extensively throughout this post explains that economists have cited the economic costs of a trade war as half a percent of total GDP, which by itself isn’t enough to spark a recession. According to the article, in order for a trade war to spark a recession, it would have to be on a huge scale and cause a crisis of confidence in the global economy. The resulting global slowdown would thereby cause huge losses in the American stock and bond markets. As global revenue for American companies plummets, companies would hold off on capital investments which would be a hit to American wealth, driving up the cost of capital for businesses which could ultimately be what pops the corporate debt bubble.

Not to despair though, according to the article, Moody’s Analytics puts the likelihood of this happening at only 10%, which brings us to another salient point. Not everyone thinks a recession is imminent. This past June, in an interview with CNBC, Warren Buffet indicated that he believes the economy has plenty of ‘runway’ left before the next recession saying, “Right now, there’s no question: It’s feeling strong. I mean, if we’re in the 6th inning, we have our sluggers coming to bat right now,” (Money: Warren Buffet Just Made A Surprising Prediction About the Economy) In the same segment Jamie Dimon, chairman and CEO of JPMorgan Chase, supported Buffet’s claim, arguing that currently the economy and consumer sentiment are strong.

Warren Buffett and Jamie Dimon aren’t the only ones who share this sentiment. Two weeks ago (Wednesday, October 25) CNBC’s Jim Cramer took to his evening segment Mad Money to discuss recent market volatility saying, “People are missing the point. Nobody’s talking about a recession. This is not the end of the world, which…you would think it was when you looked at yesterday’s action. There’s no systemic risk. The economy might go from really good to really mediocre.” (CNBC: Cramer Explains Why Another Great Recession is not in the Cards) In the segment, Cramer goes on to say that recent stock volatility is not a repeat of what happened in the markets leading up to the crisis in 2008. Rather he believes that if the Fed follows through on raising rates again in December and then three times in 2019, next year’s corporate earnings are going to be reported too high. Cramer believes that this, coupled with the President’s trade qualms with China, have led to the recent volatility that has some concerned.

It is worth noting that Cramer doesn’t count out the possibility of a downturn however, he merely notes that in his opinion, a full-blown recession is not likely:

“We’re talking about a slowdown that recesses much of the economy’s recent growth and causes rounds and rounds of layoffs. Maybe our [Gross Domestic Product] decelerates…thanks to the lack of demand for autos, housing, construction, and so many other industries. That could easily be in the cards…This is not some sort of rehash of 2007 where by that point, a crash was inevitable. It’s more like 2006 or at least a much healthier version of 2006 when it comes to balance sheets, where cash can still be averted if our leaders know what they’re doing.” (CNBC: Cramer Explains Why Another Great Recession is not in the Cards)

Market volatility and why another Great Recession is not in the cards from CNBC.

That being said, I’ll leave it to the reader to decide whether a recession is on the horizon. Despite the fact that we can’t accurately predict when or how severe the next recession may be, we can examine what the implications of a recession might be, specifically as they relate to the real estate and mortgage industries.

In a recent article from MarketWatch, Zillow’s senior economist Aaron Terrazas remarks that, “Any time there are widespread job losses, the housing market softens, even if the housing market isn’t the central cause or most prominent casualty of the downturn…The spillover to the housing market will depend on the length and severity of the next recession and if some parts of the country feel the impact worse than others, some localized regional housing markets could see deeper effects.” (Thinking of selling your home? Do it before 2020 economists say) The housing markets most likely to feel the effects of the next recession are those located in more expensive areas such as San Francisco, Miami, Los Angeles, and New York City. That isn’t to say that the housing market as a whole won’t feel the effects of the next recession when it comes.

Most notably, it is predicted that the next recession will see fewer buyers in the housing market as current home owners stay where they are during a downturn while things are uncertain, waiting to move until they feel more confident. Additionally, while the next recession could result in a dip in housing prices, it shouldn’t be nearly as severe as what we saw during the Great Recession. Borrowers today are much better equipped to handle any dip in home values associated with a recession. The vast majority of homeowners are locked in to fixed mortgages, with many having refinanced in the past 10 years when rates were so low. In a Forbes article aptly titled No Housing Recession Over the Horizon, the Chief Economist for the National Association of Realtors reminds readers that a recession today would also differ from 2008 in that lending standards are more stringent as compared to the relatively non-existent standards leading up to the meltdown in 2008 when the market was rife with sub-prime mortgages. That will not be the case this time. Even if/when a recession comes, we shouldn’t see the catastrophe and collapse in home prices we had last time. Rather, it is more likely that we will see any effects on home prices isolated to certain housing markets.

As for mortgage rates, typically any time there is a recession, rates in general (not just mortgage rates) go down. Sometimes this is caused by the Fed taking action to lower rates or keeping them artificially low to stimulate the economy in an effort to aid recovery. Additionally, the basic laws of supply and demand tend to take over, whereby in a recession, consumers tend to save money rather than spend it, meaning a greater supply of money to lend than demand to borrow. In turn, there is less demand for credit and interest rates drop. By the same logic, we would also anticipate that a recession would mean a drop in mortgage rates. However, as with the impact of a recession on the housing market, the effect on mortgage rates would not feel as drastic as they did during the Great Recession and would ultimately depend on the length and severity of the next recession.

For now though, all we can do is watch, wait, and prepare as best we can. Some things to keep an eye on in the not-too-distant future that could have a direct and immediate impact on mortgage rates are any lingering effects from the results of Tuesday’s midterm elections, any movement as a result of yesterday’s Fed decision, and the expected December rate hike.

 

 

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