US recession: past trends and future forecasts


Tuesday, August 13, 2019 | By Atul Rai, Associate, Regulatory Solutions and Zenil Shah, Associate, Regulatory Solutions

US recession: past trends and future forecasts

A reasonable number of glum forecasts have surfaced in the recent few months, the majority of which predict an outright recession on the horizon. In a recent Q2 survey by the National Association for Business Economics of 53 economists had 60% of respondents suggesting there is a risk of recession by 2020, while 15% predicted a recession to begin this year, and some 33% foresaw a recession mid-way through next year. [1] A separate Reuters poll of economists in March and April reported a 25% probability of a recession hitting during the next twelve months—the highest figure recorded since 2014. [2]

Lingering Threats:

  1. The Treasury Yield Curve Flip

As treasury bonds are backed by the U.S. government, these are considered the safest investment but have the flip side of carrying relatively low interest rates. Consequently, investors tend to avoid investing in bonds unless the economic future looks gloomy.

In general, the longer-term bonds have a higher yield in comparison with the short-term as the longer the investment, the higher the risk that inflation will eat the gains over time. In such a case, the yield curve has an upward slope.

Positive yield curve

Conversely, the higher the investor apprehension of the direction of the economy, the higher the demand for long-term treasury bonds, the higher their price, the lower their yield. In essence, this leads to a flipping of the yield curve—a surefire sign of a looming recession. The treasury yield curve has flipped before the last seven recessions with only one false positive back in 1998. Although a general trend shows it takes an average of a year and a half from the time the curve flips until the start of a recession. [8]

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

Figure 1

10-2 Year Treasury Yield Spread

Figure 2

  1. Trade Wars

The U.S. trade war with China and Mexico has only added fuel to the fire by amplifying uncertainties and threatening to slow the overall global economy. Over 600 companies and industry groups in the U.S. estimate that the tariffs could cost the average family $2,300 and lead to 2 million job losses. Morgan Stanley’s chief economist and global head of economics said, “If U.S.-China talks stall, no deal is agreed upon and the U.S. imposes 25% tariffs on the remaining $300 billion of imports from China, we see the global economy heading towards recession.” [1]

  1. Macro Indicators

An unsustainable corporate debt bubble and the proportionate retreat in business capital spending are gaining traction. Economist David Rosenberg states, “adjusting for one-time expenses and other similar items and the ratio of total-debt-to-EBITDA stands at 7x.” [4] Morgan Stanley’s U.S. capital spending plans index fell to a two-year low and S&P Global has estimated the capex growth to diminish from 11% last year to 3% this year. [4] Across the U.S., Europe and Asia, the month of May reported a downshift in factory activity which is seen as early signs of recession by some analysts. [1] Furthermore, the Chinese government is cleaning up its financial system, a daunting task given the backdrop of slowed growth, amassing debt, rising cost of riskier loans and upsurging defaults. If China gets caught in a trade war amidst this financial restructuring, it could have a domino effect across the world. [3]

Flip Side of the Coin

Not everyone opines in favor of the looming U.S. recession. JP Morgan Chase economists have downscaled estimates of recession materializing in twelve months from 65% in late 2018 to just 15% four months later.

  1. The Treasury Yield Curve Flip

The continuous quantitative easing in Europe and Japan and other banks are perhaps keeping the long-term yield low, these being almost near negative today.

A senior fixed-income strategist with UBS Global Wealth Management’s Chief Investment Office is of the view that the length of time that the curve stays inverted gives a better prediction of recession. [5] The longer it lingers in the inversion territory, the more it dissuades banks to lend, the more it tightens credit flow, the more it raises borrowing costs. Ultimately, the corporate earnings take a hit, and in turn, weigh down heavily on economic growth. Presently, the financial conditions are loose and there is easy access to capital. The curve has stayed flipped since March and isn’t a cause of worry right away. In the build-up to the 2008 crisis, the curve had stayed inverted for around ten months. [5]

Also, the depth of the inversion currently is shallower compared to history. Some models suggest the gap between bond yields gets about four times larger before the recession begins within a year.

Some experts are of the opinion that the yield curve inversion seems to be driven more by buyers investing heavily into long-term for technical reasons rather than genuine recessionary concerns; for example, a sharp spike in mortgage refinancing applications.

Economist Ed Yardeni reckons that the flip can occur prematurely. Before the recession of March 2001, it flipped a couple of times between 1995 and 1998. [6]

  1. Macro reasons and Trade Wars

An estimate by Mckinsey has projected $10 trillion in corporate debt to become due in the next five years. [3] Investor impatience over the looming corporate and sovereign debt explains their flocking to safer assets pulling the long-term yield lower. Add to that the fears of a catastrophic trade war. All these have and continue to hurt business sentiments and investment. Some experts feel that the market sentiment has become over-anxious despite the extraordinarily low unemployment rate, strong hiring shown in June’s job report and the economic growth remaining largely on track.

In a recent interview, Fed Chairman Jerome Powell said distress over the trade policy and overall weak global economy is continuing to weigh down on the U.S. economy. [7] He also stressed the risk of a downturn in business investment, which has already notably slowed in recent months, is steered by the quandary over the length of time and intensity of the trade war. The feeling that protectionism and higher tariffs are here to stay is coming at a cost to investment and growth where it could be leading firms to delay investment and slash capital expenditures.

Conclusion

This is a time for vigilance, and one can only hope that the past mistakes are not repeated. It will be interesting to see where the global economy is headed in the upcoming twelve months.

 

 

References

  1. The Looming Recession Will Be Worse Than 2008 https://www.nasdaq.com/article/the-looming-recession-will-be-worse-than-2008-cm1159133
  2. Is the United States headed toward a recession? https://internationalbanker.com/finance/is-the-united-states-headed-toward-a-recession/
  3. Bond markets send signals of a looming recession https://faculty.chicagobooth.edu/raghuram.rajan/articles/Bond%20markets%20send%20signals%20of%20a%20looming%20recession%20_%20Financial%20Times.pdf
  4. David Rosenberg: Signs of a looming U.S. recession are building, if you look beneath the surface https://business.financialpost.com/investing/david-rosenberg-signs-of-a-looming-u-s-recession-are-building-if-you-look-beneath-the-surface
  5. The longer the U.S. Treasury yield curve stays inverted, the better it predicts recession, analysts say https://www.marketwatch.com/story/the-longer-the-us-treasury-yield-curve-stays-inverted-the-better-it-predicts-recession-analysts-say-2019-07-09
  6. Inverted Yield Curve Digs In Amid Worries Over U.S., China Trade War https://www.investors.com/news/economy/inverted-yield-curve/
  7. Fed's Powell says trade, global growth concerns continue to weigh on US economy https://www.moneycontrol.com/news/business/economy/feds-powell-says-trade-global-growth-concerns-continue-to-weigh-on-us-economy-4192011.html
  8. Why the U.S. Yield Curve Inversion Has Recession Watchers Worried https://money.howstuffworks.com/why-treasury-bond-yield-curve-has-recession-watchers-worried.htm
  9. Figure 1. 7 Warning Signs of a Looming Recession https://money.howstuffworks.com/7-warning-signs-looming-recession1.htm
  10. Figure 2. Is A Recession Looming? The Answer's Still Yes https://www.forbes.com/sites/robisbitts2/2019/04/09/recession-looming-yup/#d312b943b7a3


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