Mike Taylor: We shouldn't fear recessions like our grandparents did

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While the risk of a depression always exists, we should not fear recessions like our grandparents did.
Unfortunately, forecasting on recessions is not an exact science - just look at the weather. Photo / AP
Unfortunately, forecasting on recessions is not an exact science - just look at the weather. Photo / AP

Over the past couple of weeks, I've been tearing apart information like a fast-feed auto shredder, reading anything I can find to help explain the current volatility in financial markets.

Opinions are clearly divided on both the cause and effect. I've tried to filter out extreme views, such as the Royal Bank of Scotland's suggestion to "sell everything". Drastic advice (both good and bad) needs to be ignored and seen for what it truly is - sensationalist and headline grabbing.

To summarise my findings, I'll refer you to a great quote that's been floating around the financial press: "The stock market has forecast nine of the last five recessions" (Paul Samuelson, Do Asset Price Drops Foreshadow Recessions? 1966)

Unfortunately, forecasting is not an exact science - just look at the weather.

As investors, our main focus should not be recessions, but rather asset price declines, with the aim of making money in all market conditions. However, given the market's obsession with recessions and the subsequent effect on asset prices, the likelihood of a recession is worth investigation.

I will focus on the US (despite China's wobbles) as it's still the world's largest economy and has led every major downturn since World War Two.

Before 1945, economic declines of 15 per cent or more were common as the US economy regularly fluctuated between boom and bust. Until 1919, the average recession lasted 22 months and the average expansion lasted 27.

However, since 1945, recessions have been remarkably tame.

The introduction of the Federal Reserve, banking regulation, floating currencies and the increase in government programs (unemployment benefits, social security, insurance and Medicare) have made the economic cycles longer and flatter.

In the last 70 years, the average recession has halved to 11 months and the average expansion has more than doubled to 62 months (as at today).

Therefore, while the risk of a depression always exists, we should not fear recessions like our grandparents did. Instead, we should embrace them as opportunities to purchase quality assets at discounts.

Turning to the current economic outlook, arguably the most reliable recession "predictor" is the yield curve. When the gap between short-term interest rates and long-term interest rates closes, the probability of a recession rises.

Whilst every recession has seen a narrowing of the spread between the two rates, not every move has been followed by a recession.

This model - currently used by the US Federal Reserve as their in-house recession predictor - shows only a 4 per cent chance of a US recession in the next 12 months (as at January 25). Of course, this can change and it is worth keeping a close eye on. But despite a tough start to the year for equities, this model is not forecasting a recession in the US.

Mike Taylor is founder and chief executive of Pie Funds Management.

- NZ Herald

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