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September 30, 2022
In recent months, there has been much conjecture concerning the economy and specifically whether the U.S. is in a recession. To elevate these discussions, second quarter gross domestic product (GDP) results would suggest a recession is in progress. The GDP in the first quarter was negative 1.6% and the second quarter was negative 0.6%. Historically, two consecutive quarters of negative GDP has been used to define a recession. However, the National Bureau of Economic Research (NBER), a nonpartisan group composed of academics and others, officially defines a recession. The official determination often occurs well into the recession and historical evidence has illustrated this.
Since the Great Depression, the average recession duration has been between 10 and 11 months. Contrast this to economic expansions, which typically have a length of just under 60 months. Since the 1980s, the length of economic expansions and recessions has shifted dramatically. Over the past 32 years, the average expansion has been over 86 months, including the longest ever of 128 months, or over 10 years, just prior to the pandemic. The combination of globalization, accommodative central banks in the U.S. and globally, baby boomer demographics, and other variables have benefited the residents of rich nations and, to some extent, emerging nations such as the BRICS (Brazil, Russia, India, China and South Africa) and KIMT (South Korea, Indonesia, Mexico and Turkey).
The length of U.S. recessions has averaged just under seven months since the 1980s. Often these economic cycles are v-shaped, that is, sharply down for a short period of time with generous government assistance in the form of monetary policy supporting a rapid recovery.
This recession, if it exists, will be a bit unusual. Two quarters of negative GDP would suggest a recession; however, it is unlike other down business cycles because the unemployment rate, measured by U-3 (people who are jobless and actively seeking employment) at 3.5% and U-6 (percent of labor force that is unemployed, underemployed, marginally attached to the workforce, or have given up looking for work) at 6.7%, is near record low levels. This may be the unintended consequence of accommodative monetary policy with generous fiscal policy in the form of direct checks to individuals and organizations as a result of the pandemic. The workforce participation rate declined during the pandemic, particularly amongst females who took on childcare, adult care and assisting with online education.
Next, demographics in the U.S. and abroad are influencing labor markets. Baby boomers born between 1946 and 1964 are retiring at a rate of 300,000 per month in the U.S. Often these individuals have been the beneficiaries of strong wealth built up by equity in housing real estate. One result of these retirements has been productive worker shortages across business lines and in the public sector. This has resulted in wage increases in an attempt to maintain real purchasing power equal to the rate of inflation and more specifically to retain a productive workforce.
There is a lyric in the old song by the rock band Chicago that is very appropriate for the current inflationary times, that is inflation is, “A hard habit to break!” The Federal Reserve in the U.S. and central banks abroad are in panic mode attempting to tackle inflation. Interest rate increases in the U.S., Great Britain and Europe have been at the highest levels in decades to break inflationary trends. Will the central banks overshoot interest rate increases? How will higher interest rates impact real estate, small business, and equity markets? Financial sector issues in these areas could result in consumers retracting spending despite a full employment situation. This is why historically the unemployment rate is a lagging indicator of a recession, which appears to be true during this economic cycle.
Behavioral economics is in full swing with the loss aversion principle, coined by Scott Nations in his book. The loss aversion principle states that losing money is about twice as psychologically painful as making money is pleasant. The bottom line is that if one waits for evidence of a recession in the unemployment rate, the aforementioned factors of demographics, stimulus and other variables may possibly result in a protracted U.S. and global recession.
What are the flashing lights on the business dashboard that can provide insight for both the direction and duration of the economic downturn?
Copper is a widely used commodity in both the manufacturing and technology sectors that needs to be monitored. Prices at the beginning of 2022 were hovering around five dollars per pound. These prices dropped to $3.16 per pound and have somewhat rebounded, but are still blinking red at less than $3.75 per pound. Copper is a guide to global economic direction as China consumes and stockpiles nearly 50%of this commodity.
Another dashboard metric is the Index of Consumer Sentiment, reported by the University of Michigan. A number above 90, which was predominant during the record pre-pandemic economic expansion, suggests strong consumer behavior. Consumer spending drives two-thirds of the U.S. and rich nations’ economies and 55% of emerging nations’ economies. Another blinking red light is this metric has been under 75 since August 2021. A record low of 50 was reported in recent months and it is the lowest level recorded since analysis started in 1941.
The Leading Economic Index (LEI) comprises ten variables and is another red-light flashing signs of a recession. This index has been down over three-tenths of one percent for each of the last four months, and 2.7 points overall since April. This level of decline is often indicative that a recession either exists or is around the corner. If this index continues to decline for another couple of months, it is almost certain that a recession is not only here but that it could be protracted.
One bright spot in the economy is the Purchasing Manager Index (PMI). This number has been above 50, which is indicative of an expanding economy especially in the manufacturing sector. The global economic powers such as China and the Euro sector are reporting mixed signals, with China reporting a number over 50, while the Euro sector has fallen below 50. Closely monitor this component of the dashboard for deterioration in the manufacturing segment, particularly if the PMI declines to the low 40s.
The inverted yield curve, an old standby indicator, is a strong blinking red light. Across the curve, short-term interest rates have exceeded long-term interest rates since May. This metric has predicted every recession since 1959. However, it also has predicted some that did not occur because central banks closely monitor interest rates and adjust policy.
Are we there yet? The economic dashboard would suggest a resounding yes.
Let’s circle back and discuss how a recession could impact the agriculture industry and the strength of individual producer’s financials as well as overall loan portfolios.
In some geographic regions, non-farm and other business income are reported by 50% of agricultural customers. The sustainability of this income will be crucial to cash flows and coverage ratios. Non-farm income is particularly significant to young farmers and ranchers who leveraged this income to launch and grow their businesses.
Careful assessments of the economic health of global trade partners will be critical, specifically the United States’ top three trading partners: China, Canada and Mexico. One must drill down to commodity specific or country specific data if they are aligned with specific countries or regions of the globe. For example, West Coast producers export much of their hay to Japan, South Korea and, in some cases, China. The economic health, trade agreements and value of competitive currencies will link macroeconomics back to individual business and overall portfolio success.
Will a recession slay the dragon of inflation? In the past, this has happened. However, prices received often lag prices paid. Higher costs often will remain for three to five years after prices received have declined. This will first create margin compression and then negative margins. This is followed by a drain on financial liquidity. In the past, a prolonged period of negative margins will lead to asset values declining, which creates a double effect on both income statements and balance sheets.
The next 12 months could be interesting times for the U.S. and global economies. This environment will require prudent risk management strategies and actions to navigate through the downturn or a possible prolonged recession.
Dr. Kohl is Professor Emeritus of Agricultural Finance and Small Business Management and Entrepreneurship in the Department of Agricultural and Applied Economics at Virginia Polytechnic Institute and State University. Dr. Kohl has traveled over 10 million miles throughout his professional career and has conducted more than 7,000 workshops and seminars for agricultural groups such as bankers, Farm Credit, FSA and regulators, as well as producer and agribusiness groups. He has published five books and over 2,500 articles on financial and business-related topics in journals, extension and other popular publications.