Why a Recession is Inevitable and Why It Isn’t Here Yet

Why A Recession is Inevitable and Why It Isn't Here Yet?

Recession fears have rebounded with how the economic climate has turned out over the course of the year. Consumer savings and spending have dwindled substantially as corporate revenues declined, even though the labor market is still looking rather robust amidst the tech sector’s layoffs.

If anything, the current economic outlook is mixed, with some quarters suggesting that a soft landing might be possible. Others, like ourselves, are a bit more skeptical: a recession will likely be inevitable, but how big of an impact will it be? That’s still up in the air.

The Nature of the Business Cycle

There’s a reason why it’s called the business cycle. Companies are the main drivers of economic growth: they hire people to work for them, and in return, employees get paid for their time. The income they earn is used to spend on a variety of goods and services, which brings in revenue to companies. From there, companies can use these profits to hire more people to work – and so the cycle goes.

Ideally, the business cycle helps fund economic growth in a positive feedback loop, but reality is far from ideal. We’ve seen many businesses and even banks fail over the years, with all kinds of direct and indirect effects such events have had on the whole economy.

Four phases of an economic cycle
Sourced from Britannica

The business cycle goes through specific phases. During an expansion, households demand more goods and services, which promotes more employment, and thus, wages (and prices) typically increase. It’s characterized as a rising curve that leads to a peak, signifying the economic growth that’s going on and culminating in a peak that represents economic prosperity.

Conversely, a contraction occurs as households spend less on goods and services, while businesses cut down on staff as wages and prices weaken. It generally starts from the peak as an economic slowdown – a recession – leads to the cycle reaching a trough. Eventually, through government policies and other endeavors, the business cycle goes into a recovery, going back to the expansion phase.

The length of each phase in the cycle – as well as their effects – varies greatly, being highly dependent on the nature of economic activity and internal/external factors at the time. In fact, the contraction that comes before a new expansionary phase is viewed as a normalization toward stable economic conditions to foster a new economic expansion.

It’s this cycle that usually informs analysts of the inevitability of a recession: an expansionary phase inextricably leads to a contraction phase. Various economic fluctuations can cause an expansion to turn into a contraction before eventually normalizing, and historical contexts have shown similar patterns occurring throughout history – and not just in economics.

What Leads to a Recession?

An aerial view of New York City

A recession occurs when an economy contracts from a productive expansionary phase. All good things come to an end, and this is represented by growing economic contraction, where economic activity declines significantly.

Some economists believe that recessions occur based on a number of prevailing theories. Chief among these is the occurrence of economic shocks that happen without warning. The Ukraine war and the writers’ strike are some economic shocks that happened this year. These can exacerbate a recession as the shocks disrupt regular economic activity, including supply lines, demand for specific goods, and interrupted business operations.

Other suggestions indicate erroneous decision-making on the part of monetary authorities, such as central banks, wherein there is too much or too little new money in circulation. In the case of the former, that leads to excessive inflation; for the latter, it leads to tighter credit conditions. Either way, both will result in a recession.

Meanwhile, the Austrian Business Cycle Theory (ABCT) suggests that the interaction of “central banking and monetary policy” with economic activity ultimately leads to a recession. Specifically, ABCT views the “overissuance of new money and credit” as driving an illusory image of economic growth, which inextricably leads to a recession as the illusion breaks down.

For Ray Dalio, founder of Bridgewater Associates, the patterns of the business cycle can be seen in historical contexts of changing world orders. To simplify, an expansion is predicated on the establishment of a new world order, followed by an era of peace and prosperity and a financial bubble as that peace and prosperity continue. Eventually, though, the “financial bubble bursts” and leads to an economic downturn – marking a contraction.

The boom-bust cycle is simply part and parcel of how modern economies work today, and it matters more on what can be done to mitigate the effects of a recession once it finally happens.

Where Are We Now?

The economic cycles and where we are now
Adapted from Seeking Alpha

We’re currently seeing warning signs across the current economic landscape, and you’ve no doubt felt its effects as well. Right now, as illustrated above, we’re coming off the peak after strong economic expansion in the preceding years. Important headlines that indicate we’re heading to a recession include:

  • Painful interest rate hikes by the Federal Reserve, with the possibility of one last hike before the year closes. To clarify, higher interest rates mean higher costs for businesses and consumers (e.g., higher loan repayments). It’s highly likely we’ll feel its effects in the fourth quarter.
  • Higher bond yields, with the 10-year Treasury yield – a key indicator that indicates where the economy is headed – hitting high levels not seen since 2007. It’s important for the Fed to combat inflation, but consumers are suffering the effects of this tightening.
  • Economists remain baffled by the strong labor market, with strong indications that this would influence the Fed to agree to the final rate hike for the year. That could potentially cool job and wage growth even further, but unemployment will surge as a result.
  • The consumer position is still weakening even as they continue to spend. We’ve seen it slow down in the past few months, especially as consumer savings dwindle and more people feel stressed about managing their finances.
  • Housing is still on the decline, with “elevated mortgage rates and challenging affordability conditions” making it harder to sell houses to interested buyers. This is compounded by various external factors like “shortages of construction workers, buildable lots and distribution transformers.“

You can find out more from our most recent economic watch.

So Why Aren’t We in a Recession Yet?

Some argue that the job market’s robustness is a sign of smooth sailing ahead, even though the latest job data stoked fears of a potential rate hike to further combat inflation. Others point to consumer spending that’s still happening, even as we’ve pointed out that it might not last for much longer, especially as wage gains have started cooling while prices remain high.

And there’s still the obvious case of high interest rates and the long-term impact the March banking crisis had on the country’s economic landscape. The latter is especially notable, considering that banks are fearful of a potential liquidity crisis looming on the horizon. Reuters’ own polling found that “half a dozen regional bank executives and economists” see the March crisis “had a lasting impact on the regional banking industry and the economy.”

History has shown that this kind of data we’re seeing today is indicative of an inbound recession, and it’s happened many times that economists can largely predict them with some degree of confidence. Of course, historical contexts aren’t always the same, but they still provide useful insights in making a prediction.

US effective Fed funds rate, leading by 8 quarters, 2023
Sourced from Piper Sandler

Where things stand right now, it almost feels like we’re sitting on a volcano that’s waiting to explode. A lot of it hinges on whether the final Fed rate hike for the year will tighten harder on both banks and businesses – particularly small businesses, which are more vulnerable to the inflated interest rates and higher-than-normal repayment amounts.

There’s plenty to worry about, as it is. There’s the risk of a prolonged government shutdown, the resumption of student loan repayments, the UAW and Kaiser Permanente strikes, and oil prices surging high – that’s a lot of fires to put out. All of these have the potential to throw off economic forecasts on the state of the economy.

But what’s keeping the recession away for now? We have a few pointers about why a recession hasn’t happened yet.

Consumer Spending Still Steady

We’re still seeing consumer spending happening across the board – even if it truly has weakened. According to McKinsey, consumer spending seems to be doing fairly well in spite of ongoing recession fears. The graph below shows that spending has been holding rather steady since the bank scare in March. However, this isn’t necessarily reflected across different wage groups: low-income groups are more concerned about meeting their financial obligations, such as rent.

Year-over-year credit card spending change
Sourced from McKinsey

Spending trends also vary greatly between income groups, with similar trends seen in spending on food, groceries, travel, and apparel. Consumers are becoming more value-oriented in a bid to be frugal, though high-income groups do still splurge on dining out and travel. Low-income groups are more focused on buying groceries and keeping up with debts.

Share of respondents intending to splurge in 2023, by spending category
Sourced from McKinsey

It’s hard to predict if this re-acceleration will be reflected in October or if it even maintained by the end of September, but consumers are nonetheless cautiously optimistic about current economic conditions. A recent McKinsey report found “33 percent of consumers… feeling optimistic about the economy,” while 44 percent had “mixed feelings.”

Confidence level in US economic conditions
Sourced from McKinsey

Economists agree that consumer spending is what’s helping to keep the economy afloat amidst the risk of elevated inflation and the potential Fed rate hike. Non-banks have also helped to spur that spending in unprecedented ways.

Non-Banks Empower Resilient Consumer Spending

A digital render of PayPal's logo

Historically, banks provided liquidity to consumers and businesses for a variety of needs, be it personal or business-related use. In recent years, however, the rapid growth in fintech has seen a number of non-bank entities coming in to play a new role as loan access began tightening.

Non-bank entities like Stripe, Square, and even PayPal are quickly changing that dynamic (banking-as-a-service, or BaaS) as banks are desperately playing a game of catch-up with these non-banks. Of particular importance is that these non-banks are targeting consumers and small businesses, offering them a convenient way to do their banking, including having streamlined application procedures and banking processes and ease of access to loan funding.

Take Square: the inception of its subsidiary, Square Financial Services, grants Square the ability to offer a robust banking solution for its customers, especially small businesses that rely on Square’s existing services. Its three offerings – Savings, Checking (which is currently offered “in partnership with Sutton Bank”), and Loans – interface with Square’s systems to “cater to the needs of small businesses and their reliance on cash flow.”

In the past, any significant purchases – personal or otherwise – would require some form of financing. However, your financing options can be limited depending on your credit score, and you might not be eligible for an interest-free installment plan. That meant paying a lot more over the course of the loan or not being able to take one at all. Meanwhile, poor credit scores would close you off entirely from any financing options.

With a niche now needing to be filled as businesses need liquidity fast, non-banks are quickly securing their place as a reliable and hassle-free source of funding in place of traditional banks.

It’s a similar story with the buy now, pay later (BNPL) model, which many fintech players have also adopted. This short-term financing model offers interest-free installments when purchasing a particular good or service, making it easier to stretch your dollars for things you need. Maybe you’ve been offered it before, or maybe you’ve used it in the past.

Consumers use BNPL because they’re easily approved and aren’t reported to credit bureaus. The latter part is significant, especially as the Federal Reserve of New York (FRNY) found that many BNPL users “either held a credit score of less than 620, reported having a credit application rejected, or were delinquent on a loan over the past year.” Lower-income groups and even debt-laden individuals were more likely to use BNPL despite being “less likely to be offered BNPL.”

The ability to take short-term, interest-free loans (usually over four installments) for a variety of goods and services offers plenty of flexibility for consumers to buy things they normally wouldn’t at full price. In fact, that flexibility saw BNPL use “increased tenfold between 2019 and 2021,” according to the Consumer Financial Protection Bureau (CFPB).

Statista BNPL chart
Sourced from Statista

The Bottom Line

In short, non-banks and BNPL are helping drive both consumer and corporate spending in spite of tight lending standards and economic pressures. We still believe a recession isn’t far off from current projections of early-to-mid-2024. Considering the headwinds, a recession may be just around the corner, and it pays to be cautious and well-prepared for when it arrives.