When we were kids, we all believed in monsters in one way or another. We believed that monsters hid beneath beds, in wardrobes, behind curtains and in the shadows. They gave us sleepless nights and made us fear the dark.
As we’ve grown up, we’ve realised that monsters are a figment of imagination. As adults, the fear comes around after seeing a horror movie, and our brains cannot distinguish between fiction and reality. We tend to feel afraid when our brains get tired and the night sets.
However, there’s a new monster in town. It’s not the product of myth or Hollywood fiction. It’s real even though it’s invisible. It leaves a path of destruction along the way. The name of the immortal beast is called recession.
What’s a recession?
A recession usually occurs when a country or an economy experiences a decline in output lasting a few months. The output is called the Gross Domestic Product (GDP) – the measure of the production of goods and services in an economy.
If a country has a GDP of $100 billion in the first quarter, $90 billion in the second and $80 billion in the third, then the country is in a recession.
The figures used to measure GDP are historical data, making GDP a lagging indicator. You won’t know if you’re in a recession unless official figures state so.
Foward is forearmed. Economists and investors attempt to predict a recession to protect their investments by liquidating, investing in safe havens like gold, or shorting the market (making a profit by betting when prices are falling).
How do you predict a recession?
There isn’t a standard method to predict a recession, and it’s all based on deduction or logical reasoning of the circumstances.
For example, the cause of the 2008 global recession was the “sub-prime mortgage” crisis. In short, banks issued loans to people deemed unfit to repay them. The banks then sold these loans to other banks and financial institutions like insurance companies. The process enabled banks to issue further riskier loans. Unfortunately, this resulted in the bankruptcy of one of the oldest banks in America, the Lehman brothers. Millions of people lost their homes due to foreclosure by the banks.
I highly recommend watching The Big Short. A movie based on a book by Michael Lewis that delves into the buildup to the 2008 global recession.
What about the next recession?
No one knows if there will be a recession, but the cards on the table indicate that we’re on our way to one.
Unlike the 2008 recession, the predicted recession is the outcome of the two years (so far) of COVID-19 and the erroneous policy decisions following what’s supposed to be the aftermath of the pandemic. The policy decisions relate to too many savings in banks, inflation and the Russian invasion of Ukraine.
Too many savings
The two-year restrictions imposed by the COVID-19 led to people spending less and saving more. Various economists predicted that people would spend their savings once everything returned to “normal”. Banks ended up having excess money because people couldn’t spend it.
People put their savings in banks and spent less as governments worldwide handed out their citizens’ stimulus cheques and vouchers exchangeable in shops. Some spent it, while others saved it.
A few governments worldwide imposed moratoriums on the loan payment, meaning that people had more savings.
One of the leading causes of inflation occurs when there’s too much money chasing too few goods. Too many savings increased the money supply in people’s hands. However, the likely causes for the current inflation crisis relate to the supply chain problems.
It all started with COVID-19. Restrictions on factories and other means of production slowed the supply of goods and services, causing an increase in prices.
The inflation problems became even worse when Russia began its invasion of Ukraine, and the EU and the US imposed sanctions on Russia. Russia and Ukraine export energy and raw materials to the European Union.
Consequently, the present cause of inflation comes from supply chain problems.
The Federal Reserve is trying to solve inflation by increasing interest rates. Some economists and investors are betting that the Federal Reserve is about to make a policy error. The rationale for the inflation crisis is because of supply chain issues and not monetary policy problems. Output decreased, and demand remained the same, hence scarcity.
Those against an increase in interest rates believe that if the Federal Reserve increases interest rates, it will pull the emergency breaks on an already fragile economy, discourage investment, create unemployment, and worsen inflation.
The US economy recorded an increase of 8% in March, preceded by inflation rates of 7.5% in January and 7.9% in February.
Is the recession a self-fulfiling prophecy?
Another group of economists and investors believes that the recession is a self-fulfiling prophecy. A self-filing prophecy is a phenomenon where someone convinces themselves that their thoughts predetermine the outcome, and what they think becomes a reality. Or, as the author Earl Nightingale put it, “We become what we think about.”
In this case, they believe that people and investors persuade themselves that the economy will enter a recession. They will spend and invest less, forcing the global economy into a recession.
The self prophecy phenomenon doesn’t have any scientific rationale. However, the worsening inflation data may force investors and consumers to rethink their spending habits.
They believe that things will worsen and postpone investments and consumption, upholding the self-prophecy theory. The economic data will complement the idea into believing that it’s true.
Who else is talking about a recession?
So far, it’s too early. However, things indicate that we’re heading towards a recession, as discussed earlier.
The Federal Reserve expects to increase interest rates at least six times more this year after increasing by 25 basis points (0.25%) for the first time in March 2022.
Ideally, the Federal Reserve should fight inflation without increasing interest rates. Bank of America and Deutsche Bank believe that the Federal Reserve should use tools to slow down the economy rather than grind the economy to a sudden halt to avoid a hard landing with dire consequences.
When will the recession take place?
Both Bank of America and Deutsche predict that this will occur between mid-2023 and 2024. It could be earlier, and it could never come. It all depends on the ever-changing circumstances in the global economy.
How can I protect myself against a recession?
There isn’t one clear answer. Some people say gold, some say property, and some say stocks and cryptocurrencies are the best protection against a recession.
The best asset class should weather the recession and give a good investment return.
There are two types of stocks – cyclical stocks and defensive stocks. Defensive stocks are needs, and cyclical stocks are wants.
Cyclical stocks (wants) do well when the economy does well and performs poorly during a downturn. Such industries with these types of stocks include – consumer discretionary (Home Depot, Target, Nike, Disney), technology (Apple, Google, eBay, Amazon, Microsoft), finance (Citigroup, JP Morgan, Bank of America, Goldman Sachs), industrial (General Electric, Caterpillar), materials (United States Steel Corp, Nucor Corp, Alcoa) and energy sectors (Exxon Mobil, Chevron, British Petroleum, Shell). These types of stocks correlate with the health of the economy.
Defensive stocks (needs) are goods or services that businesses and consumers buy even if the economy isn’t doing well as they’re essentials. Types of stocks include consumer essentials (Procter and Gamble, Wallmark, Coca-Cola), healthcare (Johnson and Johnson, Pfizer) and utility sectors (Duke Energy, Exelon)
Investors may consider defensive stocks to be more attractive during an economic downturn.
In the past, luxury product manufacturers like Gucci and Louis Vuitton outsmarted the 2008 recession, and their clients considered their products as an investment rather than consumer goods.
Some investors claim that property gives the best return on investment. The theory is that property prices tend to increase during economic prosperity and remain stable during periods of economic downturn.
Unlike other investments like stocks, the property sector is illiquid. Liquidity refers to the time taken to convert an asset into cash and vice-versa. For example, one can sell a stock with a click of a button, and there are millions of buyers in the market for stocks, say in stock exchanges like the S&P500 or CfD platforms like eToro. On the other hand, it can take weeks, months or years until a prospective customer buys a property. In this case, the stock market is liquid, while the property market is illiquid.
Banks don’t give out loans to buy stocks. However, they may issue loans to purchase a property. An investor can only purchase stocks with the money at hand. Therefore it may be more affordable to purchase stocks. The price tag associated with purchasing a house can run into thousands or millions. Unless you have money in your hands to buy the property outright, you’ll need to take a loan.
During periods of uncertainty, banks may be reluctant to issue loans as the risk of default on loans will increase due to the economic downturn that leads to unemployment.
Since the Federal Reserve has already increased and is planning to increase interest rates further, the cost of borrowing will increase. The increase in interest rates may put the cost of affordability of the repayment of a loan into question, as the loan’s monthly repayment will increase in proportion to one’s salary. The cost of borrowing may cut into the profitability of the property.
The above scenario may trigger a housing affordability crisis. There will be a mismatch between the buyer’s highest price (demand) and the lowest price the seller can offer for the same unit of property (supply). When the demand and supply don’t match each other, there will be a market failure.
For example, a buyer can offer $100,000 while the seller wants $150,000 to sell the same apartment. The apartment won’t sell as the buyer and afford it, and the seller won’t sell it at the buyer’s bid price.
Gold and other precious metals like platinum and silver are a few of the safest investments during a recession. Investors tend to flock to gold during uncertainty as to the price increases. On the flip side, investors sell gold during economic prosperity.
Bitcoin came about amidst the 2008 financial crisis. One of the primary objectives of Bitcoin is to decentralise finance and cut out the intermediaries like banks and other financial institutions.
Cryptocurrencies are a new asset class, and they still need to test the waters. A few proponents in favour of Bitcoin argue that Bitcoin is digital gold. Therefore, it will act like actual gold and increase its price during uncertainty periods.
Bloomberg claims that Bitcoin’s price movement correlates with the tech-heavy Nasdaq 100 index, meaning that 66% of Bitcoin’s price movement follows the performance of the Nasdaq 100 index.
The Nasdaq 100 is based mainly on tech stocks, which fall under the cyclical category. Based on this hypothesis, cryptocurrencies tend to do well while the economy is doing well and not so well during an economic downturn.
What are the possible scenarios?
No one knows what’s going to happen. One can only try to predict scenarios of what may happen based on past events and the recent circumstantial evidence.
The Lehman Brothers bank was one of the oldest banks in America. Founded in 1847 and filed for bankruptcy in 2008. In 2008 it was the fourth-largest bank in America.
The default of the Lehman Brothers was the first milestone associated with the financial crisis. It opened a financial armageddon that saw the insolvencies of millions of American businesses and several millions of US citizens losing their homes due to foreclosure.
Lehman Brothers’ collapse dragged other banks into the mess that required the American Government’s decisive action to issue bailouts to other banks, insurances, other financial institutions and even automotive industries. Sectors of the American economy deemed “too big to fail”.
The purpose was to limit the extent of the bankruptcy of Lehman Brothers, prevent the fallout from growing exponentially, and limit things from getting worse for the US and global economies.
Banks and other financial institutions conduct business based on trust. If one bank fails, it will drag others with it due to what is known as contagion. In banking, contagion occurs the financial difficulties of one bank will spill to other banks and financial institutions.
Banks operate by lending out depositors’ money to borrowers. Deposits tend to be short-term, and technically depositors can withdraw their money anytime they want. People taking loans tend to borrow money for extended periods. For example, a loan to purchase a car can have a repayment period of 5 years, and a loan to purchase a property can have a repayment period of 20 or even 40 years or more.
A contagion can cause a bank run as depositors may consider banks untrustworthy. Bank runs occur when depositors withdraw their money simultaneously based on the fear that banks will become insolvent. Banks will end up with on loans their balance sheet.
Banks may have the right to call in the loan as stated in the loan agreement’s fine print. Banks may opt to call in part or the entire loan from its borrowers. Since most borrowers won’t have enough money to repay the bank it owes money to, banks may opt to do a foreclosure on the property. A foreclosure occurs when the bank takes away the loaned property since the borrower fails to honour the loan agreement.
Once completed, banks may opt to sell the property to prospective buyers. Ideally, to those that don’t require a loan so that it can remain solvent.
In a way, a bank run is a self-fulfiling prophecy. If people think that a bank is insolvent, they can create a bank run, and the bank may become insolvent even though its balance sheet may be healthy.
While countries like the US had a depositor protection scheme as early as 1934, other countries started introducing similar protections in the aftermath of the 2008 financial crisis, especially in countries inside the European Union.
Can the 2008 financial crisis repeat itself?
The short answer is yes. People tend to repeat past mistakes, even though legislators enacted various laws to prevent something like the 2008 financial crisis from repeating itself.
Circumstances change, and people change.
There’s a difference between reading something in a history book and living the experience or nightmare. A case in point is the Spanish flu that occurred in the 1920s, no one expected to go through similar events a hundred years later.
Since 2010 the Federal Reserve has provided relatively low-interest rates, which means that people and businesses could borrow money cheaper while incentivising those with excess money to invest in lucrative investments like the stock market and other investments like property. Low-interest rates discourage depositors from keeping money in banks.
During this period, the prices of properties outpaced the salaries and wages of ordinary citizens. As time passed by, the prices of property increased, and ordinary people were required to borrow more to afford the same unit of property bought at a lower price a few years earlier.
The higher the monthly loan repayment that one has to pay compared to their monthly salaries, the less money one spends on goods and services. An increase in interest rates will increase the monthly loan repayment reducing the disposable income. Inflation will further deteriorate the purchasing power left for disposable income.
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