Shock and bore

The investor rollercoaster continues. Tariff chicken combined with the swoon in certain US economic datapoints were enough to send many running for whatever investment cover they could find. Then came the announcement from Germany...

We have similar problems to the fabled blind men shoved into a cave with an elephant.¹ As in the parable, our heightened senses are potentially leading us astray as we blunder around in the dark, feeling for clues on what lies in front of us. We routinely mis/over-interpret the information we think is provided by the lumps and bumps our fumbling hands come across.

The metaphorical elephant in our capital market’s cave unfortunately seems to be quite a bit more agitated than the one described in the parable too. This week, we take a tour through historical causes of recessions and what we can and can’t say about the moment we are faced with.

Turbulent times?

In spite of what many will understandably imagine, recessions have actually been getting less frequent and less severe over time. Prior to 1700, the UK economy (for example) contracted as much and as often as it expanded.² The result was no discernible net progress in living standards over the centuries.

Since then, the ratio of expansion to contraction has improved to roughly two-thirds vs one third. Since 1900, the economy has managed even better, with recessions only marring 17%³ of the time (Figure 1).

Figure 1: US recessions have become more infrequent

Source: FRED, Barclays

There are many reasons why we and the wider world have been getting better at dodging these recessionary salvos. One broad category of answers centres around the emergence of certain types of institutions.

The legendary Nobel prize winning American economist, Douglass North, forefather of much of the current thinking on institutions, saw them as “humanly devised constraints that structure political, economic and social interactions.”⁴ Under this umbrella, we are talking about everything from parliaments, judiciaries and central banks to trade unions, guilds and charities.

The important point here is that these institutions, both formal and informal, ultimately evolved to ever more successfully help us both protect economic gains and mitigate the nasties. The fact that so much of the global monetary response to the recent pandemic echoed that deployed during the Great Financial Crisis, which itself functioned as a corrective to policy mistakes made in the Great Depression is surely informative.

There are other factors to consider too. As more cyclically sensitive manufacturing companies dwindle as a share of total output, replaced by less cyclical services businesses, the economy in aggregate treads a steadier path.

Meanwhile, much business cycle violence of the past can be chalked up to the difficulties of adequately catering to incoming demand for goods. Bulging stock rooms provided a buffer in the good times but added substantial dead weight to recoveries from the bad. The march of technological progress is, among many other things, allowing for cuter management of stock rooms and supply chains, which in turn has taken further sting out of economic downturns.

As a result of all of this we can happily now say that, at any period in time, the global economy is much more likely to grow than not. Technological innovation, the growing dominance of services, allied to those buffering institutions are all important cogs. Therefore, over time, growth tends to far outweigh the negative shocks from a recession. The same story holds for equity markets as it goes, since the profits that drive market returns are themselves a direct function of growth.

Triggers

While it’s reassuring to know that recessions are outweighed by growth in the long run, accurately calling when the next one will hit is still a fool’s errand. Many talking heads, lured by the asymmetric reputational boost, will opt for the stopped clock tactic. If you are always doing the rounds speaking of what could go wrong, you will be right at some stage and your personal stock will briefly soar – temporarily appearing one-eyed in the land of the blind.

Back in the real world, if we examine how different GDP sub-components behave during various downturns, we can observe a very clear pattern: while consumption has declined more often than not in recessions, investment spending has accounted for the largest contributions to declines in output.

Nevertheless, knowing that recessions are predominantly driven by investment downturns isn’t particularly helpful – businesses can stop investing for a myriad of reasons. The International Monetary Fund’s (IMF) past attempts⁵ to shed some light are instructive. They were only able to identify triggers for half of their sampled recessions – the remaining half were unexplained.

Investment conclusion

The wide variety of potential recession triggers, as well as their unpredictability, make it almost impossible to time a recession. Nevertheless, long-term investors can take comfort in the long-proven fact that the occasional recession, however deep or painful they may be, have always been outweighed by mankind’s inexhaustible ability to innovate and grow.

For now, we would continue to lean against the idea that the US economy is heading into its next major recession. A mix of factors, from policy sequencing to weather, are contriving to paint the economy in a lull. However, our suspicion remains that the US economy still has too much going for it for now, as discussed in last week’s podcast and article.

If policy is beginning to hinder the economy in the US, then it seems finally ready to turn into a meaningful tailwind elsewhere. The prospects for a serious and sustained fiscal push in Germany can go a long way to change the investment prospects for both the country and wider region (as also discussed in a recent podcast and article). Diversification may be starting to pay.