Fed analysis - Recession risk > 50%

Note: As a Federal Reserve publication, this is in the public domain and not copyrighted.

https://www.federalreserve.gov/econres/notes/feds-notes/fina…

**June 21, 2022**
**Financial and Macroeconomic Indicators of Recession Risk**

**Michael T. Kiley, Federal Reserve**

**...**
**A range of approaches have been considered in calculating recession risk.**

**One strand of analysis uses financial market variables — often the slope of the yield curve — to assess recession risk.**

**A second strand augments the first approach by adding leading indicators (which summarize confidence and economic activity indicators) to recession prediction models.**

**A third approach considers the state of the macroeconomy — inflation and the business cycle, as measured by the unemployment rate — because historical analyses have emphasized how recessions were preceded by high inflation, an overheated economy, and a shift in monetary accommodation...**

**Approach**

**The risk of a recession is akin to the risk of a sizable increase in the unemployment rate. In light of this correspondence, our empirical approach focuses on the risk of a sizable increase in the unemployment rate....**

**A common approach to assessment of recession risk uses financial variables, such as the credit spread (here, the difference between the Baa corporate bond yield and the 10-yr Treasury yield) and the term spread (here, the difference between the 10-yr Treasury yield and the federal funds rate). These variables are used to predict economic activity or the probability of a recession ...**

**Recession Risk Using Leading Indicators**

**Another approach to assessing recession risk considers leading indicators identified by economists. As an example of this approach, I use the variables from the previous model (credit and term spreads) and add the change in the OECD's composite leading indicator for the United States. This leading indicator is a summary index of consumer confidence, business confidence, production and labor market indicators, and financial variables (including the term spread).**

**The probability of a recession over the next four quarters from this estimated model is reported in figure 2 and is quite low as of March 2022, at about 5 percent.**

**Recession Risk Using Inflation and the State of the Business Cycle (Unemployment Rate)**

**As of March 2022, inflation was at multidecade highs and the unemployment rate was near multidecade lows. ... A model with four variables is considered: CPI inflation (measured on a four-quarter change basis); the unemployment rate; the credit spread; and the term spread...**

**Figure 4 reports the probability of a recession over the next four quarters from this approach. This approach implies a sizable risk (above 50 percent) of a large increase in the unemployment rate over the next four quarters. Historically, elevated inflation and low unemployment have preceded recessions, consistent with the idea that such developments signal imbalances (overheated product and labor markets) that may unwind through an economic contraction...**

**The unemployment rate and inflation are stronger predictors of recession risk, relative to financial variables, over horizons longer than four quarters. The approach implies a more sizable risk of a large increase in the unemployment rate, of about 67 percent over the next two years....** [end quote]

This Federal Reserve economist is comparing the risk of recession using different models. Modeling the economy is his job. He is looking at past recessions and correlating factors.

As investors, we can use the model to plan ahead. Recessions cause higher unemployment, falling sales and lower profits for companies. This leads to lower stock prices during recessions.

The stock market has dropped considerably already, but that’s not because of a recession. The economy is not in a recession at this time. Unemployment is at a historic low. GDP is at a historic high. (The 1Q22 GDP drop was due to inventory adjustment, not a drop in sales.)

The cause of the 1 & 2 Q2022 stock market drop was the stated intention of the Fed to fight inflation by raising the fed funds rate to a “neutral” level from highly stimulative and to withdraw its purchase of long-term Treasury and mortgage bonds.

The “everything bubble” has been inflated by emergency high monetary stimulus (in addition to 20 years of continuous monetary stimulus). All assets rose together on this immense wave of money. All assets are falling together with the Fed’s announcement that the wave has passed.

The drops we have seen so far do not include the natural stock price drops during recessions. (Bond prices usually rise during recessions as interest rates fall.)

The high risk of recession was calculated without taking into account Fed Chairman Powell’s determination to wring inflation out of the system by cutting monetary stimulus. Monetary cuts aren’t able to solve the supply problems which are the root cause of inflation so they will be slow to act, guaranteeing that they will be in place for a long time.

https://www.wsj.com/articles/powell-says-fed-needs-compellin…

**Fed Chief Jerome Powell Concedes Possibility That Higher Rates Cause a Recession**
**‘It is essential that we bring inflation down,’ he tells Congress**

**Mr. Powell said the Fed plans to continue raising interest rates until it sees clear proof that inflation is slowing to the central bank’s 2% target.**

This is no time to be buying stocks even if the price seems reasonable by historic standards after recent drops. The excellent growth of the stock price in the past 10 years was driven by excess monetary stimulus which is being withdrawn.

This is no time to be buying long-term bonds since yields will be rising for the near-term future. It’s hard to say whether flight-to-safey buying of Treasuries will mute the rise in Treasury yields. Many corporate bonds that were bought with the Fed’s tsunami of monetary stimulus will fail. The companies will not be able to roll over the bonds when rates rise.

As your METAR weather reporter, I am advising everyone to take shelter and repair the roof since winter is coming. It won’t be like Hurricane Covid – fast to arrive, fast to depart. It will be slow and grinding.

Wendy

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Anyone else wanna confess to really quickly always scanning down the media part… to get to the Wendy part and read it slowly to pay attention?

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This is no time to be buying stocks even if the price seems reasonable by historic standards after recent drops.

If you are buying an index, I would agree. If you are targeting individual equities then I think this is too broad a generalization. Berkshire Hathaway is currently selling at historically attractive valuations on a price to book basis even accounting for a haircut on the equity portfolio. Google, which is not the screaming buy it was in March of 2020, is selling at unusually attractive prices even after adjusting net margins down to the 22% range. I’m finding other bargains out there such as Intel, if you believe that onshoring of chip manufacturing is an inevitability, and companies like PARA and WBD, which have been hammered with NFLX and other streamers. People forget that these companies still make most of their money through traditional cable delivery channels and content development. I’ve also started a position in SAM because … well because beer. I like beer. Sometimes I drink beer. The price seems reasonable if not spectacular.

Bottom line, while the market could well fall a lot further, I don’t know that for certain. What I do know is that being 25% cash is not a recipe for wealth creation, and getting an early start with building positions in solid companies makes sense even if there will be opportunities to build more as the future unfolds. If I hadn’t been so timid in the depths of the COVID recession, when companies like GOOG were being given away, I would be a lot better off today. My belief is that I should focus on what I can see (individual company valuations) and not the smoke surrounding us.

PP

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I was just thinking BRK as well PP! And can agree with SAM. Other stocks I think would be reasonable if we get recession along with rising rates are going to be consumer staples. Some things people always need no matter how bad the economy gets. Think food. Toilet paper. Toothpaste. Yes, beer. Maybe an apartment REIT as well? Self storage?

In this vein, FPI is still, by far, my best investment decision this year. Too bad I didn’t back up the truck on it though. MOO isn’t so bad either. And considering ADM.

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I’ve also started a position in SAM because … well because beer. I like beer.

SAM may also be a good investment for other ingestible comestibles:

https://www.forbes.com/sites/willyakowicz/2022/05/23/boston-…

“Will cannabis put the party back in Boston Tea Party?”

“Boston Beer Company, the Massachusetts-based maker of Samuel Adams, is releasing a line of THC-infused iced tea. TeaPot, which contains 5 milligrams of THC, the ingredient in marijuana responsible for the drug’s euphoric high, will launch in Canada, where cannabis is federally legal, in July.”

The US market may turn out (eventually) to be bigger.

Pete

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How acceptable would recessions be if they were trickle down?

It won’t be like Hurricane Covid – fast to arrive, fast to depart. It will be slow and grinding.

One quibble, hurricane covid did not depart quickly. There was no real path out of the plague, until the availability of the vax almost exactly a year later. The market staged a fast recovery due to a tidal wave of propaganda that everything would blow over in a couple weeks. Remember my posts about the “panacea of the week”? Remember the repeated assurances that kept resetting the goal line as one deadline after another passed?

Recession reality could probably be swept aside as easily, with an equal onslaught of “morning in America” blather. Remember the sharp V bottom the market made in March 2009? The data didn’t bottom out until months later, but all the data and earnings reports in early 2009, no matter how horrible, was always spun as “better than expected”.

Steve

<It won’t be like Hurricane Covid – fast to arrive, fast to depart. It will be slow and grinding.

One quibble, hurricane covid did not depart quickly.>

I was talking about the impact of Hurricane Covid on the asset markets, not on human beings.

Wendy

I was specifically thinking of BRK since I do read mungofitch’s posts. I admire mungofitch a lot. :slight_smile:

My reading of the Macro situation is that BRK may be in a stronger position than many other companies if it doesn’t have much debt (I haven’t studied the financials) but it will still be vulnerable to Quantitative Tightening and the coming recession.

The “historically attractive valuations” are compared with valuations that were inflated by Federal Reserve monetary pumping, like all other stocks. How much will the Fed let this deflate? It’s too early to say.

Should BRK-A valuations be compared with pre-2008 prices or with post-2008 and especially post-2020 prices when the Fed was pumping like there was no tomorrow? You can see the immediate impact of the Fed’s policies in the BRK stock price chart when juxtaposed against the Fed Assets chart. How much will the Fed walk this back? What will be the impact on BRK’s price if the Fed truly does normalize rates in their effort to control inflation?

https://www.google.com/search?client=firefox-b-1-d&q=brk…
https://fred.stlouisfed.org/series/WALCL

Wendy

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I was talking about the impact of Hurricane Covid on the asset markets, not on human beings.

The markets are influenced by humans, and my examples showed how humans can be buffaloed.

Compare the steepness of decline and recovery in 74 and 82, with the sharpness of the “everything is better than expected” V bottom in 2008, and, especially, the “hydroxychlorquine will save us” V bottom in 2020.

https://www.macrotrends.net/1319/dow-jones-100-year-historic…

Steve

My reading of the Macro situation is that BRK may be in a stronger position than many other companies if it doesn’t have much debt (I haven’t studied the financials) but it will still be vulnerable to Quantitative Tightening and the coming recession.

And it is likely to be subject to non-rational impacts on the market, like margin calls or just plain fear due to downward cascades. I’ve been looking at BRK lately, and while it seems to have a stalwart core of shareholders, much of it’s assets is in other companies, like Apple. The stocks they hold are not really under their control, other than to buy or sell.

FWIW,

IP

My reading of the Macro situation is that BRK may be in a stronger position than many other companies if it doesn’t have much debt

Wendy, my understanding is that the debt held by BNSF and BHE is non-recourse to the parent. In addition, these are both regulated (mostly) so their returns are more of less guaranteed. Debt is a normal part of their operations.

The remaining debt is pretty small in relation to the earning power of the companies. Not much leverage to worry about.

Berkshire has basically sold at a lower P/B since 2008 than before.

Since you follow Mungofitch (so do I) you already know that BRK is attractively priced now in relation to any recent history.

What will be the impact on BRK’s price if the Fed truly does normalize rates in their effort to control inflation?

Perhaps think of it this way. Insurance is repriced annually so it can keep up with events. Reserves are hurt by inflation so they need inflation to be subdued. The railroad and Berkshire Hathaway Energy will still earn regulated returns. That’s the big three ex Apple.

The remaining owned businesses are a mix of a number with pricing power (moats) and those more subject to the economy. On average, probably better than most plus the smaller part of BRK.

The equities will be impacted negatively by higher interest rates, but a chunk of that is already priced into the calculations. Lower prices will provide more homes for reinvesting BRK’s cash flow. The cash itself will be impacted positively while waiting.

On balance, I believe BRK is better positioned than most. It remains the core and majority of my holdings and I’m comfortable.

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My reading of the Macro situation is that BRK may be in a stronger position than many other companies if it doesn’t have much debt (I haven’t studied the financials) but it will still be vulnerable to Quantitative Tightening and the coming recession.

Historically, BRK’s superpower is the interest-free float from the insurance operations which was then invested into other businesses. Some say that the low interest rate environment of the last several years has blunted BRK’s advantage (combined of course with BRK’s massive size). If interest rates go up a lot–which seems to be the way things are headed–BRK might be a good buy right now. FWIW, the current price seems to be attractive without any of the above handwaving. I don’t normally post trades, but I bought some today at $270.44.

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The stocks they hold are not really under their control, other than to buy or sell.

The above has a serious omission! It should read “other than to buy, hold, or sell.”

Just because a stock goes down in price does not mean the company that issued the stock is going up, down, or sideways. What you need to know is whether the stock will bounce back and as part of making the portfolio secure, debt should be limited so as never to face margin calls or other contingent liabilities.

While I don’t follow Berkshire-Hathaway Buffett is know to have a lot of cash on hand in search of investing opportunities. BRK is like an index fund on steroids.

The Captain
no position

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The stocks they hold are not really under their control, other than to buy or sell.

The above has a serious omission! It should read “other than to buy, hold, or sell.”

The omission was yours, in failing to include the previous sentences in my post that went with the one you quoted:

“And it is likely to be subject to non-rational impacts on the market, like margin calls or just plain fear due to downward cascades. I’ve been looking at BRK lately, and while it seems to have a stalwart core of shareholders, much of it’s assets is in other companies, like Apple.”

The point was that while BRK seems to have a core of shareholders that are less likely to emotionally sell in a down market, the company has the risk of emotionally selling from the public stocks they hold when the blood runs in the streets.

IP

The point was that while BRK seems to have a core of shareholders that are less likely to emotionally sell in a down market, the company has the risk of emotionally selling from the public stocks they hold when the blood runs in the streets.

But if BRK is planning to hold the public stocks in their portfolio for the long term, as is generally the plan, then the drop in the prices has little to no impact on their business other than providing an opportunity for Buffett and his lieutenants to deploy billions of dollars of their cash horde into better-valued stocks.

While BRK does sell stocks at times, as circumstances change, overall they are a net buyer of stocks, and as such they like to see prices dropping.

Also if we encounter the bad macro-economic conditions of a recession with high inflation, the Fed will still likely be focussed on fighting inflation, so money will stay tight while businesses are under pressure from the recession. That is the kind of environment when BRK can make valuable additions to their roster of fully owned businesses or otherwise make valuable deals to provide liquidity to businesses out of their massive cash hoard.

BRK is built to flourish in tough times, which is why historically a solid measure of valuation has been price/peak book … you don’t adjust the book price down to reflect falling stock prices in their portfolio, nor do you use an updated lower official book price in the middle of a recession, because those same conditions causing the falling stock prices represent opportunity for BRK to add value long term.

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But if BRK is planning to hold the public stocks in their portfolio for the long term, as is generally the plan, then the drop in the prices has little to no impact on their business other than providing an opportunity for Buffett and his lieutenants to deploy billions of dollars of their cash horde into better-valued stocks.

I tried to explain that in a previous post. Berkshire has the option to hold, Buffett and Munger are not likely to get emotional or to get margin calls.

The Captain

“That is the kind of environment when BRK can make valuable additions to their roster of fully owned businesses or otherwise make valuable deals to provide liquidity to businesses out of their massive cash hoard.”

while most everybody knows who Buffett and Munger are, they are very old ( 91 & 98 ).
Do BRK investors have the same trust in the heir apparent(s) ? I have not followed BRK at all,no
investment dollars in it.

https://finance.yahoo.com/news/warren-buffett-charlie-munger…
“Over the last two years, Buffett and Munger have made their succession plan clear to investors, by installing four key executives at the helm of the conglomerate: Greg Abel, who heads Berkshire Hathaway Energy and is likely to become CEO, Ajit Jain, who oversees the insurance business, and investment managers Todd Combs and Ted Weschler.”

But if BRK is planning to hold the public stocks in their portfolio for the long term, as is generally the plan, then the drop in the prices has little to no impact on their business other than providing an opportunity for Buffett and his lieutenants to deploy billions of dollars of their cash horde into better-valued stocks.

Gives a hit to their book value, as was reported today on SA, sending BRK down $5.64 currently:

Get ready for a shock. The book value of Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) is in the process of falling by a scary amount. That will become apparent in about a month when it reports second quarter earnings. There are a few underlying reasons but very few companies have the unusual degree of exposure to a huge downward reset of valuations. The bear market will weigh on both reported net income and the balance sheet even as its fundamentals remain solid.

https://seekingalpha.com/article/4519091-berkshire-hathaway-…

Getting more interesting as an entry point.

IP

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The value of BRK is not meaningful for the next few years.

What is meaningful BRK has cash. And BRK has an extraordinary cashflow.

There is nothin worthwhile about investing in BRK for the short term.

There will be an opportunity to get into BRK at a much better price.