Part 1: What to expect in the next recession

With many macroeconomic indicators pointing towards the end of the longest bull market in U.S. history, it’s time to ask what investors can expect to see in the coming recession.

(check out the introduction to the series)

The great recession of 2008 exposed many structural social and economic issues that had been brewing for years. Phenomenons such as financial institutions creating Byzantine financial products or individuals using incredulous consumer finance products to live well above their means imploded to create global financial crisis. Such issues were not new or even unknown. Yet, it was only in during the economic crisis that we as a society came to terms with these challenges.

Economic crises have a habit of forcing us to confront social realities we choose to overlook. With many macro economic indicators pointing towards the end of the longest bull market in U.S. history, a market correction and perhaps a recession within the next 18 months seem all but inevitable. To paraphrase Warren Buffett, as the tide of the prolonged economic expansion turns, we’re about to discover who’s been swimming naked. The following four social and economic dynamics are likely to both deepen, and be deepened by, the coming economic turmoil:

1. Healthcare: affordable healthcare is already beyond the reach of many working Americans. Families who do not receive health insurance from their employers, and do not qualify for government subsidies, pay an average $12,251 in premiums annually. With 40% of U.S. workers making under $30,000 a year, this is all but unachievable. When the economy begins to shrink as unemployment rises, more individuals will be forced to rely on government coverage (Medicare and Medicaid), or join the 27.6 million currently uninsured population. The coming recession will further exacerbate what is perhaps our largest structural challenge to continued economic expansion and social stability — providing a growing aging population with affordable healthcare.
2. Student debt: student loans now comprise the second largest source of household debt (after housing, and before credit card and auto debt), totaling $1.4 trillion in obligations. Forty-four million Americans currently hold student loans, with the average student loan of $37,000 for a 2016 graduate. A recent Brookings Institute paper suggests that those with lower levels of debt, often those enrolling in less reputable for-profit colleges or not completing their education, are more likely to default on their loans, with default rates reaching as high as 40%. As companies face pressure to reduce costs, entry level employees are often the first to suffer. We can expect a sharp increase in student loan defaults, saddling the emerging workforce as they attempt to build their financial future.
3. Income inequality: the U.S. has long been an outlier in its exaggerated level of income inequality. Economists have argued that the peak income inequality levels pre-2008 contributed to the depth of the great recession, as low income families cut back their spending at significantly higher levels than high-and-mid income families causing consumer demand to drop. While median household wealth, at $97,300 in 2016 has not recovered from its peak of $139,700 in 2007 (in 2016 dollars), the median net worth of high income families increased from 40 to 75 times that of middle-and-low income families over the same time period. Income inequality has continued to grow, threatening not only the stability of the economic system, but the U.S.’s ability to attract the best minds and compete for talent in the global arena.
4. The Federal Deficit: with the full effect of the recent tax cuts now becoming apparent, the congressional budget office (CBO) expects the annual federal deficit to hit $1 trillion in 2020, further contributing to the current $21 trillion in national debt. The federal government deficit currently makes up 4.2% of GDP, a level typically reserved for economic crises. The high deficit and recent tax cuts mean that when we enter into an economic decline, the U.S. government has far fewer fiscal tools at its disposal to help stimulate the economy. That leaves it to the Fed, and its largely depleted toolbox of monetary policies, to jumpstart economic growth.

It is the unfortunate reality of human nature and the social and political system we live in that these challenges are going to have to get worse, probably much worse, before they get better.

It is only during great crises that issues of this magnitude are addressed on a societal scale. History is rife with examples. The lack of a social safety net was evident long before the Depression of the 1930s, but it wasn’t until unemployment hit 25% that the U.S. began creating social security and unemployment benefits.

More recently, it was only in the aftermath of the Great Recession that regulation was put in place to address the wreckless risks that large financial institutions were putting on their balance sheets. To be sure, the magnitude of these risks were know for a long time, at least since the collapse of Long Term Capital Management in 1998. However, in that instance, a disaster was averted by a last minute intervention orchestrated by the Federal Reserve. It took a far deeper financial crisis, triggered by the collapse of Lehman Brothers, to bring about a change in regulation.

The same holds true for the above challenges. As the next financial crisis shakes or collapses these fragile societal structures, we will have the opportunity to rebuild them in a manner that is more sustainable and just. Deep healthcare reform is not only financially necessary, it is a moral imperative. Similarly, our current higher education system is leading us towards a deep financial and social crisis. We must revisit our approach to higher education, both by providing students with affordable opportunities, and by shifting cultural norms from a definition of success that mandates a four-year college education.

The challenge of income inequality is closely related to the growing federal deficit. While there is no doubt that we need to improve the efficiency of government programs, thoughtfully designed taxation would serve the purposes of providing a base quality of life, stemming the growth of wealth inequality and lowering the federal deficit. If the U.S. wants to maintain its position in the global financial markets, it must address its growing deficit and mounting debt before they impair the government’s ability to provide for basic services and national defense.

While the existence and magnitude of the challenges above is beyond doubt, the solutions are complex, subject to much debate, and their execution far from inevitable. It will be up to us, as individuals, voters, consumers, and investors, to use the powers at our disposal to ensure that these issues are top of mind for our politicians and business leaders. The coming recession will hurt many of our most vulnerable communities, but its also an opportunity to build a stronger and more just society.