The S&P 500 Index made more new all-time highs in October and November. Trade tensions eased, the U.S. Federal Reserve (Fed) cut interest rates another 25 basis points, and corporate earnings came in stronger than anticipated.
Against this favorable market backdrop, third quarter gross domestic product (GDP) came in above consensus expectations, at 1.9%. This represented a slight slowdown from the 2.0% second quarter pace, and 3.1% in the first quarter. The U.S. and global economies are clearly slowing. The question remains if we are on the cusp of a recession or a late-cycle slowdown.
Whether or not a recession comes, examining the evolution from the boom of the late 1980s to the recession of 1990-1991 may help investors evaluate current similarities – and differences.
This was one of the shallower recessions in modern history: GDP contracted just -0.2% in nominal terms, with the S&P 500 experiencing a selloff of 20%. This compares with declines of -3.3% and -57%, respectively, during the 2009 Global Financial Crisis (GFC).
This recession differs from others because it lacked a clear single catalyst, such as the housing crisis or the tech bubble. It was led by three major themes: aggressive policy tightening by the Fed, the savings and loan (S&L) crisis, and the oil shock associated with the first Gulf War.
The Fed cut rates by 75 basis points after the October 1987 Black Monday stock market crash, the only single-day bear market (a drop of -20% or worse) in history. The cycle’s low for inflation and interest rates came in early 1987, with Core CPI troughing at 3.8% and moving to 4.5% by late 1988. Acting quickly and aggressively to avoid the double-digit inflation of the early 1980s, the Fed hiked rate 387 basis points, peaking at 9.75% in early 1989.
The S&L crisis was also beginning. From 1986 to 1989, 296 savings and loan associations failed. Many of their assets were in fixed rate loans, often backed by real estate. To cover the gaps caused by higher costs from rising interest rates and the static returns they were earning, S&Ls began engaging in more speculative – and risky – activities. The verdict of history: bad idea.
By 1987, the Federal Savings and Loan Insurance Corporation (FSLIC) was recapitalized by more than $25 billion to help backstop insolvent S&Ls. Yet by 1989 FSLIC was insolvent, with losses approaching $4 billion, and was wound down. The U.S. Congress created the Resolution Trust Company (RTC). While 747 S&Ls would shut down by 1995, RTC’s losses to taxpayers were partially offset by equity partnerships to liquidate the assets of insolvent institutions.
All this growing systemic risk negatively impacted leading financial indicators, such as credit spreads and the yield curve, which moved into “danger” territory in 1989. Consumer indicators were the last pillar of support for the economy, but later that year three of the four consumer signals faltered. Business activities indicators such as ISM New Orders and truck shipments failed as well. By the time U.S. equity markets peaked in May 1990, recession was arriving.
Lagging effects of the Fed’s tightening still weighed on the economy, despite the Fed’s dovish turn to lower interest rates in mid-1989. When Iraq invaded Kuwait in early August, consumer and business confidence plunged. Oil traded in the $15-20 per barrel range prior to the invasion. It peaked at $40 in October, before settling back to $25 by year end
Unemployment climbed, housing permits and retail sales fell, equities sold off by 20%.
But this recession was relatively shallow and truncated: only 87 days. Oil prices stabilized in 1991 as Operation Desert Storm led to the liberation of Kuwait. Consumer confidence rebounded and the stock market recovered its losses, and more, by the end of 1990.
Ultimately, the U.S. economy recovered fairly quickly and embarked upon 10 years of growth.
The Gulf War was not widely foreseen, but there were many signals that the U.S. economy was weakening and vulnerable to shocks, such as a rapid rise in oil prices. Hawkish Fed rate increases also turned out to be disastrous.
If we can derive any lessons from this short and shallow recession for today, it would be that our economy should continue to thrive if the consumer segment can hold up long enough for the Fed’s newly dovish policies to take effect, and we can avoid systemic blows like an escalation of the trade war or suddenly soaring commodity prices.