On today’s show we are talking about the impending recession. Yes, that’s right, the impending recession.
I believe that both Europe and the US are facing recession later this year if they are not already in an economic downturn. What is the reason?
Bloated inventories. Recessions happen when companies end up with bloated inventories. Most of the time, those inventories are the result of growing production in anticipation of continued demand growth. That’s the classic cause of inventory growth. Sometimes companies experience delays in delivery of parts because the supply chain is running at capacity. Inventory of materials or components can cushion and protect against those delays. But when the delays disappear, the excess inventory will be drawn down to normal levels before ordering more. That sharp halt in orders when it happens across a wide swath of the market is what we call an economic contraction.
So let’s take a look at inventories and see if there are situations where inventories are being built ahead of demand. If we see enough of them, and we don’t see a corresponding increase in demand to absorb those inventories, we can easily conclude that a recession is not far away.
I’m going to build the case for recession in three parts.
For exhibit A I give you Brexit
The UK has a deadline of the end of October to leave the European Union. But the terms of the departure haven’t been worked out and the risk is high of a no deal exodus. If there is no deal, there is a great deal of uncertainty about what that could mean for the flow of goods and commerce. Will goods be delayed at the border? Will customs inspections increase and materials be held up? Will there be new tariffs? British companies have responded to these uncertainties by building inventories to make sure their supply chains are not disrupted.
For exhibit B, I give you the European counterpart of Brexit. Companies on the continent that do business with the UK are also stockpiling in order to handle any possible supply chain disruptions.
For exhibit C, I give you the US China trade negotiations. Many companies in the US have ordered extra material in order to avoid the impact of tariffs on goods coming from China.
So here we have three significant places in the economy whereby there is an artificial increase in inventory ahead of demand.
We know that when that happens a stop in orders to draw down that inventory is not far away. When companies slam on the brakes and stop ordering it sends a negative shock wave through the economy. Customers who were placing steady orders week after week, suddenly stop ordering. Revenue from that customer drops to zero while the excess inventory is consumed. The supplier has no idea when orders will resume. So they respond the only way they can to protect the business. They send people on forced unpaid leave, or institute layoffs altogether to reduce expenses and protect the survival of the company.
When recessions happen, businesses fail, banks suffer losses in their commercial loan portfolio. Commercial real estate suffers as commercial vacancies increase. Some of these companies will not survive. That puts further pressure on lending institutions.
Banks today are better capitalized than they were in 2007, but still, they need to pay attention to their balance sheets. In recession times banks become more risk averse and have little choice, but to tighten their lending practices and only a fraction of the loans get approved that only months earlier would have been easily approved.
So pay close attention to your portfolio and use the current window of opportunity where loan interest rates are lower than they’ve been in a while, coupled with the favourable lending environment to lock into as long a fixed rate term as possible.