From Around the Web

Is a Recession on the Horizon? Here’s How to Prep for the Possibility

Written by Guest Post

It’s been over a decade since the recession of 2008. Some experts suggest we are due for another one. Are they right? And, if so, what signs point towards a recession, and how can you best prepare your business?

What is a recession?

We all know a recession is generally bad news for the markets, employment, retirement accounts and most businesses. But, how do you define recession?

There is no single definition of recession. In fact, in its attempt to do so, the International Monetary Fund (IMF) admits:

There is no official definition of recession.

Instead of defining recession, the IMF describes symptoms of a recession. Other economists and institutions use a similar approach to define recession. Some generally accepted characteristics of a recession include:

  • Decline in economic activity
  • Credit isn’t easily available
  • Business contraction
  • Economic collapse and rising unemployment
  • Wage growth stagnates

Notice how the above list describes economic conditions. The list doesn’t quantify these conditions through impact or time variables. After all, a slight downturn in economic activity doesn’t necessarily mean a recession has started. So, how significant must the slowdown be, and for how long must it last, before a downturn can be labeled a recession?

When does a slowdown become a recession?

Many economists use a two-quarter economic output rule to flip a downturn to a recession. For example, the IMF uses Gross Domestic Product (GDP) as the economic condition, the two-quarter rule as the time factor and consecutive decreases as the impact factor.

Using the IMF’s recipe, an economy falls into recession when overall output (GDP) declines for two consecutive quarters, significantly affecting the growth rate.

Some economists argue that the IMF’s single-metric approach is too narrow. They believe that GDP misses elements important to economic health, such as employment rate, consumer spending and bond rates. Others find that a two-quarter rule is too near-sided to accurately capture the whole view of an economy.

Regardless of the methodology followed to define a recession, economies usually find themselves in the throes of a recession before everybody agrees the recession has arrived. To make matters worse, recessions go from bad to worse quickly, and businesses feel this pain.

If it’s possible to see a recession coming, businesses could prepare for its effects. So, are we headed towards a recession? Let’s take a look at what experts are saying.

Is a recession coming to the US?

The opposite of a recession is economic expansion. The economy has currently enjoyed the longest period of economic expansion in US history. If for no other reason, many argue we are simply due for a slowdown. Economies operate in a boom-bust cycle. Assuming the cycle continues its ordinary course, a bust is next in line and it’s waiting to happen.
But, we can’t predict recessions using time alone. Janet Yellen, former Chair of the Federal Reserve, once suggested,

I think it’s a myth that expansions die of old age. I do not think that they die of old age. So, the fact that this has been quite a long expansion doesn’t lead me to believe that … its days are numbered.

If time doesn’t kill expansions, what indicators do forecast when the next recession will hit?

There are several factors and economic indicators to evaluate when attempting to predict a recession. Here are some of the most common components: unemployment rate, yield curve, manufacturing, consumer sentiment and trade.

Unemployment rate

Researchers at the Brookings Institute suggest “the unemployment rate is the most important measure” to predict an oncoming recession: “[I]ncreases in the unemployment rate can tell us about rapid deterioration of the labor market in close to real time.”

Researchers can monitor the unemployment rate on an ongoing basis, which hopefully allows researchers to predict a recession instead of identifying a recession long after it has begun. The Brookings Institute uses a methodology by economist Claudia Sahm, which looks at the unemployment rate’s three-month moving average to determine if a recession has hit.
The theory suggests:

`{`I`}`f the unemployment rate (in the form of its three-month average) is at least 0.50 percentage points above its minimum from the previous 12 months, then the economy is already in a recession.

When Sahm’s methodology is applied to historical unemployment rates, it accurately predicted the last seven recessions in the United States.

Where do we stand?

As of October 2019, the unemployment rate in the US was 3.6%, which is historically low. The low unemployment rate is not determinative in itself. Rather, the Sahm methodology looks for spikes in the unemployment rate, and suggests that a 0.50 percentage point spike indicates an oncoming recession. Before the last recession, the number spiked to 0.53 in February 2008, and did not fall below 0.50 until June 2010.

Currently, the Sahm indicator continues to be low at 0.07. For the majority of the current economic expansion, the number has been negative, so it’s growing. The Sahm indicator is not predicting a recession yet, but it’s worth keeping an eye on.

Yield curve

A few months ago, you may have heard the term yield curve in financial news.

When economists talk about the yield curve related to recession prediction, they generally mean the yield curve depicting the relationship between the 10-year treasury bond and the 2-year treasury bond. During times of economic expansion, the longer term bond (10 year) has a higher interest rate than the shorter term bond (2 year).

When the difference between the two is charted on a graph, the chart pattern is up and to the right. When the shorter term bond has a higher interest rate, the chart reverses, and the chart pattern becomes an inverted yield curve.

Looking back at history, when this yield curve inverts, the US economy has often experienced a recession within the following year or two. Similar to the unemployment spike, this has been true of every recession going back to the 1970s. However, not all year curve inversions are the same, as the Chicago Federal Reserve pointed out during a yield curve inversion in 2018. What is the yield curve telling us now?

Where do we stand?

In August, Economists warned that the last time the yield curve inverted as it did in August was December 2005. The December 2005 inversion signaled a coming recession. Sure enough, within two years, the US found itself in the greatest recession since the Great Depression. If the current economy repeats 2005 behavior, the US might be less than two years away from its next recession.

Manufacturing

Many economists use manufacturing as a bellwether for overall economic health. The Institute for Supply Management (ISM) surveys major manufacturers about orders, production, customer inventory, employment, deliveries, backlog, raw materials inventory and other business activity on a monthly basis. Based on their responses, the ISM creates an index. Index readings above 50 suggest the manufacturing sector is growing, and below 50 suggests the manufacturing sector is contracting.

A major benefit the ISM index has over metrics like the yield curve and unemployment rate is its broader look. The ISM index includes more variables and global supply chain elements that can capture recession-relevant data. It is also calculated at the beginning of each month without revision. Accordingly, it can be used as forward-looking instead of backward-looking.

Despite its multi-factor approach, manufacturing doesn’t play the role it once did in the US economy. The US, and much of the world, continues to transfer to a services-based economy. Accordingly, the ISM index may not be as useful as it once was. For example, the index fell below 50 in both 2015 and 2016, but the economy continued to expand.

Where do we stand?

The index reading for October 2019 is 48.3%. That’s a 0.5 percentage point increase from September. Despite the increase, orders, production, employment and supplier deliveries all indicate contractions. Further, raw material inventories are low, customer inventory is low and prices are decreasing. Contraction across many categories suggests that manufacturing is slowing. 48.3% is not terribly low; however, the index rarely falls below 45% without a recession.

Consumer sentiment

Consumer spending offers another insight into economic health. If consumers don’t spend money, there won’t be economic growth. Unfortunately, by the time economists identify a widespread halt to consumer spending, economies are typically well into recession territory.

In an attempt to predict how consumers will spend in the future, the Conference Board created a consumer confidence index. The Conference Board’s Consumer Confidence Survey attempts to capture consumer attitudes and buying intentions using data available by age, income and region.

Using the Consumer Confidence Survey as a measure for oncoming recessions is far from an exact science, but researchers have found that a 15% index drop, year over year, has been a reliable recession predictor.

Where do we stand?

The latest Consumer Confidence Survey indicated that consumer confidence remains high (125.9), but slightly lower than September (126.3). Although consumer confidence remained high, consumers expressed specific concerns over employment opportunities and business conditions.

There’s no sign of a 15% drop, but one of the nice characteristics of this metric is its ability to capture drastic changes in a single month. For example, consumers react quickly to news like natural disasters, political unrest and trade wars. If a factor such as these causes consumer panic, we could see a 15% drop in a single month.

Trade wars

If consumer sentiment has the ability to predict recessions, the Trump administration and its trade wars with China are certainly pertinent to any recession conversation. After almost two years of an increasingly heated trade debate between China and the US, journalist Mark Gongloff captured consumer sentiment around the issue: “On Friday, President Donald Trump said he’d struck a trade truce with China, and stocks soared. This morning, China said it needed more talks to reach a truce, and markets tumbled. Having fun yet? No.”

This market rollercoaster tied to the President Trump administration’s back and forth with China isn’t an isolated incident. Every time the countries make an announcement (e.g., a new list of tariffed goods, a retaliatory tariff or a potential deal), the stock market reacts strongly. Why? Because the market incorporates consumer sentiment.

Where do we stand?

Of all the economic indicators used to predict recessions, the Trump administration’s trade war with China is the least likely to be quantified. But, the trade war’s potential to trigger a recession helps introduce an alternative view of recession prediction.

Some economists reject any notion that we can regularly predict recessions. In his book, “The Black Swan,” Nassim Nicolas Taleb concludes, “The inability to predict outliers implies the inability to predict the course of history. The strategy for the discoverers and entrepreneurs is to rely less on top-down planning and focus on maximum tinkering and recognizing opportunities when they present themselves.

“So, I disagree with the followers of Marx and those of Adam Smith: the reason free markets work is because they allow people to be lucky, thanks to aggressive trial and error, not by giving rewards or “incentives” for skill. The strategy is, then, to tinker as much as possible and try to collect as many Black Swan opportunities as you can.”

Taleb could encourage you to disregard all of the economic indicators mentioned above. He might suggest that none of these will predict the next recession. Rather, an unpredictable Black Swan event will pitch the economy into its next recession, so it’s best to prepare your business for the unknown, rather than the known.
George Washington University economist Tara Sinclair has spent much of her research time on business cycles and predictive analysis. However, she summarizes the reality of recession prediction by saying,

Historically, the best that forecasters have been able to do consistently is recognize that we’re in a recession once we’re in one. The dream of an early warning system is still a dream that we’re working on.

What does a recession mean for your business?

Are we headed towards a recession? Some indicators suggest yes, while others suggest not yet. Historical timing says one is right around the corner. Black Swan theory assures us, yes, but we have no idea when. What should you do to prepare your business for the next recession?

Prepare

Did Ben Franklin really say, “By failing to prepare, you are preparing to fail.” Who knows, but it’s great recession planning advice. Think back to the symptoms of a recession. Three in particular should grab your attention in the pre-recession stage:

  • Economic activity declines
  • Available credit declines
  • Unemployment rises

An overall slowdown in economic activity generally results in a reduction in business. Prepare for that, now. Don’t overextend your business with excessive debt, oversized overhead expenses and non-essential business expenses.

On the credit front, money is cheap right now. Interest rates are low and moving towards zero. A Danish bank is actually offering a 10-year mortgage rate of -0.5%. If you need to make purchases on credit, or mortgage a business property, lock it in now. Make sure you get into a fixed rate, so you don’t get burned by an adjustable rate if, and when, the recession arrives. Take advantage of the cheap money environment.

When unemployment rises, good employees look for work. Remember, unemployment spikes before recessions start. You might be able to recruit quality employees during pre-recession layoffs. Pre-recession planning will help you prepare for a recession; however, recessions also offer unique opportunities to grow your business.

The silver lining: business opportunities during a recession

How does a recession present a business opportunity for you? Take a look at some businesses that started during recessions:

  • General Electric (1890)
  • IBM (1896)
  • General Motors (1908)
  • Disney (1923)
  • Tollhouse (1933)
  • Burger King (1953)
  • FedEx (1973)
  • Microsoft (1975)
  • CNN (1980)
  • Smashburger (2007)
  • 24Hr HomeCare (2008)
  • Kabbage (2008)

What’s the secret to these recession-born businesses? The negative impact to consumers and businesses caused by recessions calls for creative and innovative solutions that aren’t necessary during periods of economic expansion.

Innovation

Businesses are forced to reduce headcount and spending during recessions. Everyone needs to accomplish more with less. This opens an opportunity for innovative businesses to creatively solve problems. For example, Microsoft offered the PC as a cheap alternative to the mainframe computers, and the PC’s compute power helped replace formerly manual tasks.

Price-quality balance

Budgets tighten during recessions. Consumers and businesses, alike, need to save money during economic downturns. Businesses that can offer a quality product, while remaining price sensitive, have an opportunity to grow during recessions.
Former Smashburger CEO, David Prokupek, described how the company excelled through the last recession, stating,

The recession amplified our growth, plugging into a long-term trend of providing great food, fast and affordable—stealing share from casual dining and quick service, alike.

“Smashburger is a fresh approach to not just “better burgers,” but to the fast casual segment as a whole. We will continue to set ourselves apart from the competition with not only award winning burgers, but signature chicken sandwiches, black bean burgers and salads that are as great as our burgers—all for around $8-10 and a 25-minute dining experience.”

Incumbent vulnerability

Even massive, longstanding businesses feel the pain of recessions. When corporate giants weaken, opportunity for new players in established industries arises.

For example, as the largest banks in history were failing, or being bailed out during the last Great Recession, an entire Fintech industry was born. Prior to the recession, big banks used lobbying power to keep financial startups at bay, or acquired them out of existence. The recession gave Fintech startups a chance, and now, big banks are struggling to keep up.

Competition dwindles

The online pet store competition of the dotcom bubble perfectly illustrates how a recession weeds out competition. Before the bubble burst, a new online pet supply store seemed to pop up everyday, such as Pets.com, Petstore.com, Petopia.com, PetPlanet.com and Petsmart.com.

Even though Pets.com managed to raise $82.5 million in an IPO and buy its largest competitor Pestore.com, it suffered from the same unsound business model that most of its competitors did, and was forced to liquidate less than a year after it went public. After the Dotcom Bubble burst, this niche industry cluttered with competition, narrowed to the few competitors that built businesses instead of catchy commercials.

Whether a recession or financial crisis hits next month, next year or five years from now, you will eventually run into a recession that will impact your business. You can prepare for that day with good business practices today. Then, when the recession arrives, be prepared to capitalize on the weakened competitive environment with innovation and quality.

This article was produced by the QuickBooks Resource Center and syndicated by MediaFeed.org




About the author

Guest Post

If you would like to contribute a guest post, click here.

Scroll to Top
%d bloggers like this: