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The logic behind Wall Street’s recession fears

To the logical investor, and to most economists, Wall Street’s fear of a U.S. recession appears irrational. Is it? While there is no current evidence that the U.S. has entered a recession, or even that one is approaching, there have been two instances in modern history where the financial markets have precipitated a recession; 1929 and 2001.

The negative feedback loop

Summed up, the logic is that a bear market in equities, falling interest rates in bondland and a continuous negative slant of the business media team up to get businesses concerned. And, as a precautionary move, businesses cut back on orders and reduce their hiring. Result: recession.

Let’s now look at the detail. Wall Street fears that the insanity of OPEC’s desire to bankrupt America’s fracking industry turns into a huge set of credit and liquidity events which significantly impact the banking industry. It’s not just banks’ loans to the oil industry, as these are known to be a very small percentage of bank lending. But the fear is that layoffs and bankruptcies in the oil fields spill over to other sectors that supply and service the oil industry including pipe-makers, truckers, railroads, and other businesses. This explains why the financial sector has been hit so hard in the recent equity market selloff. In addition, bankruptcies have begun to occur in the high-yield space where energy debt composes about 20 percent of the total market.

Negative interest rates

The talk of negative interest rates only exacerbates these fears. Negative rates, while irrational from an individual investor’s perspective, occur when the central bank charges member banks for deposits (reserves). In the U.S., negative interest rates would cripple several vital institutions. The first of these are the banks. Their profitability would plummet, not only because they would lose money on their reserve deposits at the Fed, but because lower interest rates squeeze their loan profits. This is another reason this sector has taken it on the chin in the latest market selloff.

The second set of victims of negative rates in the U.S. are companies that have defined benefit pension plans. Such pension plans use a discount rate to calculate the present value of their future liability payments to plan participants. While it is not likely that the discount rate would actually ever go negative, profitability at these companies is severely impacted when the discount rate is lowered, as their annual pension contributions skyrocket. Lower profits mean lower equity prices.

The third and probably most critical set of companies to be impacted are money market funds. Every investor in the U.S. selects a money market fund in which to park unused cash when they open an account at a custodian bank, be it a regular brokerage account, an IRA, a 401(k), etc. Most of these funds are members of a fund family, like Vanguard or other large mutual fund companies, and the fund companies have been subsidizing these money market funds over the past several years of zero short-term rates with revenues earned in the other parts of their fund businesses. A negative interest rate policy (NIRP) may tip some of these money market funds over, and if several are unable to pay back 100 percent of principal (called “breaking the buck”), think of the panic and fear that would result in the financial industry.

Chairwoman Yellen, at her congressional testimony the week of Feb. 8, while being carried on the national TV business networks, indicated that negative interest rates had been discussed by the FOMC, as if such rates were a real and even impending possibility. Instead of indicating that such a policy was only theoretical and unrealistic for the U.S., her testimony caused even more angst on Wall Street. On Thursday, Feb. 11, William Dudley, president of the N.Y. Fed, tried to walk back the idea that negative interest rates were coming to the U.S. But the damage had already been done, and such fears remain in the market.

Let’s get real

All of this, of course, is tied to the price of oil because without the imagined issues in the banking system due to the metastasizing of the oil patch debt to other sectors, recession fears abate. So when the price of oil returns to levels that alleviate the banking and bankruptcy issues and takes negative interest rates off the table, the equity and fixed income markets will rapidly spring back. The DJIA rallied on Friday, Feb. 12 (314 points) and again on Tuesday, Feb. 16 (223 points) and Wednesday, Feb. 17 (257 points) based on OPEC talks about output controls. This is just a taste of what might happen if supply is actually restricted somewhere near demand levels.

Conclusion: investor choice

For those not faint of heart, if you believe that OPEC will cut production prior to a U.S. recession, the markets may be offering the best buying opportunity since the March ’09 low. But, if you think Saudi Arabia and other OPEC producers, whose sovereign wealth funds are bleeding heavily, will continue to cut off their noses to spite their faces, then markets could move lower from here. Current markets appear to be in limbo – from here they are likely to go either significantly higher or significantly lower

Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, Inc., is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, Inc., a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. All accounts welcomed. Call him at (775) 284-7778.
Statistics and other information have been compiled from various sources that Universal Value Advisors believes to be accurate and credible but makes no guarantee to their complete accuracy. A more detailed description of Concert Wealth Management, Inc., its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.
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