Less than a decade ago, the world economy sank into the Great Recession: the deepest and most widespread downturn since the Great Depression of the 1920s and '30s. Since the stock market crashed in 2008, recovery has been long and slow, marked by persistent bumps in the road along the way. Nonetheless, an economic recovery has, indeed, taken place. The S&P 500 index rose more than 92% over the past five years until market volatility kicked in during the second half of 2015. So far in 2016, the S&P 500 is down almost 9% since the start of the year. U.S. unemployment has dropped from nearly 10% at the height of the Great Recession to 4.9% today.
A lot of this apparent growth, however, has been fueled by government bailouts, loose monetary policy and huge injections of capital in the form of quantitative easing. The problem is that expansion cannot continue forever, fueled only by cheap money and central bank support. Ultimately, the underlying fundamentals of an economy must catch up with the stimulus to create real growth. Because the real economy has lagged in many ways, it might be the case that we are on the verge of another global recession. Here are some signs that a recession may be on the horizon.
The European Situation
The sovereign debt crisis that followed the Great Recession in Europe has been a persistent issue, and Europe represents a significant part of the world economy. The European Central Bank (ECB) has also taken the extraordinary measure of implementing quantitative easing in the Eurozone to stimulate growth. The so-called PIIGS nations (Portugal, Ireland, Italy, Greece & Spain) have been bailed out repeatedly by the European Union and the IMF, with mandatory austerity measures imposed on their populations. Not only has austerity been unpopular, such measures may have also restricted growth by reducing aggregate demand and keeping the debt burdens in these nations high.
The worst of the PIIGS has been Greece, which defaulted on an IMF loan in 2015. The Greeks had elected an anti-austerity government which called a popular referendum, rejecting EU bailout terms and calling for an end to austerity. Even though Greece itself represents a relatively small portion of the Eurozone, the fear is that if Greece leaves the European common currency (the so-called Grexit), other PIIGS countries will follow and contagion will spread, putting an end to the euro experiment. A collapse of the euro would have widespread negative consequences for the world economy, perhaps bringing on recessions.
Mohamed El-Erian: Investopedia Profile Part 1
The Chinese Bubble Has Begun to Pop
The Chinese economy has grown by an extraordinary amount over the past few decades. Chinese GDP is second in the world only to the United States, and many economists believe that it is only a matter of time before China will overtake the United States.
China's government, however, imposes capital controls in order to keep its money within its borders. Therefore, as the Chinese middle class has grown, they have few options when it comes to investing their new wealth. As a result, Chinese stocks and real estate, two of the places where Chinese people can invest, became increasingly expensive, with the hallmarks of a bubble forming. At one point last year, the Chinese stock market had an average P/E ratio higher than the rest of the world's, with the Chinese technology sector showing bubble-like valuations of more than 220 times earnings on average. To put that in perspective, the tech-heavy NASDAQ market had an average P/E of 150 times before the dot-com bubble burst. The Chinese stock markets have been experiencing a correction, with the government taking such cautionary measures as curbing short selling. Most recently, in an attempt to curb volatility, China implemented circuit breakers that would halt all trading on the country's stock exchanges if losses fell to 7%.
Meanwhile, the real estate boom has led to overproduction of building resulting in so-called ghost cities, entire urban landscapes where nobody lives. When the market sees that the oversupply cannot meet demand, prices may collapse in the Chinese housing market.
If the Chinese economy slips into recession, it is likely to drag down the rest of the world as well.
A Debt Problem Growing in Student Loans
The debt crisis that accompanied the Great Recession had a lot to do with the burden of home mortgages that were issued to people who simply could not pay them back and bundled into securities called collateralized debt obligations (CDO) and sold to investors with an illusory 'A'-credit rating. Today, something similar seems to be going on in the student loan market.
The U.S. government backs nearly all student loans, so ratings agencies pin a high credit rating to these debts, even though a student may not have the ability to repay. Right now, the government is on the hook for over $1.2 trillion in outstanding student loans that need to be paid back. To put that in perspective, Australia's GDP in 2014 was only $852 billion.
Not only could a wave of defaults impede the U.S. treasury's ability to function properly, but student loan burdens prevent young people from engaging in other economic activity such as buying homes and cars.
The Unemployment Picture is not as Rosy as it Seems
The U.S. unemployment rate fell to 4.9% in January, the lowest level since the crisis began. But that so-called headline unemployment rate does not include discouraged workers who have taken on temporary or part-time work to make ends meet. When accounting for that part of population (called the U6 unemployment figure), the unemployment rate jumps to 10.5%. There has been a steady decline in the labor force participation rate, which measures how many people in the potential workforce are actually working, to levels not seen since the 1970s. Since even the U6 unemployment rate accounts for those in the workforce, the actual unemployment rate when accounting for the declines in the workforce participation rate is much higher.
Even for those working, the real wage has remained fairly stagnant. The real wage accounts for the effects of inflation, and a stagnant real wage can indicate a weak economy that isn't showing real economic growth.
Central Banks Have Little Room to Work With
Central banks typically employ loose, or expansionary monetary policy to stimulate an economy when it appears to be slowing down. They do this by lowering interest rates, engaging in open market operations, or through quantitative easing. Since interest rates are already near-zero, with some European countries even deploying a negative interest rate policy (NIRP), that policy tool is no longer effective for banks to use to stave off the next downturn. Meanwhile, quantitative easing and the buying of government assets has already ballooned central bank balance sheets to unprecedented levels. Again, central banks will see their hands tied in trying to avert a recession.
Economic Data Shows Patterns Similar to Right Before the Last Recession
Aside from the "stories" unfolding in the global economy above, some finer economic data is beginning to show some eerily similar patterns that have predicted recessions in the past:
- Retail Sales have dropped the most since before the last recession. The same is true with wholesale sales.
- U.S. factory orders fell in December of 2015 by the most in a year, according to the Commerce Department.
- Real U.S. GDP growth is slowing.
- U.S. export growth has been weakening.
- Corporate profits are declining.
The Bottom Line
We may be on the verge of another global recession. Patterns in economic data are showing signs of weakness, and the troubles persisting in Europe or the bubble bursting in China may be the trigger that sends the economy over the edge. Unlike in 2008, when central banks were able to lower interest rates and expand their balance sheets, central banks now have much less elbow room to enact loose monetary policy to prevent a recession from happening. Recessions are a normal part of the macroeconomic cycles that the world experiences, and happen from time to time. The last recession was already seven years ago. Signs may show that the next is right around the corner.
If you are looking for more information about investing in turbulent markets, Investopedia tackles the topic in the article 9 High Growth Stocks for an Uncertain Market.