Signs of Recession Are All Around
The long U.S. business expansion probably reached its peak in the second quarter, and the economy in all likelihood is now in a recession. Of course, it will be many months and many data revisions until we’ll know for certain, but most of the classical signs of a peak are already in evidence.
Contrary to popular view, business activity doesn’t continue to grow rapidly until the very end of the expansion but experiences a slowing growth rate as the next recession approaches. Now, all of the major economic components are showing normal late-expansion characteristics.
As usual, the rise in interest rates since the 1987 stock market crash slowed housing and other interest rate-sensitive sectors. This in turn has reduced growth in employment, making consumers cautious as they worry that if they lose their jobs, getting relocated could be difficult.
As a result, consumer saving has skyrocketed and in the first quarter of this year individuals saved 45% of the increase in their after-tax income over the fourth quarter of 1988. This far exceeds the already large 34% average in the final quarter of the last three expansions, probably because the widespread use of variable-rate borrowing in the 1980s means that many more borrowers have been pinched by the rise in interest rates since late 1987 than in past business cycles.
Earlier, only the last people to apply for mortgages sweated out a rise in mortgage rates while everyone else congratulated himself for being a genius because he got his earlier at cheaper rates. This time, everyone with a variable-rate loan has been sweating.
The flip side of more saving is depressed spending, and the cutbacks in purchases of autos and other discretionary items have, as usual, led to a buildup in
inventories. Few producers or retailers see inventories as excessive--but then they never do until a recession gets under way and sales plummet while production and inventory cuts lag.
The continuing strength in inflation, exports and capital spending is to be expected at a business cycle peak, for these historically lag the overall economy. Even the moves by the Federal Reserve toward easing rates in the past month are right on target. The credit authorities have switched from tightening to easing within a few months of all postwar business cycle tops.
We may well be, then, already in a recession. It could be long and deep in view of the many protectionist pressures and financial problems--the savings and loan crisis, over-leveraged American corporations, over-borrowed consumers, bankrupt Third World debtors, vulnerable real estate investments, etc.--that could explode in the course of a business contraction and seriously impair business and consumer confidence.
Will Hit Cyclical Firms
Furthermore, the next recession will probably be global. All major countries are concerned over excessive economic growth and inflationary pressures and are competing to increase interest rates in response. This, plus the spreading effects of U.S. weakness, will probably make the business slump worldwide by early 1990.
The advent of a recession means dramatically lower short- and long-term interest rates, as the Federal Reserve eases and as the inflation fears that have bothered investors wither. I continue to believe that the next big investment opportunity will result from falling interest rates, with long-term Treasury bonds, now yielding 8%, reaching the 4% to 5% yield range and providing fabulous investment returns over the next year or two.
Nevertheless, the decline in yields since last August is very early in relation to past recessions and may have gotten ahead of itself. The strengthening dollar and the safe-haven appeal of U.S. high-quality bonds to foreigners pushed yields down, but both trends appear to be abating. Furthermore, inflation is not yet dead and--as is normal--may continue to worry bond investors until the recession is much more clearly visible.
The recession will also cause big disappointments over earnings of cyclical companies. Massive cost cutting in this decade by manufacturers has dramatically reduced break-even points but in the process has shifted the cost structure much more toward fixed and away from variable costs. As a result, cutting costs in step with sales volume declines will be much more difficult in the recession, especially if it is severe.
The stock market obviously has not yet anticipated a recession. This could change dramatically, however, when the many who have interpreted all the signs of an approaching recession as indicators of a nice, comfortable soft landing are forced into agonizing reappraisals.