Stock market turbulence: is US recession risk rising?

Stocktake: Investors shouldn’t confuse a slowdown with a recession, ‘that’s just wrong’

‘It wouldn’t surprise me at all if we slipped into a recession real soon,’ says Nobel economist Robert Shiller. Photograph:  Reuters/Michelle McLoughlin

‘It wouldn’t surprise me at all if we slipped into a recession real soon,’ says Nobel economist Robert Shiller. Photograph: Reuters/Michelle McLoughlin

 

The US economic expansion, now almost 10 years old, is within seven months of becoming the longest in history. However with stocks falling into bear market territory last month amid mounting fears regarding global growth, is a recession around the corner for the world’s biggest economy?

The year began with stocks enjoying a strong rebound while Merrill Lynch’s latest monthly fund manager survey shows only 14 per cent expect a global recession in 2019.

Still, the “overall judgment of financial markets is that recession is significantly more likely than not in the next two years”, warned Harvard professor and former treasury secretary Larry Summers earlier this month, citing bond market movements, softening commodity prices and widening credit spreads.

Globally, most equity markets have fallen into bear markets notes Goldman Sachs, and almost all have experienced double-digit corrections.

Bulls point out that while the stock market is meant to be a leading economic indicator that anticipates the future, it is far from omniscient and has, as Nobel economist Paul Samuelson once quipped, predicted nine of the last five recessions.

Still, there’s no shortage of concerned experts. Summers thinks there’s “better than a 50/50 chance” of a US recession in 2020. “It wouldn’t surprise me at all if we slipped into a recession real soon,” says Nobel economist Robert Shiller, who famously foresaw the popping of the late 1990s technology bubble as well as the US housing crash that ushered in the global financial crisis.

Economist polls

The US economy is expected to continue growing in 2019 but concerns are growing. There is a 40 per cent chance of a US recession in the next two years, according to a Reuters poll of economists last month. A more recent Bloomberg economist poll found a quarter expect a recession in the next 12 months – the highest number in seven years, and one that closely corresponds to economist polls conducted by CNBC and the Wall Street Journal.

Almost half of chief financial officers expect a US recession before the end of 2019 according to a Duke University survey, while 54 per cent expect a recession in Asia and two-thirds foresee economic contraction in Europe – worrying figures, perhaps, given negative economic expectations could potentially become a self-fulfilling prophecy if cautious businesses pull back from investing and spending.

A number of issues are worrying economists and investors – the US-China trade war, rising rates and tightening financial conditions, the stock market selloff, economic weakness in Asia and Europe, with many economists warning Germany may already be in recession following unexpectedly awful industrial and manufacturing data earlier this month.

For investors, the recession question holds obvious relevance. Looking back on the last 14 US bear markets, LPL Research notes stocks fell an average of 31 per cent.

The key determinant of the severity of losses was whether the bear market was accompanied by a recession. In non-recessionary bear markets, losses averaged 24 per cent, compared to 37 per cent during recessionary bear markets.

Recessionary bear markets lasted almost three times as long as non-recessionary bear markets. Separate analysis from JP Morgan’s Nikolaos Panigirtzoglou finds the S&P 500 averaged losses of 26 per cent over the last 11 recessions.

Not all recessions are created equal, of course – stocks fell by only 20 per cent over a three-month period during the shallow recession in 1990, compared to 57 per cent over an 18-month period during the global financial crisis. On average, says Panigirtzoglou, stocks lost 18 per cent during mild recessions, compared to 33 per cent during deep recessions. The good news, he adds, is if the US does fall into a recession, it’s extremely likely – the odds are 88 per cent, estimates Panigirtzoglou – to be of the mild variety.

Economic data

Economic bears point to a number of concerns. Citigroup’s economic surprise index, which measures data relative to expectations, has fallen to seven-month lows. There has been some long-standing weakness in the US housing sector, with new home sales peaking 13 months ago, mirroring trends typically seen prior to recessions.

Meanwhile, there is anxiety surrounding the partial inversion in US bond yields. It’s customary for long-term bonds to yield more than short-term bonds. However, the yield curve has inverted, with 10-year bonds yielding less than short-term bonds, prior to each of the last nine recessions, making it a much-watched recession indicator. Last month, three-year yields fell below five-year yields – the first inversion since 2007.

However, some argue the indicator is less relevant than it used to be due to the US Federal Reserve’s interference in the bond market in recent years. In any event, they add, longer-term yields have not yet inverted and it can be a long time – sometimes years – before inversions are followed by recessions.

Other data – employment numbers, retails sales, industrial production – is encouraging, and most indicators suggests the US economic expansion will become the longest in history by July. JP Morgan chief executive Jamie Dimon is not worried on that front, saying markets have overreacted “to short-term sentiment around a whole bunch of complex issues”.

Nor is Federal Reserve chief Jerome Powell. “I don’t see a recession,” said Powell earlier this month, saying the economy was “solid” and showing “good momentum”.

Allianz chief economist Mohamed El-Erian goes further, saying recently he was “stunned” by recession talk. No raging bull, El-Erian tends to be cautious but he says investors should not confuse a slowdown with a recession – “that’s just wrong”.

Still, economists rarely see recessions coming. Only two of the 60 recessions recorded (in 77 countries) during the 1990s were predicted a year in advance, according to a 2008 paper by the International Monetary Fund’s (IMF) Prakash Loungani, and 40 were not spotted just seven months before onset. Forecasters are too slow to update their forecasts and are “also slow to absorb news about developments outside their own economies”, leaving the impression they are “chasing the data rather than being a step ahead of it”.

The IMF updated its analysis last year, but the conclusion was unchanged: forecasts are revised too slowly and while forecasters are “generally aware that recession years will be different from other years”, they miss the magnitude of the downturn until the year is almost over.

A reflexive recession?

El-Erian acknowledges the outlook is uncertain. Recent German economic data was “scary” and weak global growth could weigh on the US, so he wants the US to show “leadership” globally to focus on pro-growth policies. That’s far from guaranteed, given Donald Trump’s confrontational and isolationist instincts.

Secondly, El-Erian is concerned the US talks itself into a recession, saying “that’s how bad technicals become bad economics”.

The same point is made by Shiller. Iconic investor George Soros often talks about reflexivity, arguing markets try to reflect reality but their movements can end up changing that reality. Echoing this, Shiller cautions people curtail their spending and put business ideas on hold when they think a recession is coming. Right now, there’s “a lot of talk” about inverted yield curves, which “leads many people to expect a recession, as they have in other times of inverted yield curves”.

Currently, the consensus is the US will not enter recession anytime soon, but a further deterioration in sentiment might be damaging, suggests Shiller. Recession talk, he cautions, “can be a self-fulfilling prophecy”.

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