The best information we can ever provide investors is the mechanics of how we think about macro conditions over time rather than what we think about them at any particular time. Consistent with this idea, we present our Macro Mechanics, a series of notes that describe our mechanical understanding of how the economy and markets work. These mechanics form the principles that guide the construction of our systematic investment strategies. We hope sharing these provides a deeper understanding of our approach and ongoing macro conditions.
The concepts explained in the notes above form the basic pillars of understanding macro investing. Today, we turn to a key underlying driver of the value of these pillars: recessions. Recessions are a dominant driver of macroeconomic volatility in growth, inflation, and liquidity. Further, the volatility they cause impacts all macro beta (stocks, bonds, and commodities). Finally, the infrequent and episodic nature of recessions creates market dynamics where recessions are rarely priced into markets, and their occurrence leads to extremely large price moves, which are alpha opportunities for macro investors. Given these outsized impacts of recessions on macro and markets, we think a clear understanding of the cause-and-effect relationships that drive recessions is crucial for investors to contextualize where we are in the cycle and assess where we may be headed.
Before we explore the drivers of recession, let’s define it. A recession is a persistent and pervasive downturn in economic activity, including spending, income, output, and employment. This definition is largely consistent with the National Bureau of Economic Research (NBER) definition. Recessions’ persistent and pervasive nature makes them self-reinforcing, i.e., once they begin, they collect momentum and continue. This self-reinforcing nature is due to the interconnectedness of economic activity through the labor markets. Once one person’s incomes decline, another person’s spending declines, creating a spiral downward. The response to these conditions is usually a policy response, which implicitly or explicitly supports economic activity.
Now that we have defined the symptoms of a recession, we can now turn to the sources. There are two types of recessions, with two different causes, resulting in the recessionary dynamics: idiosyncratic recessions and business cycle recessions. Idiosyncratic recessions, as the name suggests, largely occur due to factors exogenous to the economic cycle— like pandemics, wars, terrorist events, etc. These events cannot be forecasted with any meaningful rigor by a disciplined, data-driven macro strategy. That does not mean that these strategies cannot exploit the opportunities presented by idiosyncratic recessions, as markets often misprice recessionary circumstances even as they are ongoing; it just means that there is no reliable cause-and-effect relationship that allows one to estimate the onset of these types of recession.
Business cycle recessions, on the other hand, largely have consistent cause-and-effect relationships that determine their evolution. As such, tracking the evolution of these symptoms allows a systematic process to have a modest edge in estimating the potential for a recession. Business cycle recessions are primarily private sector phenomena, wherein corporations face profitability pressures to the extent that they need to lay off workers. The path towards this situation is largely consistent over time.
At the beginning of most economic cycles, economic conditions are largely positive, with nominal income positive, debt services costs relatively low, and employment steadily rising. As an expansion gains momentum, economic participants become more upbeat about future economic conditions and invest more to create future output. This investment occurs through increased capacity utilization, tightening labor markets, and investment in new projects. A very significant portion of this investment is financed by borrowing. Unlike productivity and population dynamics, there are no physical constraints on how much borrowing can expand. Most significant investments in the economy are fueled by borrowing, and as such, this creates a volatility in investment that is not seen in other parts of the economy. This allows investment to often rise at a much faster pace than GDP, particularly when economic expectations are strong. Over time, this increased pace of investment tightens capacity utilization & labor markets, and nominal spending. While this initially creates a strong backdrop for businesses (higher revenue and output), over time, it begins to create inflationary forces as the factors of production can no longer keep up with the pace of debt-accelerated nominal spending. This rise in inflation usually sparks policy action by the Fed, whose objectives are to maintain stable inflation and output. The Fed seeks to achieve its dual mandate by managing interest rates and usually responds to rising inflation through interest rate hikes. This increase in interest exposes the implicit bet in all borrowing. The implicit bet in all borrowing is that the ongoing pace of revenue growth created by investment will offset the interest expense created by the borrowing. Said differently, revenue growth needs to outpace debt service costs to maintain corporate profitability. However, when the Fed hikes interest rates, it pushes up all debt service costs without benefitting revenue growth. This creates a backdrop where corporations are faced with increasing profit pressure. Crucially, policy rate hikes typically occur just as inflationary pressures eat into profits.
While business investment can expand extremely rapidly at the onset of leveraged investment, it takes time for nominal spending to tighten the labor market and for the ongoing pace of nominal spending to become entrenched to the extent that it makes its way up the supply chain. As such, businesses can benefit quickly from a surge in nominal spending, but employees take time to catch up to these gains. As wages rise as a function of broad-based inflation, but investment begins to slow because of elevated debt service costs, we see the most accurate profit pressures on businesses.
These profit pressures are not evenly distributed throughout the economy, with some sectors far more exposed to them than others. Two features determine the exposure to these pressures: the leverage intensity and wage sensitivity to inflation of the underlying business. Sectors with a high degree of leverage intensity and wage sensitivity are what we call cyclically sensitive businesses. They tend to have much more volatility in sales, output, profits, and employment than other sectors because they largely depend on changes in financial conditions. These sectors often have a lot of leverage embedded in their production and consumption; examples include real estate, motor vehicles, and household furnishings. These sectors form the ultimate transmission mechanism that drives an economy into recession. When these sectors undergo a pullback in leverage and resilience of wage costs, the only way for corporations to protect their profitability is to lay off workers. While this may be good for one firm on a standalone basis, expanding to a sector in a macroeconomy removes both a consumer and producer from the economy, dragging on nominal spending, output, and incomes. This takes the pressure from within the cyclically sensitive sector to the broader macroeconomy. Often, this sector can experience contractions, many multiples that are experienced by the rest of the economy without us entering a recession. When the effect of these losses is large enough to begin dragging on income, spending, and employment of non-cyclically sensitive areas to the extent the whole economy is affected, we have entered a recession. The reversal of a recession usually occurs when policymakers create enough easing, via spending or interest rate cuts, to reverse the drag on profitability and engender more positive expectations.
These measures can be quantified, and their evolution can be tracked to understand the probabilities of a prospective recession. Doing so is not easy, but having a nuanced understanding and tracking of these conditions allows for a modestly better understanding of these pressures than what is typically priced into markets and allows for alpha generation over time. Until next time.