Of all scenarios, why a recession?

In my market analysis, I tend to ponder extreme scenarios, even some unfathomable ones. It is useful to identify red flags that allow me to set up exit strategies. For example, I’ve played the Trump trade through exposure to US banks and manufacturing companies. However, I’ve played it while bearing in mind that Trump could be unable to materialize policies benefiting those companies. This last point has proven to be wise.

We didn’t have a recession since 2008, exception made to some negative isolated quarters. The recovery has been slow but steady. Several analysts have stated that with so many years without a recession, one must be due at any time.

I don’t agree with this view, after all economic developments are broadly indeterminable and bull markets don’t die of old age. Nevertheless, we must keep a recessive scenario on the table. Just in case.

Photo credit: Matty Ring

What might cause a recession?

Generalizing, we can select credit contraction as the pivotal point of any recession. Obviously, not every recession started as a credit contraction, but ultimately, most of them got serious when credit was reduced. There are some good reasons for this, like the fact that economic agents are connected through a financial system that relies heavily on the credit market.

A simple example is the connection between the stock market and the credit market. It is common that at the end of a bull market, investors rely heavily on credit to invest (through margin accounts or other instruments).

The collateral for those transactions is the same stocks being bought with credit. This works very well when the stocks are rising, but when they come crumbling, investors need to put up more collateral that, usually, they don’t have. This incentivizes the lenders to reduce their loaning activities, which in time will depress consumption and investment. The circle will be completed when earnings exhibit a downtrend and the stock market reacts accordingly.