I wrote last week about the increased discussion of a recession in the business media (and also discussed the definition of a recession here). It’s safe to say that many in the US are on the lookout for a recession in the coming months.

I read an interesting analysis a few weeks ago discussing two broad types of recessions we’ve experienced in the past – a balance sheet focused recession and an income statement focused recession. I’ll share the highlights of this analysis below.

Balance Sheet Driven Recession

For the non-accountants reading this, a balance sheet is a financial statement that details assets (what you own) and liabilities (what you owe). A balance sheet driven recession is therefore one that is caused primarily by challenges involving asset prices and the associated debt.

Typically, in this type of slowdown, you have a highly leverage economy (ie: one with high levels of debt/borrowing) that propels asset prices to wildly high valuations. At a certain point (perhaps as growth slows), asset prices get brought down (ie: the bubbles pop), debt stays the same, and the problems begin. This mismatch (what you own is worth less than what you owe) is ultimately what forces the recession as investment and spending have to be stopped in order to pay down debt to get it in line with the lower asset values.

Balance sheet recessions are not easily impacted by monetary policy (ie: Federal Reserve managing interest rates) as the primary focus is on debt paydown – not on borrowing more money or saving more money (which tend to be rate sensitive)

Balance sheet recessions tend to be sharper corrections with a slower recovery (due to limited government response abilities and time it takes to restructure and repay debt to bring things back into equilibrium).

The Great Financial Crisis of 2007-2009 is a perfect example of a balance sheet recession. A large contributor to that crisis was overvalued real estate (many properties were being sold without underwriting) and complex debt obligations backed to the mortgages that ultimately went unpaid as home owners defaulted. Real estate values crashed and it became clear there was a massive overleveraging in the system. The recession lasted 1.5 years – illustrating the slow and prolonged nature of the recession when asset repricing and leverage are involved.

Income Statement Driven Recession

An income statement is a financial statement detailing revenues (what you earn) and expenditures (what you spend). An income statement driven recession first sees a slowing labor market, which translates into lower wage growth for employees. This leads to lower disposable income, which leads to less spending/consumption and results in an economic contraction (given how focused the US economy is on consumption).

Unlike a balance sheet recession (where debt has to be paid down as it backs assets now worth less than before), in an income statement recession, individuals are dialing back spending and increasing savings (in response to wages (ie: revenues) coming down and the fear that they could continue to do so).

With a heightened focus on saving (as opposed to a rush to pay down debt), monetary policy can prove more useful, helping to limit the downside and duration of economic weakness.

Income statement recessions see income slowing, spending cooling, and margins compressing – but they don’t tend to be as long and protracted as a period of debt deleveraging and balance sheet repair.

Provided an economy goes into an income statement recession from a place of strength (individuals and companies have high levels of cash, relatively low debt when it begins), the economy can be relatively resilient to this type of a recession. These tend to be shorter in duration and have less downside – which also leads to a stronger and more rapid economic recovery

What Now?

Is a recession – fitting into one of these two buckets – inevitable? No – but it is looking more likely as the days and weeks progress. It’s hard to know how the high level of uncertainty and “let’s just hold off for now” sentiment will read thru into the data. But it certainly seems as if growth can continue to contract.

I never like to make predictions (when are they ever right?), but my best assumption at this point is if we do in fact enter a recession, I believe it will be more of an income statement focused recession. We are starting from a position of relative strength. Consumer has record levels of household cash and net worth. Businesses have record levels of free cash flow and most have termed out their debt well into the future. While certain asset prices are elevated, the recent pullback has washed out much of that excess and removed leverage (ie: margin) from the system by a meaningful margin. In short, households and business have room to absorb a shock and balance sheets are in a good spot.

It goes without saying that the longer tariffs stay in place and there is no clear path forward, this position of strength may weaken. But for now, balance sheets are resilient. It’s the earning and spending side of things (ie: the “income statement’ side) that is of more concern.

Spending is already being cut and a renewed focus on saving is taking hold. Wages are holding their own but can start to weaken as companies face margin pressure. All of this flows thru to less activity and may potentially result in a contractionary period. The duration and size will depend on the path of policy from here but hopefully, given its likely nature (income statement driven), it will likely be shallow and short lived. As always, we will find out what the future actually holds when we get there.

Onward we go,