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Recession Risk: Should We Be Concerned?

by Paul Lipcius, CPA | July 14, 2022

Rising prices, rising rates, falling stocks, and headlines all mentioning Recession. What does it all mean and where are we going from here?

Let’s address the elephant in the room. Recession risk. A recession, by definition, is two consecutive quarters of falling GDP (a measure of total US economic activity). We’ve already posted a negative Q1 (-1.6%) so there’s a good chance Q2 will confirm that we are already in one. Nobody hates the “R” word more than Wall Street. Because economic growth is the lifeblood of the stock market. So it’s natural to see the headlines talking recessions. It’s worth mentioning that despite a poor result, Q1 GDP was still up over Q1 2021 by 3.5% although you wouldn’t know it from the news. It may not all be doom and gloom.

For starters, the stock market is a forward-looking mechanism. The recent sell off from highs (-31% for Nasdaq and -21% for S&P 500) are already pricing some of that risk in.

Things were also running hot. A mix of ultra-easy money and supply chain bottlenecks has sent inflation soaring. And the Federal Reserve is trying to tame it by raising rates. A side effect of rising borrowing costs is a slow down in economic activity & business investment. While this may indeed tip the economy into a recession, recessions have historically done well to tame inflation. Periods of contraction challenge businesses in the near term and therefore hurt stock prices. However, arguably worse for stocks in the long-run would be persistent runaway inflation. Consider it short-term pain for long-term gain.

Rising rates not only impact the underlying businesses but also the way investors value assets. As borrowing costs rise, bonds yields rise. When bond yields rise, they become more attractive low risk investments. Which causes investors to demand a higher return on stocks and particularly favor cashflows now vs. the prospect of a company turning profits 5 – 10 years later. This tends to bring down stock prices in most segments, but companies with strong fundamentals and balance sheets will outperform less stable firms and lower quality assets. We’re seeing this in action right now. Bubbles in crypto, NTFs, blank-check SPACs, and tech start-ups have begun to unwind very rapidly. Meanwhile, value stocks have held up reasonably well. A trend that’s likely to continue if the economic circumstances continue to deteriorate.

By historical standards, this is the most "normal" the market has been in some time, as we lift off from decades of artificially suppressed borrowing costs.

While there’s no doubt a recession would cause some pain, not every recession results in a full-blown financial crisis. We all remember ’08: it was a doozy. But the two recessions in the early ‘90s and early 2000’s were far less severe. Single digit unemployment and peak GDP contraction of -1.4% and -.3%, respectively. It’s far too early to tell where this will end up, but it’s important to remind ourselves of this context. The best case scenario is that we avoid widespread havoc and double-digit unemployment and instead see a healthy rebalance and return to basics. Where the froth of excess is blown off and valuation return to reasonable levels.

Regardless, times like these tend to reward businesses and investors who display patience and prudence.

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