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What Goes Up Must Come Down

by | Jun 8, 2022

I spent time with my father this weekend. A retired banker with an MBA from Wharton, my dad begged me to study economics in college. I wanted nothing to do with it. Years later he is thrilled that, by necessity, I spend much of my time studying economic and housing data. Whenever we are together these days he likes to test me on my knowledge and lovingly school me on some of my false assumptions.

This weekend’s talk started with hot air balloons and ended with recessions: Are we in one, what defines them, and how do they fit into the overall economic cycle?

The National Bureau of Economic Research defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” A decline in economic activity is measured by negative gross domestic product growth, rising unemployment rates, falling retail sales and contracting income. If economic experts track consistent decline in the aforementioned categories for two quarters in a row, they declare that we are in a recession. It’s always in hindsight because a recession is the period between a peak and a trough. It’s one half of the natural business cycle. The economy is either expanding or contracting, not unlike Newton’s third law of motion: what goes up must come down.

So, are we currently in a recession? No. Are we headed for one? Yes. It’s the natural cycle. The question is when. The GDP shrank 1.4% in the first quarter of the year. This was the first contraction we have seen since lockdown (February-April, 2020). It shrank because U.S. exports were down, likely because of supply chain challenges; and government spending was down. But consumer and business spending increased in Q1 and over 400,000 jobs were added to the U.S. economy in March alone. Last month, the stock market entered a bear market with a 20% drop since January. But bear markets can happen outside of a recession, as Ben Carlson points out in “A Wealth of Common Sense,” so the stock market is not alway a reliable leading indicator.

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And then there is record inflation. Too much inflation can cause a recession, like the country saw in the 1970s. Inflation is high right now because of 1) the cost of labor, 2) the high cost of energy prices and 3) rising interest rates. Don’t forget that the Fed controls the interest rate piece and that the rise in rates is an intentional cooling off mechanism to balance the large amount of government spending the U.S. did to keep our economy from crashing in the beginning of the pandemic.

If you think about recession as part of the natural cycle of things, it’s far less doomsday than headlines suggest.

On Friday, the Bureau of Labor Statistics announced an addition of 390,000 jobs to the U.S. economy in the month of May. The stock market dipped in reaction anticipating another rate hike. The idea is if the labor market continues to be strong then the Fed can go ahead and raise rates quickly in an attempt to battle escalating prices. So rates are going up, that is pretty much a given. The question remains whether the Fed will pull off a soft landing as it continues to let air out of the high inflationary balloon.

I like the balloon analogy here. A hot air balloon works by the basic scientific principle that hot air rises in cooler air. Modern air balloons are powered by propane. The hot air makes the balloon rise and a parachute valve at the top lets out air to allow it to descend. If you are a balloon pilot, you essentially have only the propane pilot switch and a parachute cord to control the direction of the balloon. But really you are subject to the wind and its unpredictable gusts and changes in direction. It’s crazy to think about, right? Imagine being a pilot with only two controls?

If you think about recession as part of the natural cycle of things, it’s far less doomsday than headlines suggest. If you consider the housing market cooling off a correction or normalization, it’s also far less dire than some might proclaim. There is no point in worrying about what we cannot control, right? Instead, let’s think about the things that you can control, particularly as it relates to your business. Maybe it comes down to a couple of things. What if you had only two controls? If you had to name them, what is your pilot light and what is your parachute?

Until next week,

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