Four key signs that a recession is imminent

Well folks, the bad times are clearly back. There is a growing risk of a recession. Worse, there may even be stagflation, where inflation remains high while economic output falls.

For those of you who have invested consistently since 2009 or earlier, experiencing a recession is only part of the economic cycle. Bad times follow good times. Bad times lead to innovation and efficiency, which in turn leads to good times.

But if you’ve only been working and investing since 2009 or later, experiencing a recession can be more shocking. We actually experienced a mini recession in 2020 during the start of COVID-19. However, that recession lasted only two months.

The next recession will more than likely last longer. The impact of a recession on your livelihood depends on your risk exposure, job stability, number of income streams, age and cash balance.

Signs that a recession is imminent

After publishing my newsletter review on recession signs, I thought I’d write more broadly on the topic in this post. Then I can update the post as time goes by with the latest signs.

1) The yield curve is flattened

The spread between the 2-year government bond yield and the 10-year government bond yield has been compressed to its narrowest margin since March 2020. Notice how every time the 10-year Treasury yield falls below the 2-year Treasury yield, a recession occurs within the next 12 months. An inverted yield curve is a reliable recession indicator.

In a healthy economy full of optimism, the yield curve slopes upward because of the time value of money. A dollar today is worth more than a dollar in the future due to inflation. However, if you are pessimistic about the future, you tend not to invest in the future. Instead, you hoard cash and buy government bonds and other shorter-dated assets.

Fortunately, expectations for aggressive rate hikes by the Fed over the next 12-24 months have eased. But even if the Fed doesn’t raise at all, the yield curve could still turn negative, as the Fed doesn’t control the government bond market, but the market does.

You can track the yield curve through the St. Louis Fed, which has the best economic data. Once the line below goes below the dark horizontal line, we have inversion.

Yield Curve - Recession Indicator

2) Long bond yields do not rise with rising energy prices

Energy prices are rising as a result of the war in Ukraine. Since Russia is one big gas station, imposing economic sanctions will hurt the global oil and gas supply.

In a rapidly rising inflation, longer-term Treasury bonds would normally increase as the bonds sell out. Ten-year government bond yields fell, however, and do not appear to be moving beyond 2%. The reason is that the fear of a recession is greater than the fear of higher inflation.

Investors prefer to own safety and losses in real terms, rather than investing in risky assets and losses in nominal and real terms. In other words, wouldn’t you rather still earn a nominal return of 1.8% and a negative real yield of 5.7% in a government bond, than a nominal loss of 20% in the stock market and a negative real negative yield of 27.5%+?

Most would say yes, which is why investing in I-Bonds that pay 7%+ and municipal bonds is so much fun during a downturn.

Brent Crude Oil Price Historic - Signs of a Recession

3) Negative real wage growth is recessive.

While real wage growth is strong for lower income earners, real wage growth is generally negative due to high inflation. However, unlike negative real mortgage rates, which are great for real estate, negative real wage growth is negative for the economy.

Negative real wage growth simply means that average wages fail to keep up with a basket of goods and services. As a result, the cost of such goods and services becomes more expensive and disposable income decreases if consumption is not reduced.

BofA shows a chart that says that if real wage growth is still negative by the summer, the chances of a recession in the US increase. Based on the current state of affairs, aggregate real wage growth will certainly be negative for the rest of the year.

This data point is a good reminder to focus on building more income through investment, not labor. There is more friction when trying to get a raise through labor (asking for it, job hopping, etc).

Negative real wage growth is a sign of recession

4) Dramatically higher energy prices have historically preceded a recession.

Below is another chart showing the probability of a recession with rising energy prices.

Fluctuation in energy prices leads to recession

Incredibly, on April 20, 2020, the price of West Texas Intermediate crude fell nearly 300%, trading around the negative $37 a barrel. In other words, anyone trying to sell a barrel of oil would have to pay a buyer $37.

Intuitively, we all know that rising oil and gas prices make life more expensive. We need oil and gas to heat our homes, drive our cars with combustible engines, fly and produce other end products. Here are some great charts from the US Energy Information Administration.

US Petroleum Products Consumption by Source and Sector

US Petroleum Products Consumption by Source and Sector

The probability of a recession in the next 12 months

Based on the above factors, I estimate for the US that the probability of a recession in the next 12 months is 70%.

The Fed is likely to raise Fed Funds rates by another 50-100 bps over the next 12 months, further flattening the yield curve. Inflation is likely to remain above 7.5% for longer due to a strong rise in energy prices. Meanwhile, even if the Russians stop slaughtering innocent people, the Russians will find a way to take economic revenge.

We could certainly come out of a recession in the next 12 months. However, the odds are not in our favor right now.

In contrast, the Russians are already in a recession. But their recession will be much worse. Unless they invest abroad and flee the country, life as they knew it will never be the same.

The main concern of the recession: massive layoffs

The labor market is currently robust. Nominal wages are rising and the number of vacancies is reaching record highs. However, as publicly traded companies see their stock prices hit, the propensity to hire decreases. The same is true for private companies that experience valuation compression from competitors and investors.

Sooner or later, managers are told to scale down their workforce and do more with less. Because fewer jobs are available, the wage pressure is decreasing. As wage pressures decrease, consumption also decreases. In industries where a significant portion of a worker’s wages is in the form of inventory, the slowdown in consumption should be even greater.

Therefore, even if you are not worried about losing your job, you should take steps to strengthen your work safety. Do more before you are told to do more. Build stronger relationships with your managers. Have more friendly chit chats with your competitors. Contact people before you need anything.

If you’re job hopping for more money and a better title, you could be the first to be fired during the next layoff. Last in, first out (LIFO) is the standard way to cut. So carefully weigh the pros and cons before taking such a step.

A recession might not be so bad

Losing money on your investments is one thing. If we have the right asset allocation, you should be fine, as recessions usually don’t last more than a year. We can always work longer to make up for our losses. Furthermore, time is usually our friend when it comes to investing in risky assets.

However, losing money in your investments and losing your job is a terrible combination. Without the ability to operate, it becomes much more difficult to invest at the bottom and make up for your losses. Violating the first rule of financial independence in this scenario is anything but a certainty. Therefore, the importance of sideline activities and passive income investments is increasing.

The saving grace of a terrible recession is that both the federal and state governments have shown that they are standing up and helping. Most recently, the US government provided improved unemployment benefits, stimulus and PPP loans to small businesses. I suspect a similar amount of government funding during the next recession.

Investment upside down after a recession

The VIX, or CBOE Volatility Index, is currently trading above 30, a high level. The VIX is a real-time market index that shows the market’s expectations for volatility over the next 30 days. Investors use the VIX to measure the level of risk, fear or stress in the market when making investment decisions.

The good thing about an elevated VIX is that the returns over the next 12 months for the S&P 500 are generally strong. If there is a surprisingly peaceful resolution to the war in Ukraine, we could easily see a 3-5%+ rise in the S&P 500. Take a look at this chart from investment house Schroders.

VIX Level and S&P 500 Future Yield Up

CNN Money’s Fear & Greed Index also points in the direction of Extreme Fear. This is another sign that we may be getting close to the bottom.

What do I plan to do if a recession comes?

My goal is to continue to live the way I want, even if a recession comes. Living the way I want means spending more time with my kids and less time working online. I also plan to travel more with my family to see my parents and in-laws. I’ll just be poorer in the process.

I’m in an interesting position because I can’t be fired from a day job because I don’t have one. Well, I think my wife could fire me!

All the work I do online is mainly due to my pleasure in writing and connecting with like-minded people. Writing is like therapy. Writing also gives me purpose. If online revenues drop, so be it. It has always been seen as bonus money to boost my passive income investments.

Although ~32% of my wealth is hit in public equities, I’m still convinced that real estate will continue to outperform in a possible recession. I clearly remember owning several properties during the worst recession in 2008-2009. Not much happened because the tenants kept paying the rent and I just kept living in my main residence.

As a perennial optimist, I see a recession as a good time to think about what we want to do with our lives. The opportunity cost of building wealth and getting ahead decreases during a recession. Therefore, if you can afford it, what better time to slow down and enjoy life more?

If we get another recession, I don’t think it will last more than a year. I also don’t believe we will see a more than 20% drop in the S&P 500. The best protection against a recession is to continue to live each day with joy and meaning. As a longtime FS reader, I hope you’re prepared for what’s to come!

Readers, what do you think is the probability of an imminent recession? Are you prepared for a recession? What are the things you are most concerned about when we enter a recession?

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