Since the end of WWII, three major recessions have marked important economic turning points. Today, various indicators and unique economic factors suggest another recession is likely. The big question is how severe it will be.

The Fed, which continues to say it wants inflation of 2%, could ensure that it’s severe. That’s because 2% inflation is wholly inconsistent with current structural economic factors. If the Fed doesn’t reverse course, it could trigger an economic and geopolitical calamity of historic proportions. Fortunately, its latest projections suggest multiple rate cuts this year. However, if inflation picks up again, it could change the decision-makers’ minds.

If the Fed does ease, a bad economic downturn could be averted, but a milder recession still could happen. The problem is that given the fractured state of the U.S. economy, even a mild recession could snowball.

Can’t Count on China Stimulus

In the Great Recession of 2007-09, which ushered in an age of quantitative easing, our extremely high debt levels made the recovery more difficult to achieve. China’s willingness to sharply stimulate its own economy, which provided extra worldwide stimulus, was a critical factor in our recovery and likely meant we suffered far less than otherwise. Back then, China probably would have stimulated even if there was just a mild U.S. recession. Today, though, China is far less dependent on U.S. markets.

Also consistent with recession are demographic factors, such as the drop in U.S. life expectancies from a high of 79 years in 2014 to 76 years today. True, the pandemic played a role. But the pandemic was a global phenomenon. Since the century’s start, U.S. life expectancy is about flat vs. a three-year average gain in developed countries, to about 79 years. China’s life expectancy this century has risen by six years, to 78.

Throw in a highly fractured populace and an upcoming presidential election likely to feature major party candidates each of whom currently has sharply unfavorable poll readings, and it’s a recipe for even a mild recession sparking social upheaval. That could bring on further economic weakness, in a vicious circle that ends with the U.S. a vastly diminished force.

Worrisome Indicators

Not surprisingly, many indicators have reached extreme levels. For example, the yield spread between 10-year and 2-year Treasury notes have been negative since July 2022. Typically, longer-term yields are higher, because longer-term loans are inherently riskier. You only get an inverted curve, in which shorter-term rates exceed longer-term rates, as is the case today, if the market is being “manipulated.” For more than a year, the Fed, whose control is largely over shorter rates, has deliberately engineered a situation in which short-term rates exceed long-term ones.

The degree and duration of the current inversion has been seen only once in modern history, in the early 1980s, when it led to a harsh recession in which unemployment, by one measure, reached double-digit levels. Fed Chair Paul Volcker did succeed in bringing down inflation.

Today, the economic picture is very different. Most important is the far higher level of debt at all levels – consumer, commercial, and government. With short-term rates so high, it costs a lot more to service long-term debt. For consumers, this can mean paying higher interest on mortgages and maybe having to borrow at high short-term rates to do so. For businesses, it means deferring capital expenditures that would fuel future growth. For more than half a century, whenever 2-year yields exceeded 10-year yields, a recession has followed. Given today’s already high debt levels, the Fed is playing with fire in virtually ensuring higher debt levels throughout economy, laying the ground for a downturn that could easily feed on itself.

Market Divergence Another Red Flag

Another negative indicator is the under-performance of smaller-cap stocks against their larger counterparts. The 2023 rally by the S&P 500 was largely driven by the mega-cap tech stocks at the top of the index. It was not a broad-based rally that lifted all stocks.

Simply because of their size, smaller companies are inherently riskier than very large companies. When the overall market is on solid ground, small stocks outperform big stocks because they have more room to grow. But in riskier markets, the small fry will underperform.

In the current economy, net debt to earnings for companies in the Russell 2000 is more than twice as high as for the larger-caps in the S&P 500. That’s one big reason why smaller stocks have trailed the big ones in return.

Does this mean that the stock market is headed for a big fall? Not necessarily. But it does mean despite the strong return for the S&P 500 last year, the market and the underlying economy aren’t in as good a shape as last year’s 24%+ return for the S&P 500 might suggest.