Is the U.S. economy heading toward a recession? This question is seemingly perennial, but no doubt has been a hot topic in the last year. Google Trends has shown the search for ‘recession’ is up several hundred percent since 2022.
I’ve also been asked the recession question with much more frequency as of late. The follow up question is generally something along the lines of “What should we do with my portfolio? Should we go to cash?”
The U.S. economy faces several potential factors that could contribute to a recession in 2023. While it is important to note that economic forecasting is inherently uncertain, I can outline a few reasons why a recession might occur.
Cyclical downturn: Economic cycles are a natural part of any economy. After a sustained period of expansion, a contraction phase may follow. The U.S. economy has experienced a prolonged period of growth since the Great Recession of 2008, and a cyclical downturn could be overdue.
Tightening monetary policy: The Federal Reserve has aggressively raised interest rates and reduced its asset holdings to combat inflationary pressures and may further tighten monetary policy. Higher borrowing costs for businesses and consumers tend to lead to reduced spending, investment, and economic activity, potentially triggering a recession.
Geopolitical tensions: International conflicts or trade disputes can have significant economic consequences. Heightened tensions between major economies, such as the U.S. and China, could result in increased tariffs, trade restrictions, and disruptions to global supply chains, negatively impacting the U.S. and global economies.
Fiscal policy challenges: The U.S. government’s fiscal policy decisions can influence economic performance. If there is a lack of consensus or gridlock in Congress regarding fiscal matters, it could hinder the implementation of necessary stimulus measures or lead to austerity measures that dampen economic growth.
Financial imbalances: Excessive debt levels, asset price bubbles, or vulnerabilities within the financial system can undermine economic stability. If there is a sudden correction in financial markets or a wave of defaults on loans, it could trigger a broader economic downturn.
It is important to emphasize that these are potential risks, and their actual impact on the economy is uncertain. Various factors could mitigate or offset these risks, such as effective policy responses, technological advancements, or positive developments in global trade. Economic forecasts should consider multiple variables and their interactions, which makes accurately predicting a recession challenging.
Or more plainly said by Warren Buffett when asked what he thinks of economic forecasts, “Worse than useless.”
Fear of a coming recession might lead you to consider moving out of riskier investments such as stocks and into cash. Warren’s quote says it all but allow me to back up Warren with some data.
There have been 30 recessions since 1871, according to the National Bureau of Economic Research. (This is the longest period for which performance data is available for the S&P 500 Index and its predecessor index.) In the 6 months leading up to these recessions, stocks produced a positive total return 70% of the time or in 21 of the 30 recessions. So, getting ahead of the recession might not be an effective strategy.
Even if you could time the beginning and end of a recession exactly, you still might not beat the market. Stocks produced a positive total return during 12 of the 30 recessions or 40% of the time.
Overall, during the periods beginning six months before and ending six months after each historical recession, the market produced a positive return 22 of 30 periods or 73% of the time. The median total return over these periods was a whopping 16%. Good luck beating that return with cash.
It should now be apparent that the stock market and the economy don’t necessarily move together. The stock market is forward-looking. Yet, predicting and even timing a recession 6 months in advance has historically been a losing portfolio proposition. Worse than useless indeed Mr. Buffett.
As recession talks continue in 2023 and you feel fear radiating in your mind, channel your inner Warren. Recall the few stats above that show even perfect predictions of recessions didn’t necessarily yield better portfolio results. In fact, perfect predictions still had a losing probability.
Sitting tight is probably the right answer for most. This does, however, presume you already have a well-diversified, science-based, process-driven investment strategy. The investment strategy should also be aligned to your financial life goals and cashflow needs. A tax-smart overlay helps too.
If you are unsure of these presuppositions, it is never a bad idea to get a competent second opinion.
Kevin Kroskey, CFP®, MBA | May 2023
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