THE risk of a US recession is back on the agenda, and rapidly moving towards the top of it. As the year turned, with many concerns facing the globe, it was treated as axiomatic that there was no risk of imminent recession in the US, and hence any damage would be limited.
Any rise in recession risk from that low level would lead to falls in the price of risk assets, which is exactly what we have seen, even if an outright US recession remains on balance unlikely. The list of market indicators that make no sense unless there is a clear danger of a recession is growing.
Long-term inflation expectations are their lowest since the crisis; spreads on corporate and particularly low-quality high-yield credit are widening; the yield curve — as shown by the gap between two-year and 10-year Treasury yields — is the flattest since 2007, showing scant belief that inflation or interest rates will be rising in the years ahead.
When banks make it harder to borrow, it is usually a sign that a recession is coming
And of course the stock market is down, while within it defensive stocks such as Walmart and Procter & Gamble are far outperforming cyclical stocks, which would fare worst in an economic downturn.
These are market-generated indicators. They show that we are in at least the most severe US ‘growth scare’ since the 2009 Great Recession, and these financial conditions in themselves raise the risk of a recession, by making life harder for companies and consumers. Should recession fears be averted, there should also be a nice rebound to be had from stocks and from betting against bonds.
So what is the possibility of a recession, and how can it be calculated?
According to the US fund manager John Hussman, who writes a widely followed weekly commentary and has been notably bearish in recent years, a recession is an ‘imminent likelihood’. He suggests financial markets generally act as leading indicators — which they are doing — followed by data from the industrial economy. Industrial production has fallen in 10 of the past 12 months; since 1919, every time it has fallen as many as eight times in such a stretch, there has been a recession.
Over the past 12 months, Alan Ruskin of Deutsche Bank points out, no country’s ISM index has fallen more than that of the US — casting grave doubt on its ability to play the role of the world’s growth locomotive. Services ISM figures have looked far better, but the noticeable decline in January’s figure suggests there are limits to how well the services economy can perform without manufacturing.
Mr Hussman adds weakness in retail sales as further evidence, while confirmation would come from worsening unemployment data and big falls in consumer confidence.
Financial conditions are also important. When banks make it harder to borrow, it is usually a sign that a recession is coming. In a survey of senior loan officers by the US Federal Reserve, produced this week, a growing majority of banks said they were tightening standards for commercial and industrial loans, in a way unseen post-crisis. There was no tightening for real estate or consumer loans.
Corporate profits provide cause for concern. Companies are finding it hard to maintain profit margins or raise revenues — possibly a testament to the strength of the dollar.
However, the evidence that the US is not yet in recession remains strong. Aneta Markowska of Société Générale puts the chance that the US was already in recession in December at 3pc, using a model based on private employment, real income, real sales and industrial production. Only the last is anywhere near recession territory.
SocGen’s model suggests the recession risk is almost negligible. Wage pressures are only just beginning, monetary policy is still very easy and profits on domestic businesses are still high, while corporate balance sheets are healthy with the exception of energy. All of this points to a cycle that does not turn into a downturn until 2018 or 2019.
A clear signal that these forecasts were wrong would come from the labour market, where the improvement has slowed in recent months. The labour market provides the strongest evidence that the US is not heading for a recession, and forthcoming data will be critical in determining whether this is a growth scare that will blow over — bringing a nice rally with it — or the start of the recession that the markets are signalling.
Published in Dawn, Business & Finance weekly, February 8th, 2016
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