Labeling the Economy

Labeling the economy is a common practice when talking about the broad economic landscape. However, there are many ways to describe it. It can be recessing, expanding, and more. Preston Caldwell, Chief US Economist at Morningstar joins Cassidy Clement to discuss. They cover these prevalent labels and provide examples of them throughout history.

Summary – Cents of Security Podcasts Ep. 70

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement:

Welcome back to the Cents of Security Podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers and today I’m your host for our podcast. Our guest is Preston Caldwell, Chief U. S. Economist at Morningstar.

Labeling the economy is a common practice when talking about the broad economic landscape. However, there are many ways to describe it: recessing, expanding, and more. We cover these widespread labels and provide examples of them throughout history. Welcome to the program, Preston.

Preston Caldwell:

Hey Cassidy, thanks for having me.

Cassidy Clement:

Sure. So since this is your first time on the show, why don’t you let our listeners know a little bit about your background in the industry?

Preston Caldwell:

Yeah. So I’ve led our economic research here at Morningstar since 2020. I joined Morningstar originally in 2016 as an energy analyst. I went from a very volatile environment for energy stocks, a very interesting time to be an energy analyst, then becoming our lead Economist in 2020 in the midst of the pandemic, which is really the most interesting economic scenario of our lifetime, next to the Great Recession itself, I would say. So, it’s been an exciting career certainly so far. I manage our forecast for all the usual economic variables, GDP, inflation, interest rates, and so on.

Cassidy Clement:

Great. Yeah. So we’re kind of looking at it from that perspective. Those elements that you’re talking about that you manage actually go into a lot of the criteria, if you will, to label an economy for what’s happening in the time that we’re studying. So for The general audience, you know, you’ve heard those common labels, everybody does when we’re talking about the recession or the depression, but what are those common labels, whether it’s in a list format or however you would like to explain them, and what exactly do they mean?

I mean for myself, I have a business background and I’m in the marketing department, but I’m familiar with recession, depression, there’s wartime and peacetime economies, an expanding economy, and then a contracting economy. There’s so many different ones. But what are the main ones that people would hear, whether it’s studying for exams or even listening or watching or reading financial commentary?

Preston Caldwell:

Yeah, so you mentioned recession. That’s really the most important, so I’ll spend the most time on it. You know, many people are surprised to hear that there’s no strict definition of a recession. A recession refers to a period in which there is a meaningful reduction in economic activity, but that’s a loose definition. I mean, how do we measure exactly economic activity and what’s a meaningful reduction in economic activity? There’s plenty of subjective judgment entailed in answering those questions and therefore determining whether a recession has occurred. Now, you may have heard the more precise definition that a recession is two consecutive quarters of real GDP declining sequentially, or, negative real GDP growth in quarter over quarter terms. That is actually just a rule of thumb. That’s not the official definition of a recession. The best illustration of this is that this actually happened, in the originally reported data in the first half of 2022. We saw two consecutive quarters of real GDP growth being negative but at the time, most economists didn’t think that was a recession.

 I didn’t think it was a recession and that really proved to be correct because if you looked at it, the two preceding quarters in the second half of 2021, GDP growth was extremely high. And so that still left us in a situation in the second quarter of 2022, when GDP was up in year over year terms. So really what we were looking at was kind of a temporary wiggle in the data with the overall trend of the economy still moving upwards. And so in that context, we wouldn’t call that a meaningful reduction in GDP. We would call that a blip on the radar, and not a recession. So the data always has to put into context and a good deal of judgment apply to decide whether recession is happening or not. But when we do have a meaningful decline in economic activity, you know, people feel it. You see unemployment go up by a large amount. You see incomes fall. You see asset prices fall. You see lots of very tangible consequences of that.

 Now there’s also a depression. I think Harry Truman originally quipped that a recession is when your neighbor loses his job and a depression is when you lose your job. So a depression is just an extreme version of a recession. It’s a reduction in economic activity that is very severe, very large, and very long lasting. Now, an expanding economy, that really is the economy’s normal state. The economy is growing, it’s not in a recession. And, you know, since it began to be measured about 100 years ago, U. S. real GDP has grown on average about 3 percent per year. So that, that can really only be the case if an expanding economy is the normal state of being. You mentioned, the idea of maybe a wartime and a peacetime economy there. I would say kind of that depends on what specific kind of war we’re talking about. But, you know, we really haven’t seen anything like the wartime economy of World War II or even the Korean War. But really we’re talking about something that’s decades in the past, but, maybe more relevant than it used to be just given a rising geopolitical tensions around the world. So yeah, I think we covered really the main definitions there.

Cassidy Clement:

Yeah, I mean, those are the ones that most people are probably familiar with or maybe hear and didn’t actually know the entirety of the background or let’s say more of the economic definition than necessarily the headline definition that gets used a lot within media or journalism. So you had touched a little bit on some examples and some history points within your answers but for myself as a millennial, I’ve seen several different types of economic shifts in my lifetime. And while the Great Recession of 2008 is the one that I can, I guess, remember the most of next to the economic changes that COVID brought on in the past five years or four years. What are some examples and timeframes that you can give for some of those labels that you answered with in the previous question? And why exactly were they labeled that way?

Preston Caldwell:

So, according to the National Bureau of Economic Research, which is the closest thing that we have to an official decider of whether a recession happens or not. Most economists agree with their definitions of whether a recession has happened. According to the NBER, the U. S. has had 12 recessions since the end of World War II. There’s really not a prototypical example because recessions come in many different flavors. Now, the most severe recession over that period was the Great Recession of 2008 through 2009. And I say that partly because of how bad it was at the beginning. Unemployment rising by over 5%, real GDP growth, real GDP being down 4 percent cumulatively through the second quarter of 2009. But I say it’s the most severe really because of how long lasting and permanent the impact was. Real GDP never recovered to its pre Great Recession trend line, that’s pretty dramatic. This gets a bit into the weeds, but one of the best ways to kind of measure the amount of economic slack there is, is the employment to population ratio for the prime age or working age population. Employment to population ratio declined from about 80 percent in 2007 to 75 percent by 2011, and it didn’t recover back to its 80 percent 2007 level until 2019. So, in some respects, the labor market was just in 2019, a decade later, getting fully recovered from the effects of the Great Recession, and maybe not all the way fully recovered. So that was really, kind of what we hope to avoid in terms of a recession was the Great Recession.

Now, others might also expect me to cite the pandemic recession of 2020, and indeed in the short run it was, it was catastrophic. It seemed that way. GDP declined by 10 percent in the first half of 2020. That is the worst decline on record, but equally remarkable was how short lived the effects were. So, real GDP had recovered to its pre pandemic trend line by about the fourth quarter of 2021. And now, based on the latest data that we have, real GDP is in excess of where people thought it was going to be before the pandemic. We’ve exceeded the pre pandemic projections and trend lines by a good deal. So, you could say there really have been zero long run ill effects in aggregate from that recession, which is really remarkable.

And then you have something like 2001, which was a very mild recession and this is interesting because we never had two consecutive quarters of real GDP declines actually in that episode and annual average GDP growth for the full year, 2001 was 1%. So, you know, solid growth, not a deep decline. Unemployment increased by only over two percentage points. So recessions can really, run the gamut from being quite mild to extremely severe in terms of the consequences. And then, of course, the one time in modern history that we apply the label of depression is the Great Depression, of course, lasting four years from 1929 to 1933. Real GDP declined by 30%, unemployment rose to maybe 25 percent and, you know, we dug ourselves such a deep hole in terms of the economy that we really didn’t see anything like a full recovery until well into World War II in the early 1940s, a decade later. So yeah, I mean that was truly a catastrophe. The effects were terrible in terms of people’s standards of living, obviously a decline in GDP of 30 percent. You just imagine everybody across the board being 30 percent poorer. And then, the aftereffects politically in terms of the rise of fascism and political instability everywhere were terrible as well. So, that just goes to show you how important economics can be when we consider the prospects of something like a Great Depression and how lucky we are to have not made that mistake again. But then, again, most of the time, the economy is really in a state of economic expansion. That’s the norm. That’s the state we’re in right now. That’s the state, you know, we were in after the Great Recession and the 2010s however, tepid the recovery might have been.

But of course, this hasn’t always been the case though, because if you go all the way back to the late 19th century, economic output was a lot more volatile then. So we saw much more frequent incidents of economic downturn in that period of time, all the way leading up through the early 20th century, really to the creation of the Federal Reserve and the advent of modern monetary policy. We have a flexible currency now we don’t have an inflexible gold standard anymore. So that stabilizes economic output a lot better. The Fed seeks to keep the economy out of prolonged slumps and we have physical policy, stimulus as a tool when needed. And so all that has enabled the economy to grow for more extended periods of time than it did in the past.

Cassidy Clement:

Yeah, I mean, you were mentioning something about, late 19th century through the early 20th century, at least in the United States, when it comes to economic expansion. For any of the history buffs out there, you’re talking about the main industrial revolution throughout the United States. So you have more workers, more money being fed throughout the country. So of course you need these economic levers to be put into place in order for that money, that wealth, the potential for new innovation to find its way because before that just a couple of hundred years earlier, we were just starting out as a country.

So when we’re talking about these economic labels and the different timeframes that may be associated. We explained, okay, sometimes you may hear this media piece saying it’s time for a recession or a depression is on its way or something like that, but for the most part, we’re looking for economic expansion. So, what are some things for investors to keep in mind if they’re entering a market and one of these economic labels is being thrown out there into their research? Looked at as something potential for the timeframe that they’re looking to invest in.

Preston Caldwell:

Yeah, I’d say the first thing is really to be wary of just relying on labels, which are really a shortcut to thinking. I hope I illustrated this with my remarks earlier, but, recessions, for example, come in many different flavors, a wide range in terms of how severe they are. Just telling you that the economy is going to be in a recession doesn’t necessarily tell you a whole lot exactly. You still really have to think about the economy in quantitative continuous terms. But, still though, in, in general terms, we can say that recessions tend to be accompanied by stock market declines, but the size of this decline can vary greatly. I mean, the peak to trough decline in the S&P 500 was just 10 percent in the 1960 recession. Compare that to the Great Depression where we saw stock prices decline 90%. So for every 10 dollars in the stock market you had in 1929, you had 1 dollar by the trough in 1933. That’s, that’s amazing.

I would also say the size of the stock market decline doesn’t always correlate with how severe the recession is. So 2001, very mild recession, but a huge stock market decline of over 40 percent cumulatively. By contrast, 2020 was the opposite, right? I mean, at least in the short run, the economy, you know, wide swaths of it totally shut down. The stock market declined by about 20 percent peak to trough which is not super severe in the long run. And then of course it bounced back very quickly and the stock market did very well for the remainder of 2020. So, what you see is a stock market doing very well in spite of at least the economy in the short run.

 So it’s very hard to make predictions just based on if you can pin down what you think the economy is going to do. Trying to understand how much the stock market will decline is, is very difficult. And, you know, because recessions are temporary, for the most part, the decline in stock prices is also temporary. That would suggest that maybe you could time the market to some extent, but I think that’s very poor advice. I think it’s really best for most investors to stay the course, to not try to sell high and buy back low because the exact timing of the stock market relative to the economy can vary quite a bit. The best thing you can do is just avoiding panic and selling at the bottom before things spring back again.

Cassidy Clement:

Yeah. That’s actually one point that I found within my research around some of the recession labels for the investment activity around those economies. While there may be certain economic or geopolitical events actually being the root cause of a lot of the peaks and valleys within the market, a lot of the trading activity is not necessarily done from a strategic standpoint, but more a fear of the unknown or an uncertainty in the market type of reaction. And that’s where you start to get the strategies of timing the market or not being quick enough or being too quick and missing the actual sweet spot. There really is no perfect way to do it. But that’s why there’s a lot more to your research than just like you said, looking at a label and saying, okay, well, I need to hold, or I shouldn’t do anything right now. You could definitely research and find out other ways to form your strategies for your investments.

Preston Caldwell:

Yeah, yeah, certainly. Ultimately, if we think about valuing assets based off their long term cashflow, the amount that asset prices declined during recession is not justified by the hit to their cash flows. What’s happening is this fear factor this increase in risk premia that occurs during a recession and predicting that is all about predicting human psychology, which is not a game that I want to play. So, yeah, trade with, with danger around a recession certainly.

Cassidy Clement:

Yeah. Well, thank you for joining us today, Preston, you brought up a bunch of really good points.

Preston Caldwell:

Well, thanks Cassidy. I enjoyed it.

Cassidy Clement:

Yeah, sure. So as always, listeners can learn more about an array of financial topics for free at interactivebrokers.com/campus. Follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening.

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