Given the apparently close historical relationship between various financial indicators and the economy, some commentators have been quick to talk up the danger of a US recession in view of recent market developments. Such fears appear unfounded, even if growth is likely to slow, argues Michael Grady.
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US markets have endured a difficult ride of late with both equities and bonds suffering sizeable losses. After hitting a record high on October 3, the S&P 500 had lost nearly 17 per cent of its value by January 3.
As for corporate bonds, spreads over comparable government bonds have widened appreciably as well, although from historically-narrow ranges. Nevertheless, such spreads are often seen as the canary in the coal mine of recession risk.
The most obvious drivers of the recent sell-off in risk assets are concerns around the ongoing trade dispute between the US and China and tighter global liquidity as the Federal Reserve (Fed) continues to raise rates.
Reading too much into the yield curve?
Although bond yields have fallen sharply over the past month, the yield premium offered by ten-year bonds over two-year debt remains close to an 11-year low. Since most of the US recessions seen in the post-World War II era have been preceded by an ‘inverted’ yield curve, pessimistic commentators have been sounding concern for some time. The recent sell-off in risk assets strengthened their conviction the economy could be heading for troubled waters.
However, investors should be wary of reading too much into recent developments. We see little prospect of anything more than a modest slowdown in growth, and certainly minimal risk of a recession in 2019.
For a start, while economic data and financial market conditions are clearly linked, the linkage may not be as close as some claim. Relying on market indicators such as inverted yield curves or equity bear markets to predict recessions is dangerous, if not foolhardy. While economists may not be particularly good at forecasting recessions more than a quarter or two in advance, contrary to popular belief it is unclear financial indicators are much, if at all, better.
Take the yield curve. While it may be true an inverted yield curve has usually been a prelude to a recession, the time lag between the two events has varied enormously. For instance, as the chart below shows, although the recession of December 1973 to April 1975 began just eight months after the yield curve inverted, there was a lag of almost three years between the yield curve inverting and the start of the recession of 2001.
Such wide variations highlight the information embedded in the yield curve is of questionable value when predicting recessions. And for those tempted to draw any inference from the current shape of the curve, it is worth remembering it was as flat as it presently is in August 1984; six years before the economy went into recession. Similar curve analysis outside the US proves to be even less fruitful, with no clear relationship.
Chart 1 The US yield curve tends to invert ahead of recessions
As for equity markets, they appear an even less reliable guide to the impending fortunes of the economy. The chart below shows the performance of the S&P 500 since 1950, with recessions superimposed in green columns and bear markets; defined as a fall of 20 per cent or more from peak to trough, in red columns. Not only did the US equity market fail to warn of the recessions of 1953, 1960 and 1980, it provided false sell signals on four other occasions. In 1962, 1966, 1987 and 1998, bear markets were not the precursor of a recession.
Chart 2 US equities are an unreliable guide to recessions
Data tells a different story
While rising bond yields and equity bear markets may help cause recessions via tighter financial conditions and wealth effects, it seems highly unlikely markets are presently sensing this kind of negative feedback loop. Rather, it appears they are simply reacting to the range of risks currently facing them, including rising interest rates.
However, while tighter monetary conditions are likely to take some steam out of the economy in 2019 and beyond, there appears little cause for alarm based on current economic data. For a start, growth is coming from an extremely high base, with output set to have expanded by around three per cent in 2018. That would represent the biggest annual gain since 2005. It is true growth is likely to moderate in 2019, for several reasons. First, the impact of deep cuts in corporation and income tax introduced at the start of 2018 – which added around 0.5 percentage points to US economic growth in 2018 – is set to fade. Together with tighter monetary policy and higher prices, this seems likely to weigh on household consumption and business investment.
Nevertheless, these effects will be nowhere near enough to tip the economy into recession; not least since they will be partly offset by higher government spending. Growth is expected to remain above potential in 2019.
That is not to say there are no downside risks. Chief among them is the possibility the trade dispute between the US and China escalates, potentially dragging in other nations. The measures taken already are expected to subtract around 0.2 percentage points from US growth in 2019. It is feasible that if the US were to slap a 25 per cent tariff on all Chinese imports, as President Trump has previously threatened, the impact could be enough to slow growth in the US by a lot more, particularly if business and consumer sentiment, which currently is high, were to slide.
However, even in this worst-case scenario it is hard seeing this being enough to push the economy into recession. Moreover, it assumes Washington does not take steps to cushion the economy from the impact of any further tariffs.
Another risk to growth comes from the possibility that investment in mining and oil exploration contracts sharply, as it did in 2014, should oil prices fail to recover from recent falls or, worse still, the sell-off intensifies. But it is difficult to see this subtracting more than 0.3 percentage points from growth in 2019.
Some concerns have also been raised about a recent plunge in residential real estate investment. However, given the much-reduced leverage in household balance sheets and the fact this sector now accounts for little more than three per cent of the economy, even if activity falls further this is unlikely to trigger a recession.
Others have talked about an excessive build up of debt on non-financial corporations’ balance sheets. But again, with companies having taken advantage of low long-term interest rates on offer in recent years, this is not a cause for concern at this juncture. And importantly, while non-financial corporations’ balance sheets may have become stretched, the same cannot be said for banks. They appear to be in much healthier shape than in the run up to the financial crisis of 2008. That is important given the central role they play in the economy.
The role of the Fed
All told, growth is expected to remain above potential in 2019. Even if all these risks were to play out simultaneously, it is difficult to see how this could be sufficient to tip the economy into recession. While in theory there is a risk falls in financial asset prices trigger a recession via negative wealth effects, markets would need to fall significantly further for this to happen.
For now, we expect the Fed to continue raising rates through 2019. If it hikes by 75 basis points, as we expect, policy will be only just be moving into restrictive territory. Should one of the downside risks play out, the central bank could pause or even stop hiking rates. That possibility is yet another reason not to expect a recession in 2019 and to be wary of those trying to read too much into recent market events.
Source all market data: Bloomberg