Not necessarily in the immediate future—although the probabilities of one have moved higher in recent months—but at some point, yes. Based on a rough survey of indicators put forth by various sources, the odds of one happening in the next year have risen to about one-quarter, with one a few years away are up to around one-half. Market-implied probabilities were even higher than this at the start of the year, with expected levels for the fed funds rate at the end of 2019 showing little to no movement from current levels. Interestingly, when looking at fed funds futures for December 2019, the odds of rates moving lower (now about 20%) are now above the odds of rates moving higher, which was a seemingly absurd thought just a few months ago. Despite the soured outlook, these measures are actually back in line with historical averages—since a recession has occurred about once every five years, a one-fifth probability in any given year has been a reasonable estimate.
Where have the recent concerns come from?
Several economic indicators have shown deceleration from fast-growing levels. These include the industrial and manufacturing segments, as well as consumer and business sentiment, not to mention the ongoing sluggishness in homebuilding—despite housing prices remaining at elevated levels nationally, which has given owners perhaps a misplaced sense of confidence. The difficulty in evaluating such changes in real time during an economic cycle is that it’s impossible to tell if they indicate one of several mid-cycle ‘slow patches’ or, more ominously, signs of the cycle’s later innings morphing into recession. We’ve experienced several slow patches in the current decade-long cycle, perhaps best thought of as ‘mini-recessions’, where growth stayed positive, but just at a slower degree. It’s important to note that slowing growth or deceleration is very different from negative growth, or contraction.
The good and bad news is that the Fed doesn’t have a crystal ball, either. This is where the ‘data dependency’ language comes from, speaking to a reevaluation of conditions on an ongoing basis to re-test for further weakness. This unpredictable nature of the economy reminds us that it’s more than a set of static data points; it’s an organism in continual movement and evolution.
What causes a recession?
Recessions seem mysterious but typically have originated from a limited list of causes. Historically, these have included tangible industrial/manufacturing slowdowns or spikes in oil prices, or the less obvious (until afterward) sources of too-stringent monetary policy, financial imbalances or government fiscal policy.
Cyclical business factors, such as inventories, have become less of an issue during the last several decades compared to tendencies seen prior. Historically, companies had a difficult time gauging demand and adjusting production quickly, as conditions changed, and, consequently, firms could end up with bloated inventories at the same time growth slowed. Better technology and ‘just-in-time’ manufacturing techniques developed in more recent years, as well as a steady shrinking of manufacturing as a proportion of the economy, and larger share assumed by services, has also played a role in this cyclical sensitivity decreasing. Oil shocks were also a more frequent source of economic disruption, but greater efficiencies have resulted in lower net petroleum use in developed nations, as well as higher U.S. shale production, which has acted as an important price stabilizer to cushion the impact of such shocks.
For as much criticism as the Federal Reserve gets, it’s done a relatively good job of maintaining its primary mandates of stable prices (i.e. low inflation) and maximum employment, using the blunt instruments of short-term interest rates and, more recently, long-term rates through quantitative easing. Modern monetary management has been more effective than in the past, given the better access to data and tools available. All still operate with a time lag, though, so precision is difficult and chances of a policy error haven’t been eliminated. A policy error refers to a central bank raising rates either too much or for too long—causing the intended slowdown to accelerate into a recession. Obviously, this is not the intent going in, but have come from the time lag and unforeseen events that crop up during the hiking process, and are more common than many think.
Financial imbalances, or even bubbles, can play a role in raising recession risks. Borrowing from the scientific realm, work in chaos theory, such as the study of mountain avalanches, etc., has been applied by some researchers to financial markets. The attempt is to measure which snowflake is the one that triggers the avalanche, but the less reassuring news is that the cause is often random and impossible to predict—only after the event occurs do the unstable fissures under the surface (sometimes) appear. Contrary to the last recession, when consumer spending and housing were growing at high rates, many called this growth the ‘new normal’ at the time. This time, economists have been watching growing levels of corporate debt, rather than consumer debt, for signs of strain, in addition to high levels of government debt worldwide taken on during and after the financial crisis. There could be other bubbles or fractures growing, but we likely won’t know until after the fact.
Government fiscal conditions can also act as a catalyst for a recession, whether it be from an oppressive tax policy, hurdles to trade or a miscellaneous geopolitical event, such as war. A situation such as ‘Brexit’ could dampen (and have dampened) growth, as uncertainty over key fiscal and regulatory arrangements can cause consumers and businesses to pull back on spending in a ‘wait and see’ mode until conditions are clarified. In a sense, this works similarly to a deflationary price feedback loop, where falling prices keep buyers on the sidelines due to the expectation of continued falling prices, where discounts to be had next week are better than those today. Then, no one buys, at least until a point of necessity or final capitulation, but a lot of pain can be had in the meantime as business activity is locked up. While rarer than more cyclical forms of economic decline, this type of sentiment can be far more damaging and long-lasting, as seen in many emerging market nations over their lifetimes, particularly in places where there has often been no light at the end of the tunnel for improvement (Turkey and Argentina come to mind in recent years).
Recessions sound scary, but they’re a natural part of the organic economic cycle, and impossible to avoid. In fact, an economy with no downturns can result in excesses that create other imbalances, which themselves heighten the odds an eventual ‘Minsky moment’ and a downturn at some point—it’s an infinite loop. Even in Australia, where the current economic cycle is going on 25 years and counting, recession-free, certain fundamentals have grown more inherently unstable, including extremely high housing prices and a dependence on the secular growth of China to support exports.
In our current case, U.S. growth is expected to evolve from the 2-3% level this year, declining towards 2% and maybe even the high 1’s during the next few years. This isn’t a lot of room for error in avoiding recession. But, at the same time, the difference between growing very slowly and no growth, or even slight negative growth (even a technical recession) isn’t that dramatic, compared to the full-accelerator to full-brake type of cyclicality seen decades ago, where the contrast was much more stark, harder to anticipate and counterbalance with policy, and causing much more damage to recover from in financial and labor markets. The Great Recession was a bit of an outlier in this sense, where an extreme financial excess resulted in the recession’s severity.
No Wall Street firm feels very good about forecasting a recession, let alone trying to get the timing right. What about the U.S. treasury yield curve? As we’ve discussed before, a yield curve inversion (where short-term rates rise above long-term rates, the opposite of the normal relationship) has been an effective predictor of recessions and, at least, economic slowdowns. Such downturns have tended to happen around 12-18 months from the time of a sustained yield curve inversion, historically. Bond markets have been a bit better than equity markets in forecasting incremental doom, so corporate credit spreads and bond defaults are other potential items to watch.
Even when they do arrive, typical recessions are not the end of the world, with the Great Recession of a decade ago being a deviation from the norm. Most do not last more than a few quarters, with the severity of the decline based on the cause and size of any excesses in the uptrend just prior to it. Of course, there is economic and societal unpleasantness in the difficult business conditions and higher unemployment rate. At the same time, it can be a fruitful time to invest—when no one else wants to.
