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Dec 8, 2015

How does one predict the next recession?

Economists are famous, as the quip goes, for having predicted seven of the past four recessions. The only thing they can really predict with certainty is that another one is inevitable at some point. No U.S. economic expansion has ever lasted more than a decade.And the current expansion is embarking on its seventh year; it’s now 18 months longer than the average since World War II.

Economists also can’t predict why or when the next recession will strike because each one is unique. The irresponsible commercial real estate lending that bankrupted the savings and loan industry triggered the 1990–1991 recession. The 2000–2001 recession resulted from the internet bubble.

The Great Recession of 2008–2009, meanwhile, grew out of the residential housing market implosion. Banks and hedge funds that had invested in mortgage-backed securities suffered huge losses as homeowners defaulted on their loans. Banks stopped lending to one another as the value of their collateral fell, creating a massive credit crunch.

The next recession could result from free-falling oil prices, a strong dollar amid a weak global economy or rising interest rates. If profits plunge, oil and gas companies will lay off workers from high-paying jobs. A rising dollar will also dampen demand for U.S. exports, weakening multinational companies’ earnings and crimping their share prices. Rising interest rates would increase borrowing costs and hinder business expansion.

Recessions often come as a great surprise to many, although in hindsight, they may be very obvious.

Here are five warning signs to look for:

  • Inverted yield curve and widening credit spreads. The rarely seen inverted yield curve occurs when short-term interest rates are higher than long-term rates. This means bond investors have a negative long-term outlook and expect long-term bond yields to fall. Companies, such as banks, that borrow at short-term rates to fund lending at long-term rates see profit margins fall. Widening credit spreads indicate lenders demanding higher interest rates for taking on more risk. Historically, an inverted yield curve has indicated a recession.
  • Reduction in capital spending. After businesses add new plants, inventory and capacity, they scale back once demand weakens. A buildup of excess capacity and inventory forces businesses to cut prices, leading to deflationary expectations. Consumers in turn spend less, fueling a vicious cycle.
  • Falling consumer confidence. Consumers make up approximately 70 percent of the U.S. economy. When they are confident about their personal finances, the economy flourishes. When they worry about job security and declining household wealth, the economy doesn’t grow.
  • The Federal Reserve overshoots short-term interest rates. The full results of this may not be seen for 12 to 18 months. When the Fed lifts interest rates too high, borrowing becomes too expensive. Businesses’ cost of capital also goes up, and borrowing and consumer spending slow.
  • Weak commodity prices. Commodities, especially copper and oil, are a barometer of industrial production and economic growth. Falling prices suggest less demand for industrial production. At the same time, commodity producers see their incomes shrivel.

Recessions are difficult to endure, but they’re not the end of the world. Since World War II, they’ve lasted on average 11 months while expansions last four to five years.

In the long run, recessions provide attractive buying opportunities. High quality companies usually emerge stronger and more profitable. Weak competitors fall by the wayside, leaving the victors with more market share. Prudent equity investors would do well to tune out the noise and focus on the long term. The stock market is always looking ahead. It will peak months before the economic data weakens. And it will rebound when the economy appears most dire and everyone seems most pessimistic.

Information expressed herein is strictly the opinion of Kayne Anderson Rudnick and is provided for discussion purposes only. This report should not be considered a recommendation or solicitation to purchase securities. Past performance is no guarantee of future results.

This article was originally published in the December/January 2016 issue of Worth.

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