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Are we headed toward a recession - how should you invest?

The climate of the markets and the economy is a strange one: Stocks are stagnating, bond prices and the GDP are decreasing, but the unemployment rate is at pre-pandemic levels – Can this be labelled a recession? Amid the strange economic climate, the Fed is trying to mitigate extremely high levels of inflation. The central bank fears that trying to stop inflation could cause a recession. If that does happen and even now - how can you profit from investing? As all investors are uncertain about the future, many don’t even think about investing at all...

What is a recession exactly?

The most exact definition of a (domestic) recession is the decline of the country’s Gross Domestic Product (or GDP - the market value of all produced goods in a country) in two consecutive quarters. The National Bureau of Economic research in the USA looks for contractions in areas such as production and sales; the NBER tends to make rough estimates and judgement calls when defining what constitutes a recession, such as describing economic contractions as „deep and long “.

Recessions typically include two major things: A high unemployment rate (relative to what it was like before) and a decline in economic activity or GDP. The GDP has fallen for two consecutive quarters: In Q1 of 2022, it fell 1.6% and in Q2 it fell 0.9% - certainly a recession by the official definition. But if we are already in a recession, the following makes no sense: This is the first time that a “recession” and a low unemployment rate have occurred at the same time. Not just that, companies are desperately looking for workers - why?

To understand that, we must take a look at how inflation has created recessions before, how governments have responded and what they were like, in general.

The OPEC oil crisis of 1973

When people think of the OPEC oil crisis, they think about inflation and high oil prices, but they often forget about the events that preceded that. In 1971, president Nixon took the US Dollar of the gold standard. The gold standard was the concept of the value of money being tied to the value of gold. This gives currencies a tangible backing. Nixon did this because at the time, France reduced their dollar supply, since the country didn’t trust the USA enough. This, together with continuous strain on the economy because of the Vietnam war caused US gold reserves to deplete, causing Nixon to take the Dollar off the standard - a solution that was meant to be temporary. Instead, the USA changed the entire definition of its currency, basing the US economy on fiat money, which means that currencies aren’t based on tangible assets such as commodities. This allows for an increase in the supply of money and, yes, inflation (hence the oil crisis that ensued).

As a result of this move, the value of the Dollar fell. Since Arab countries or OPEC (Organisation of petroleum exporting countries) countries relied on the Dollar to sell oil, their income was reduced with the decline of the Dollar.

In 1973, the US opted to support Israel during the Yom-Kippur war, a move that angered many Arab countries, including OPEC. This was the last straw for the Organisation and an oil embargo ensued; the Embargo was directed at the USA, but also Japan and western Europe. This caused the oil prices to quadruple from approximately $3 to $12 per barrel. The aforementioned countries consumed about half of the world’s energy at the time, which made this even more damaging.

Rising oil prices causes a general rise in the CPI, which, at its peak was at about 8.6%. Businesses were forced to keep wages high because of laws at the time, which meant that the only option for them was to lay off workers. The workers couldn’t pay for goods and services, which meant the profits of firms decreased. In response they further laid off workers and so on. Even after the war ended, oil prices remained high. Interestingly, much like how Germany is currently imposing restrictions on gas consumption, due to the lack of gas, the US government-imposed restrictions on oil consumption. Trust in the government was at an all-time low, causing people to spend less, worsening the recession. Even businesses couldn’t plan for the future, since the government showed no clear direction, because they raised and lowered interest rates too many times. This further kept prices high; the unemployment rate remained high, still.

Finally, in 1974, after the end of the war, OPEC ended the embargo. The economy of the western world stagnated in the 70s, until it had finally learned to rely less on OPEC through domestic production.

After the oil crisis, inflation and economic stagnation (stagflation) continued throughout the 1970s until the Fed raised interest rates, causing a recession in the early 80s. The measures did cause inflation to scale back, even though unemployment was at 11% at its peak. Later, this decreased as well.

The great recession of 2007 - 2009

The recession of 2008 was caused, for the most part by a mortgage crisis. It started with houses being made more readily available to the public through easier to obtain mortgages. Many found that getting interest payments from a mortgage was better than getting secure payments from a bank, since the American Treasury Bond was pretty low at the time. This caused the general number of mortgages to increase and to get sold (you can sell mortgages to someone else - the interest payments go to whomever owns the actual piece of paper). Mortgage-backed securities became more and more popular as the price of housing increased through high demand caused by mortgages with low (But variable!) interest rates. Banks like Lehman Brothers bought these securities like crazy and were actually going into debt to obtain them - a bad decision, as a bubble was building up. Subprime mortgages became more common. These were mortgages where the borrower had bad credit and usually wouldn’t get approved for a traditional mortgage. By 2006, there was a subprime mortgage crisis. More and more borrowers would default on their loans. Because with a mortgage, banks have the house itself as collateral in case the borrower defaults, they got the houses back. Before, they could just sell the houses. Now, there was no one to buy - and the price of housing fell. Those who didn’t default directly were hit with the disadvantages of variable rate mortgages, which skyrocketed. This caused many more to default. The government had to provide multiple stimulus packages to prevent a total global depression. In 2008, a recession was already underway as the GDP was down 2.1% in Q3. Early signs of a looming recession were actually visible in 2006 as less goods were ordered to be produced than the year before, signalling a future drop in GDP.

On September 15th, Lehman Brothers finally collapsed. It is odd that those in government at the time didn’t save it from collapse earlier, considering it saved all other banks later. When congress rejected a bank bailout bill, the stock market crashed on September 29th making the recession even worse. The peak unemployment rate in 2009 was at about 10% and the decline in GDP during the recession was 5.1%. The ridiculous number of foreclosures caused people to stop spending as well as firms to lay off workers and reduce hiring. Banks weren’t lending to anyone in 2009 because of increased distrust but opened up their restrictions soon. The stimulus packages of the Obama administration caused the Dow to finally hit a low of 6,547.05, a decline of 53.5% from the latest high. This was the worst market crash and recession since the great Depression of 1929.

After the recession, the various stimulus packages and low interest rates caused more and more money to flow into the economy in the 2010s, resulting in a long-lasting bull market and economic recovery.

The current market

The general cycle of a recession is always: either the firms or the consumers don’t have any money, the consumer doesn’t buy anything, the firms lose profits and lay off workers who don’t buy anything – it’s a vicious cycle. So, who doesn’t have the necessary funds now? The firms? No – In fact, the UN Secretary general Antonio Guterres accused oil and gas companies of being “immoral” for making sky high profits during the Ukraine war.

"It is immoral for oil and gas companies to be making record profits from this energy crisis on the backs of the poorest people and communities and at a massive cost to the climate" - Antonio Guterres, Secretary general of the United Nations

Oil firm BP tripled its profits to $7 billion, angering British MPs. But it’s not just oil, gas and coal companies profiting from the war – revenues of tech companies that have little to do with it, like Apple – which doubled profits in 3 months after customers bought the more expensive 5G iPhone - and Microsoft are also soaring. Clearly, the war is not harming these companies as much as some might think. Most firms are still making ample money and the consumers are still buying. The problem is not who doesn’t have any money now, it’s who won’t have any money in the future. Inflation is still raging on and firms are increasing prices like crazy – which is why they’re profiting. Wages are just not keeping up and unless it stops soon – which is unlikely – we will once more enter the deadly recession-cycle. Right now, the Ukraine war has caused gas prices to skyrocket. Combined with the coronavirus (which could cause even more supply-chain disruptions in the winter) the increasing gas prices have caused inflation to go on for even longer. So, what can the Federal Reserve do?

What can the Federal reserve do?

The Fed has already raised the Federal funds rate – the rate at which banks can lend each other money – several times since inflation started to rise in March 2021. Since then, the Fed has raised both the Discount rate and the federal funds rate 3 more times, most recently on July 27th, with the Federal funds rate between 2.25% and 2.5% and the discount rate 2.5%. This can have devastating consequences for the economy – if the interest rate is too high, the same thing that happened in the 80s happened: A recession starts because of the “recession” cycle. This time, it’s not the consumers and workers that are left without money – it’s the companies, that have to loan money at higher rates, slowing economic growth. Slowed growth or even losses in revenue can be the cause of layoffs. If too many people are laid off, they won’t buy anything, reducing profits for the companies.

It is clear there is a dilemma: If wages won’t keep up with inflation, there will be a recession soon. However, if measures taken against inflation slow economic growth, companies will lay off workers, causing a recession. The only option for the Fed now is to raise interest rates while keeping them low enough as to not give the companies the incentive to lay off workers. The central banks around the globe must thus find a “sweet spot” for battling inflation.

How can you profit?

Amid this economic uncertainty, investors have started betting against the market and are left looking for other good investments. Should you even invest at all?

The answer is: Yes, you should – even if one opposes investing, there’s no denying that inflation, which has reached a whopping 8.5% in the USA – is eating away at ones purchasing power like never before. But how, with the fear of a recession looming continuously?

In an interview, German portfolio manager Andreas Beck said that “as a portfolio manager it [the recession] doesn’t matter to me”. Why would he say this, though? If the population loses money, surely the companies will too? Yes, which is why it’s important to invest into solid businesses with good fundamentals and even better future potential. The industry of the company is an important factor here. The usefulness of the industry in the next few years plays a key role. For example, the weapons industry and stocks like Lockheed Martin (Price at the time of writing: $416.91) and Northrop Gunman (Price ATR: $479.23) will be of importance, as Europe has increased its military budget because of the Ukraine war. Oil and gas firms from the middle east and the US will make profits in the next months, since the EU has no one else to buy from. Finally, long term industries should also be considered. These may include Hydrogen Fuel cells and truck companies such as FuelCell Energy (Price ATR: $3.880), Nikola (Price ATR: $5.07) and Bloom Energy Corp. (Price ATR: $24.94). It may also include revolutionary technologies that might be of importance in the next 20 years, even. SO why invest now? Well, like I said, profits are still to be made and waiting to invest will only cost you money because of inflation. And the recession isn’t here yet anyway. If you invest in fundamentally sound businesses in indispensable industries, they will continue to make profits, even if the stock price goes down. This is actually a good thing too, since, if you’re not sure how long to invest and the recession hits, taking down the price of your still fundamentally sound company with it, you can always buy more stock at a cheaper price, securing even more future profits.

In terms of value investing, that ship may have sailed because of the 2010s Bull market. Growth stocks are key here.

Bottom line: recessions and investing

A recession might be looming. If inflation rages on and the fed fails to do something about it, the “recession cycle” will ensue. Investing in fundamentally sound stocks in indispensable industries will do the trick. These industries should be at least somewhat innovating, in order to have both military and civilian applications. They include weapons, energy, clean water and many more, that have some connection to the recent developments with climate change, the Corona virus and the Ukraine war.


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