Why non-transitory recession is coming and how to face it as an investor

I am not an economist, but, looking at this picture, it is hard to see how we can avoid a recession. Ironically, we’ve been in a recession most of 2022 – real GDP declined in the first and second quarters. Economists attributed declining GDP to a “transitory” recession caused by an overhang of pandemic-induced supply chain issues. 

As inflationary pressures squeeze consumers from all directions, they simply will not be able to buy as many widgets as they bought the year before. Demand for widgets will decline; companies will have to readjust their workforce to the realities of new demand and thus reduce their employee headcount; and this will lead to higher unemployment. All this, in turn, will lead to lower demand, and voila, we’ll find ourselves in a non-transitory recession. 

Recessions do not worry us. Though I am sympathetic to people losing jobs and suffering economic hardships, recessions are a natural part of the economic cycle. They force both companies and individuals to become more efficient and thus make them stronger in the long term. 

Recessions are like forest fires – small ones are healthy for the forest, as they get rid of dead wood and convert it to fertilizer. However, the longer you suppress the fire (with the best intentions, thinking you are doing a good thing) the more dead material the forest accumulates. Eventually, when fire does pay a visit, it is more devastating and its effects are more long-lasting. 

Some folks are upset about what the Federal Reserve is doing now. First off, it is not clear that it is the Fed that is in control of interest rates today and is responsible for their going up. Since inflation is running 7–9%, where would we expect interest rates to be? Second, we should be upset at Uncle Fed for allowing negative real rates for almost a decade, manipulating the price of one of the most important commodities of all, the interest rate (the price of money). This caused bubbles across all assets except one: common sense did not experience much growth. 

Since we are on the subject of uncles, we should also not forget to thank another uncle – Uncle Sam. The one who ran our debt from $10 trillion in 2008 to $31 trillion today. When our debt is $31 trillion, each incremental 1% interest rate increase costs the government about $310 billion in interest payments, which equates to a major category of our government spending. The cost of the first 1% increase equates to about how much we spend on Medicaid, a 2% hike in rates costs us about as much as our defense spending, and 3% about equals our Social Security outlays. 

Though we have to accept the new reality that income tax rates are likely going higher, it is going to be difficult to tax ourselves out of the current situation we are in – the hole we have dug is simply too big and deep. Also, we are not going to cut Medicaid, Social Security, and especially defense (now that we are in the foothills of Cold War 2.0 with China and/or Russia). That would be a sure way for politicians to lose their jobs. No, we are going to do what every country that can issue its own currency has done since the beginning of time: We are going to print money and thereby try to inflate ourselves out of trouble. 

Summing up, the economy is likely heading into a non-transitory recession, and this one may last longer than past ones (we have accumulated a lot of dead wood).

The recession should lead in time to lower interest rates (good news for the housing market) and higher unemployment (bad news for the housing market). Consumer spending is going to be under significant pressure from all directions – a significant headwind for the economy. 

Recessions in theory should reduce inflationary pressures. However, the combination of lower tax revenues and higher interest expense (interest rates may decline from the current level, but they are unlikely to come back to 2021 levels) means that our government debt will continue to climb, and the resulting money printing will bring higher inflation (more money chasing fewer goods), thus keeping interest rates not far from their current level or even pushing them higher. 

As unemployment rises and we slide into a recession, the Fed may start lowering rates and fall back on its old tricks (buying back government bonds) that we saw over the last decade and a half. However, if inflation persists the Fed may find that the problem it has created over that time is bigger than it can handle.

If reading this gave you a minor headache, imagine what I experienced writing it. Neil deGrasse Tyson has observed that “The universe is under no obligation to make sense to you.” This also applies to the current economy. 

To make things even more interesting, while we are facing this economic whirlwind, the market (the average stock) is still expensive. Bonds, though they are yielding more than they did six months ago, still provide negative real (after-inflation) yields and are thus not an attractive asset from a long-term capital-preservation perspective. 

What is our strategy in an economy that makes little sense and is under no obligation to do so? Invest humbly and patiently. Humbly because we don’t know what the future will hold (nobody does!). You handed us your irreplaceable capital, and thus we’ll err on the side of caution. 

We’ll invest patiently because we don’t get to choose the economy or the overall market valuations we find ourselves stuck with – Stoic philosophers would call those externals – and we have no control over them. The only thing we can control is our strategy and how we execute it.

(Stoics would call that an internal.) We are going to continue to do what we’ve been doing: patiently and methodically keep building a portfolio of “all-wheel-drive,” undervalued, high-quality companies that have pricing power and should get through anything the economy throws at them.

In fact, if you look carefully through your portfolio – and this is the beauty of custom, separately managed accounts – you’ll see that the revenues of most of the businesses we own are not tied to the health of the economy. 

Also, though we may end up being wrong on this (not the first time), the consumer seems like the weakest link in the economy. Though completely eliminating the consumer is an impossibility in a diversified portfolio, over the last year we have significantly reduced our exposure to consumer spending. Our current exposure to the consumer is tiny. 

One last thing: We’ve been slightly reducing the size of individual positions to avoid the potential impact of unknown unknowns, shifting us from 20–25 to 25–30 stock positions.