From Depression to Recession to...
Updated: Mar 21
The stock market had increased six fold in just 8 years. And after prices peaked, economist Irving Fisher proclaimed:
Stock prices have reached what looks like a permanently high plateau.
The stock market would fall 89% from it's peak. Around 15 million American's would be jobless, unemployment would exceed 20%, almost half of the United States' banks would fail, and GDP would fall by 30%. Those that were able to keep their jobs, saw their incomes shrink by one third. The Great Depression, which began in 1929, lasted up until about 1939 - 10 years of grueling economic pain. The stock market would not return to its pre-crash heights until November 1954 - 25 years later.
During the Great Recession of 2007, the stock market would fall 46.13%, unemployment would peak at less than 10%, and GDP would decline just 4.3%.
It would be silly to expect every bear market to turn into the Great Depression. It would be equally wrong to expect that a fall from overvalued, to more fairly valued, couldn't badly overshoot on the downside. - Seth Klarman
A lot has changed since the 1930s. In fact, a lot has changed since the turn of the 21st century. I mean this in so many different ways. I had a pile of books in the garage to donate, one of which included my economics text books from university. My wife asked me why anyone would want these old economic text books, because everything has changed. Although I knew this subconsciously, it took me a moment to realise what she had just said. I jokingly replied, what do you mean, nothing's changed?
In this week's chart I wanted to look at the boom in commodity prices and what this has historically meant for economies. I plotted the commodity index and adjusted it to show me the annual percentage change. I then included each US recession, which you can see in grey, and added a horizontal red line which highlights a 60% change in total return.
Although not every boom in price leads to a recession, however when we see large price increases such as the one we are seeing today, and prices rise 60%, historically has led to a recession.
Higher commodity prices, which includes energy, grains, livestock, soft agriculture (such as coffee, sugar, cocoa etc.), industrial metals (aluminium, copper, zinc, nickel etc.), and precious metals, suck demand away from the rest of the economy. Economists call this elasticity. For example, goods that are elastic tend to have a high correlation between price and demand. When prices of a good increase, demand tends to decrease. This relationship makes sense because you’re not going to pay for a good that you don’t need if it becomes too expensive. Inelastic goods, however, are goods that are so essential to consumers that changes in price tend to have a limited effect on supply and demand. Most commodities fall in the inelastic goods category because they’re essential in our everyday lives.
Higher commodity prices can also lead central banks to tighten monetary policy faster than the economy may be able to handle - à la what we are seeing today. I'm not saying the economy can't handle higher rates, I think it can, and I don't think 25 basis point is going to do anything for anyone right now. What I do know is however, is that the Federal Reserve needs to get off zero, and they've lifted off in the gentlest way possible.
Recessions aren't always caused by higher commodity prices, there are a number of instances where the economy has fallen into recession without a boom in commodity prices. Further, I believe we are seeing structural changes in the global economy as it relates to commodity exposure in consumer spending. In fact, groceries and energy as a percentage of personal consumption in the US has fallen from 28% in 1958 to just 12% today - although it probably doesn't feel like it. Electric vehicles still have a while to go, making up 9% of the global auto market. Then again, what do you think the batteries are made from?
What hasn't changed however, I believe, is the basic, fundamental, economic cycle. One thing causes prices to rise, another causes prices to fall. And I do not believe anyone can, with a high degree of confidence or consistency, predict the outcome of the markets' actions today. What I do believe is this, that any outcome is not binary to the extent that it is boom or bust. Is it at all possible that we enter a recession that is as mild from an economic stand point as is duration? Or must the next recession look like that of 1929? If the last few years have taught us anything, is that the world we live in today, is far more entangled and moves faster than ever before. That policy makers are far more involved in stability beyond price and employment. That we can go from negative oil prices to forecasting $200 a barrel within 24 months.
Will we see a recession in the years ahead. Of course we will. Will it be in the next 12-18 months? Maybe. who knows. History tells us we have a recession, on average, about every 3-4 years. And they last around 18 months. Since WW-II however, we've gone an average of about 5 years without a recession. The last one was less than 24 months ago, and the one before was almost 15 years ago. These things never play out on averages. In fact, the average return in the stock market is about 10% pa. However the stock market has returned 10% pa in only a handful of years. You’re more likely to experience a double-digit loss in a given year than a return that’s close to the long-run average. And more than one-third of all years have seen a gain of 20% or more.
Look, history says there's a 37% chance of a recession in the next 18 months. When and what the real cause of the recession won't really be known until after the fact. Even then, well, we may never know what really caused it. Just like the stock market, averages are averages because that's what they are.
My colleague Matt Rigby and I talk more about this in last week's The Wide Lens podcast. I've shared the exact chapter where we discuss this below.
You can also listen to the podcast on Spotify or wherever else you listen to your podcasts.