They say bull markets don’t die of old age. With this one lasting for more than 10 years and gaining value by more than 340%, you’ve got to wonder how long it has left. The best way to find that answer is to ask an entirely different question—that is: Why do bull markets end? Let’s find out…
Recession Reason #1—Tighter Monetary Policy
The most popular cause, the one you hear financial pundits repeat over and over, is the tightening of monetary conditions—that is, the Fed raising interest rates too much or too fast. The reason this leads to a recession is because a tighter monetary policy limits the amounts of money and of available credit in circulation. This in turn slows the economy, limits economic growth potential, and, when the conditions tighten too much or too fast, can reverse economic expansion altogether. It is understandable why this theory is so popular when you look at how many times tighter monetary policy has led to recession in the last few decades. This was the case in 1956, 1966, 1968, 1980, and 1990.
The 1980 example is probably the most illustrious one. Paul Volcker, Fed chairman at the time, raised Fed funds rates to 20%, the highest in history, to rein back runaway inflation and save the U.S. currency from collapse. Volcker’s method worked. Inflation fell from 14% to 7% in a year. Unfortunately, however, it also led to a recession in 1981 that lasted 16 months and caused the S&P 500 to fall by 27%.
Verdict: While the Fed has tightened interest rate policy in recent years, I wouldn’t say they have hiked rates too far too fast, as they have done in the past. The U.S. economy has remained strong, unemployment and inflation low, as interest rate hikes have been gradual and well telegraphed so as not to frighten the market. Moreover, due to the global economic slowdown, the Fed is now lowering interest rates as a preemptive measure. So, now, monetary policy is loosening, not tightening. Therefore, I don’t see Fed practices leading to recession.
Recession Reason #2—Tighter Fiscal Policy
A less-known cause of recession—with similar mechanics to tighter monetary policy—is tighter fiscal policy. Governments sometimes run loose fiscal policy to stimulate the economy. They do so by reducing taxes or investing in infrastructure, both of which increase the amount of money in circulation. Again, when this policy is reversed, the amount of money in circulation decreases, slowing the economy. When the decrease is great enough, recession can follow. This was the chain of events that played out in the early part of the 20th century, when Keynesian Economics first became popular.
Keynesians believed that government infrastructure spending was the answer to the Great Depression. While their strategy worked, it stalled when the U.S. government slashed spending in 1937, leading to a stock market downturn and a subsequent recession. The same thing happened in 1945, when the U.S. government cut back on its war spending spree, resulting in another downturn and recession. Keynesian Economics are not a perfect solution.
Verdict: Trump’s 2018 tax cut was a form of fiscal stimulus. However, I don’t think it will trigger a recession. First, the stimulus was small compared with those in 1937 and 1945. Second, the effects of the tax cut have already begun to fade. If they were going to cause a recession, they already would have done so. Third, for fiscal policy to tighten, the government would have to increase the taxes it cut. I don’t see Trump’s government doing that. With democrats in the Oval Office, however… who knows.
Recession Reason #3—Asset Bubbles
Asset bubbles have become so common in modern history that some even look at them positively… as an easy way to get rich quick. We all have a friend who likes to brag about how they were one of the earliest investors in Bitcoin and made big bank as a result. However, asset bubbles aren’t really such positive events. In reality, most people lose money investing in them. When these bubbles build momentum, with many investors and institutions buying the popular asset, they pose systemic risk. With so much of the economy invested, the effects when the bubble finally pops are big and broad. The whole economy is dragged down, resulting in a recession. This happened at the end of bull markets in 1961, 2000, and 2007.
The Dot-com bubble serves as a perfect example of investors getting caught up in a buy-at-any-price mania. The buying frenzy pushed stocks to unsustainable valuations. Companies were raising millions of dollars through IPOs, then going bankrupt shortly thereafter when it turned out their business models were unproven and unstable. The same situation played out in 2007. This time, it was the housing bubble that triggered a recession.
Verdict: In the aftermath of the most recent financial crisis, central banks around the world adopted zero or near-zero interest rate policies, inflating stock and real estate prices. Some are calling this The Everything Bubble. Certainly, current valuations are high, but I wouldn’t call them extreme. So I don’t see this situation leading to recession at this point.
I do, however, see another by-product of near-zero interest rates as a threat—corporate debt. Because yields on traditional investments, such as government or high-grade corporate bonds, have been so low for the last decade, investors have been opting for riskier high-yield bonds. The latest estimates show that there is more than $5.5 trillion of corporate debt of low or marginal quality in the United States alone. This means that, as soon as the economy weakens to a certain point, we’re going to see a series of defaults from these companies, making their bonds worthless. You can read more about this problem here.
The point is, there’s never been so much money invested in corporate debt. The resulting risk is systemic. When the next crisis hits, this will certainly exacerbate the situation and deepen the crisis. However, corporate debt alone isn’t enough to trigger a crisis at this moment. But another risk could…
Recession Reason #4—Geopolitics
Geopolitics are one of the least-known recession causes. That’s because they are rarely the sole trigger that causes one, though it does happen. More typically, they are the prelude to a recession. In 1973, for example, they acted as both. At the time, the United States was dealing with a major geopolitical situation—the abandonment of the Bretton Woods system. Up until then, U.S. dollars were directly convertible to gold. However, when the system broke up, the value of the Greenback quickly deteriorated, resulting in rampant inflation.
Then, geopolitics acted as the trigger. In October 1973, OPEC issued an oil embargo, targeting countries that supported Israel in the Yom Kippur War. Unsurprisingly, many western countries, including the United States, were on the list. This resulted in a crisis that saw the price of oil quadruple, triggering a stock market crash and a recession. This is not a lone case.
Oil prices also acted as the prelude for the 1980 and the 1990 recessions. In 1979 they rose because of the Iranian Revolution, and, in 1990, they increased as a result of the invasion of Kuwait. And it’s not only oil prices that can have this kind of effect. Tariffs, for example, can be just as devastating for the economy. In 1930, the Smoot-Hawley Tariff Act exacerbated the Great Depression. And the U.S.-Japan tariff war contributed to the Black Monday crash of 1987.
Politicians wield immense power over the economy. Especially when they use protectionist policies or widely used resources like oil as weapons to push their agenda. Making geopolitics are the single biggest risk to the current economic expansion.
Verdict: We are once again facing a situation where geopolitics could act as both the prelude and the trigger for a recession. The U.S.-China trade war has been an ongoing concern for the global economy for nearly two years. Even more concerning is the fact that the two sides aren’t getting any closer to reaching an agreement. While the situation hasn’t quite pushed the world into a recession, it has significantly slowed the global economy. Even the massive monetary stimulus major central banks launched last year wasn’t enough to reverse it.
We are now hanging by a thread. If the U.S.-China trade negotiations fall apart, they will trigger a worldwide recession. And, due to the systemic risk stemming from high levels of corporate debt, it promises to be a severe one.
For now, I remain optimistic about the outcome. A deal simply makes too much sense for both sides. But, then again, it wouldn’t be the first time that politicians let me down. That’s why I keep at least 20% of my portfolio in counter-cyclical assets, such as gold. I suggest you do the same.