Recession Risk

Wall Street is talking about a recession. 

CNBC Chatter

The trade war might trigger it. 

The recovery out of the 2008-2009 Financial Crisis is getting old. Trump's presidency has enjoyed a long tailwind of a strengthening economy, which Trump takes credit for. 

It is the nature of economies to cycle, to back and fill. Trends develop based on market or price signals, and then businesses realize they got ahead of themselves. Or a counter-trend develops. This isn't a flaw; it is a feature, like inhaling and exhaling. 

Example: People in Southern Oregon have a close up view of an expansion with the explosion of hemp grows. A few hemp farmers last year made a great deal of money--an unambiguous price signal. People noticed. Make hay while the sun shines! So this year there is hemp growing on every available acre of flat ground. If these growers go bust thanks to oversupply, then we will have seen the "exhale." If they make money this year, many more will grow hemp, and those that grow will put in even more acreage, on hillsides or whatever other land they can find. At some point they will have over-planted and the price will collapse. 

They will chase the trend until they discover they should not have. It is what entrepreneurs do.

Hemp: foreground just planted; behind planted 2 weeks ago; and in distance more going in.

Note that as the growing expands I said farmers would expand onto hillsides, land that is more marginal, i.e. less productive. Possibly the margins will still be good enough that those marginal hillside grow sites make money--or not. Entrepreneurs will test the boundaries, and the boundaries are discovered when some grow sites fail. Maybe some land can productively grow hemp. Some cannot. 

There will be trial and error. Failure is part of the system. 

Extremes are building up in the world and national economy.

Interest rates. The sovereign debt of Japan went negative in 2016. Now it is negative over much of Europe. Interest rates in the United States are still positive, but very low, with the 30 year bond at 2.19% and the 10 year at 1.69%. Inflation is at about 2% in the US, which means that there is essentially zero net yield for savers, and already a negative yield for a saver after taxes, since even that puny return is subject to federal tax.

Stretch for yield risk. Many investors want--need--a safe place to get a return on investment. Retirement funds (i.e. for public employees) make assumptions about the productivity of the pool of money they have accumulated to pay the liability they bear, i.e. payments to existing and future retirees. The plan is for investment returns to provide about 75% of those total payments, the returns coming from investment earnings over the 20 to 30 years that money is paid into that system. Oregon's "assumed return" figure is 7.2%--typical of other PERS systems nationwide. Obviously this return cannot be achieved by investing the money in the guaranteed investment of government bonds at near zero net returns. Retirement systems have added risk to try to find something that will pay them. They have no other choice. They may get the return. The certainly have the risk.

Things need to work out. Sometimes they don't. We have experienced two profound market failures in the past 19 years: the collapse of the technology bubble in 2001-2003, and then the mortgage-real estate-stock market Financial Crisis of 2008-2009.

Yield assets get mis-priced. There is a corollary to this search for yield: risky interest bearing investments are too popular. Institutional and private investors who want--need--a positive return have accepted lower and lower quality security for their bonds. What they want is a government bond that pays 6% but they don't exist so they settle for bonds of highly leveraged businesses, bidding up the price and bringing down the yield. Corporate bonds that might normally pay 10%, to compensate an investor for the significant potential that the bond will default, now only yield 5 or 6%, since the demand is so high.

Real estate assets get mis-priced.  In a low interest rate environment buyers of homes get only a portion of the benefit. With mortgages rates so low, borrowers can afford a larger mortgage with the same payment, with the result that home--and other prices--go up. This is good for home owners and others who have assets already, but it pushes the price of them ever-higher in relation to the incomes for potential buyers. That puts buyers at higher risk if the economy falters.

Budget deficits at boom time. The GOP tax act of 2017 increased the deficit at a time of economic boom, the exact opposite of prudent budgeting when the economy was at full capacity. It is the opposite of the Biblical story of the Egyptian granary, when at times of plenty they filled the granary to provide for the times of famine. Trump and the GOP abandoned their purported fiscal principle and added debt at a time of plenty. 

Net result: the Trump economy is fragile. 

Risk is being piled onto risk. The tough trade talk with China, combined with the UK's Brexit problems, plus the overall slowdown in manufacturing, plus the slowdown in China, plus the perennial problems of war and disputes all provide flash points to topple the house of cards.

But not yet. Democrats should not count on Trump forging ahead with a tariff war with China if it seems likely to him to trigger a recession. Trump won't "take one for the team." He is a winner. He likes people who do not get shot down in combat. He had bone spurs. 

He may or may not understand trade wars, but experience is showing him that he was wrong in saying that "trade wars are easy to win." If it appears to endanger his recovery, I fully expect him to back off and declare victory. He knows that a recession would likely be fatal to his re-election hopes.

But it may be too late. There are subtle signs that a recession is already underway. The risks and excesses are catching up with him--with all of us.