English Personal Finance

Stress Test – Are You Ready For A Recession?

Stresst Test - Are You Ready For A Recession

The yield curve in the US has officially inverted, short-term yields are higher than long-term yields. This is interpreted as a signal for an upcoming recession as all US-recessions during the past 50 years have been preceded by a yield-curve inversion by 6 to 18 months. Not every yield-curve inversion has been followed by a recession, though.

That’s probably due to the fact that cause and effect cannot be distinctly separated: at this point, the untypical lower yields for longer-term loans only express that investors expect lower interest-rates  in the future. When do interest-rates fall? When central banks want to encourage lending. That’s a monetary policy tool used in recessions to push the economy.

 

The inverted yield curve expresses an expectation

So the inversion of the yield suggests that an overproportional number of market participants expect a recession. But we can’t see whether their expectations are based on fundamental data – such as companies’ lagging order books – or on subjective feelings. As the economic upwards trend has been fairly continuous since the big recession in 2008/09 for a rather unusual length, I would expect more and more market participants to “get a feeling” that there must be a turn for the worst at some time.

If this kind of feeling is multiplied by the media, it can have real effects on consumption: larger purchases are postponed, people start to save more, and the economic growth rate goes down. If the central banks are in a position to counter this with careful adaption of interest rates and there are no fundamental economic problems, the downward trend doesn’t have to intensify and a recession can be averted.

 

Actual economic data has an influence on expectations

But if there are real problems, potentially affecting whole economic sectors, consumers will feel not only imaginary but real consequences in their lives: When turn-over starts to go, companies will try to counter this by lowering their expenses. This typically results in jobs being cut. Households’ disposable income goes down, with negative effects on consumption, and thus the overall economy.

This phenomenon as well tends to be aggravated by fears and reduced consumption of those households not (yet) hit by unemployment. Odds that monetary policy can prevent a recession in this kind of scenario are much lower.

 

The inverted yield curve is not a 100 percent indicator

To come to a more solid prediction about whether a recession in the US, with potential global run-on-effects, is in the offing you have to take a look at other indicators as well. The number of people filing for unemployment benefits for example, or consumer spending. This is what commentators like Bank of America CEO Brian Moyhinan stress as well, who claim there’s no need to fear an immanent recession.

I would agree with this conclusion. But to this is not the right question to ask anyway. Previous recessions didn’t start right after the yield curve inverted either. I’m sure that Donald Trump will do everything he can to prevent a recession before the 2020 elections. His aggressive attacks on the Fed make this pretty obvious.

 

Can US consumers do it?

But then the US base rate is already at a comparatively low level which limits the Fed’s room for downward maneuver. At the same time, private consumption relies heavily on consumer debt, and almost 40 percent of the population have – despite low unemployment figures – emergency funds of less than 400 dollars. Which means they’re living paycheck to paycheck. That’s not sustainable purchasing power to me.

What do things look like in Germany? The Ifo Business Sentiment Index fell to its lowest figure since November 2012.  According to Statistisches Bundesamt preliminary data, we are actually in a technical recession (negative economic growth in two successive quarters). There is no year-on-year decrease yet, though. Taxes and social security payments keep rolling in. And the consumption climate is forecast to stay stable in September.

 

Do I have a déjà vu?

Nevertheless I’ve noticed some developments during the past months that remind me of the years 2007/2008 in hindsight. At the time I didn’t see these signals. Or I didn’t give them any further thought. And was all the more unpleasantly surprised by my job being cut in fall 2008. At almost the same time the agency my husband worked for went through being acquired by another market player. This could have easily resulted in him losing his job as well.

Luckily this didn’t happen. And I quickly found a new job as well. Had I kept a watchful eye on the overall economy though, we would have had to rely on luck less. And with better preparation for what was coming, we would have been able to use the opportunities the 2008/09 stock market crash provided – this would have propelled us some years ahead on our journey to financial independence.

 

Warning signals?

Where do I see parallels to the beginnings of the “Big Recession”? Many companies seem to dial down their advertising expenditures. Those costs are the first to come under scrutiny when turn-over drops and profit goals are at risk. 

In the automotive/automotive supply sectors – Germany’s biggest corporate employer – short-time work and redundancies don’t seem to be one-offs anymore. There are usually a lot of temporary workers employed in these industries who can be disposed flexibly with short-term fluctuations of order volume. If parts of the permanent work force are made redundant things seem more serious to me. 

The US’s aggressive trade policy and the looming Brexit increase companies’ and consumers’ insecurity. This is particularly damaging for the German economy which has grown to be very dependent on exports since the introduction of the Euro. Then there are the technical indicators. And the psychological factors. CEOs and MDs don’t act in a rational, numbers driven vacuum, they are influenced by multiplied opinion as well.

 

Recession stress test your finances

It therefore makes sense to have a look at your personal financial situation and take a mental “recession stress test”. If you find any weaknesses, you can counter them actively now. And in a much more rational state of mind than if you were unexpectedly hit with the loss of your job during a recession like me.

I assume you read on this blog because you’re interested in financial independence. Maybe you’ve already taken the first steps towards this goal. The “stress test” is intended to make sure that you put what you already built up at as little risk as possible if a recession hits.

 

Recession proofing your finances #1: Your job and your income – how secure is your cash-flow?

Ideally you keep your regular income, your expenses are significantly lower than what you earn, and you can continue to save and invest. You won’t be at existential risk as long as your income covers your expenses sustainably. For a certain time, you’d be able to cover your outgoings from savings, see next part. At this point you’ll probably agree that low fixed expenses are an advantage and that consumer debt is not a good idea.

 

Ask yourself these stress test questions:

  • How secure is your job? If you’re a tenured civil servant, you’ve obviously hit the jackpot. Else, the economic sector you work in is important. Is it cyclical or non-cyclical (think automotive versus utilities)?
  • Within a sector, there are stronger and weaker players – how good is your employer’s competitive position (or your clients’ if you’re self-employed)?
  • Do you work in a publicly listed company or does your company belong to an international holding that is publicly listed? In this case there will be additional pressure to reduce costs (= lay off employees) from the capital market. How did your employer act in previous recessions?
  • Are you still within a trial period? Do you have a temporary contract? Do you have a permanent contract? Do you have an executive contract that is exempt from general employee protection laws?
  • How long have you been with your current employer? Do you have personal circumstances that could prove advantageous if “Sozialauswahl”became applicable in lay-offs (term of employment, older age, dependent children, severe disability)?
  • Would you be entitled to a severance payment? How much would it amount to?
  • How does your superior view your performance? How did your last performance review turn out? (Not necessarily saving you from a lay-off: I had received a very good performance review and a raise fairly shortly before I lost my job).
  • (How) can you make your self indispensable (commitment, internal networking) that your the last person your superiors would voluntarily let go?
  • Is your qualification so sought-after that you would be able to quickly find a new job in a recession?
  • Do you maintain a network of contacts, that would enable you to quickly find a new job, even in a recession?

 

Recession proofing your finances #2: Your safety net – have you built up enough savings?

If you live in Germany, work a job subject to social security contributions and meet some minimum standards, you can claim unemployment benefits if you lose your job. If you’re self-employed you probably didn’t insure against unemployment. As you have to claim unemployment benefits first, and payments will only be made at the end of the month at the earliest, you’ll need some savings in any case. The less benefits you can expect, the higher your emergency fund should be.

The goal is that you should not find yourself in a situation where you have to liquidate your investments because of a temporary loss of regular income. There is no immediate connection between a recession and a crash on the stock and real estate markets. But there is no guarantee either that there won’t at least be some big corrections. If you’re forced to sell at that point, the losses incurred might be significantly bigger than opportunity costs for funds held risk-free.

As far as the emergency fund is concerned you can find different opinions across the community, see this post, for example. But as I understand it, Karsten focuses on “normal” emergencies such as a broken washing machine or a larger car repair that could be cash-flowed from your regular salary. And the post was written at a time, where there were no recession signals at all. I would neither invest our personal emergency fund nor the funds earmarked for our rental real estate at a risk bigger than that of a call money account.

 

Ask yourself these stress test questions:

  • Have you made contributions to the statutory unemployment insurance for at least 12 out of the last 24 months?
  • How high is the unemployment benefit you could claim (important to know: the insurance will pay a calculatory net amount, only up to the contribution ceiling. You can find a calculator here)?
  • How long are you entitled to unemployment benefits (Standard are 6/12 months, extending to 15 months for people older than 50, and 18 months from 55, there will be deductions if you voluntarily sign a dissolution of contract)?
  • How large is your emergency fund/liquid reserves? Sufficient to cover 3 months of necessary expenses? 6 months? 1 year?
  • Do you need additional funds for rental real estate where larger repairs have already been voted on?
  • Have you invested your emergency fund in a way that actually enables you to quickly draw on it in an emergency?
  • If your emergency fund is not big enough yet: how fast can you grow it to that point?

 

Recession proofing your finances #3: Your investments – does your asset allocation reflect your risk profile?

Even if you feel well prepared looking at the two first topics, please be really honest with yourself about your risk tolerance at this point. You want to make sure a recession doesn’t require you to liquidate assets that were intended to help you grow your net-worth. Lest, to realize losses from this.

But if your asset allocation is not in line with your risk profile, there’s a very high probability that you will sell assets during a correction or a real crash. Not because you have to but because you get scared share prices will only continue to fall, and will not recover from this. I was quite surprised how many commentators who had described themselves as stoic buy-and-hold-investors on blogs before, became very nervous during the short correction at the end of last year, and sold assets at a loss.

I’m not referring to speculative investments here, where it obviously make sense to limit your losses in a position. But to long term investment where – especially for young investors – a correction should provide a welcome opportunity for buying, but never a reason for selling. I think it’s psychologically easier to stick to your plan if you invest in broad index funds/ETFs: you only have to convince yourself that it’s not very probable that all stock markets will collapse totally and forever. Rationally, that’s an argument much harder to make for an individual stock. 

 

Ask yourself these stress test questions:

  • What does your asset allocation look like on a pie chart? What percentages do you hold in each asset class?
  • Have you invested funds in P2P? In crypto currencies? In real estate crowdfunding? To which risk class would you attribute these investments? Would an investor with 20 years more experience than you attribute them the same way? If yes, why? If no, why not?
  • Have you really only invested money at a higher risk that you will not need in the coming 10 years?
  • What was the maximum your stocks have been in the red so far? How did that feel?
  • How often did you look into your stock portfolio during the correction at the end of last year? Did you buy more shares during those weeks? Were you tempted to sell shares? Did you sell shares? Why?
  • Imagine your portfolio of stocks is 30% down. 50% down. Put these new numbers in your net-worth tracking chart. How does this feel? What would be your next steps if this became real?
  • Have you leveraged your risk by taking on debt? This would be the case for most people investing in rental real estate. More in my post on the current real estate hype.
  • How does your cash-flow calculation change if you have more vacancies than you originally planned for?
  • Would you be forced to sell an apartment if – due to falling real estate prices – your bank sets the value at 30 percent lower than when you took out the loan, and now wants you to compensate for this in cash?

 

If you’re honest with yourself when engaging with these questions and tackle any necessary changes, you should be very well prepared for a recession. This will enable you to act, rather than to react. You don’t have to radically change your habits from one day to the next. Just keep track of what’s happening, and adjust things as you go.

And don’t let the crash and the apocalypse prophets pull you down: recessions are a normal part of economic cycles. (So are the prophets, at some point they will naturally be right this way). Stock and real estate market crashes will happen once in a while as well. If you have your personal finances in order, and if your asset allocation is in line with your risk profile, a crash will be an opportunity to you. Don’t let anybody tell you differently.

Financial Independence Rocks!

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2 Comments

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    Adrian
    September 3, 2019 at 2:02 pm

    As an IT engineer working in automotive for a German company, I strongly relate to the concepts and viewpoints you presented (especially stress test 🙂 ) For sure, your post is raising some interesting questions which I will look into. Thanks for sharing your insights and personal experiences, especially the ones concerning the 2008 crisis.

    • Financial Independence Rocks!
      Reply
      Financial Independence Rocks!
      September 3, 2019 at 2:33 pm

      Glad you can relate to this, Adrian – and all the best for your personal recession stress test ;-).

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