United States

Here is why recession fears are overblown

THE REAL ECONOMY  | 

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Economic growth slowed in the final quarter of the year, which coincided with significant volatility across global asset markets and further declines in the price of oil and commodities. The combination of slower U.S. growth and declining oil prices has resulted in growing concerns that the economy may be teetering on the brink of a recession. In our estimation fears of a recession are overblown. 

The U.S. economy is experiencing a growth scare linked to a mild inventory correction and sagging global demand rather than facing a significant probability that the current business cycle will come to a premature end. Economic recessions do not evolve slowly. As evidence of slowing demand appears, economies tend to fall off a cliff as firms abruptly curtail fixed business investment, inventory accumulation and as hiring slows. 

Our preferred recession probability model, the Atlanta Federal Reserve’s gross domestic product-based recession indicator index, implies about a 10 percent probability of a recession. For this indicator, which relies on real-time fundamental economic data, values above 50 imply data are more consistent with a recession than economic expansion, while values above 67 indicate the economy has slipped into recession. Given the sharp increase in volatility in global asset markets, somewhat weaker than anticipated economic data in December and tighter financial conditions, we believe that the model will yield a recession probability closer to 20 percent once we get final economic data for the first quarter of 2016.

Middle Market Insight: This finding comports nicely with the our recent RSM Middle Market Leadership survey which points towards growth in earnings and revenues, and perhaps more importantly plans to increase capital expenditures over the next six months all of which reflect a fairly healthy real economy excluding energy and mining sectors.

While recession models using the Treasury yield curve or initial jobless claims data suggest slightly higher probabilities of economic contraction, our view is that seasonal noise in first time claims data and the distortion in the yield curve caused by the long period of unorthodox policies conducted by the Federal Reserve falsely inflates chances of recession at this time. 

Contrary to popular belief, a recession is not simply two consecutive quarters of negative economic growth. Rather, it is a significant decline in real gross domestic product, real income, employment, industrial production and wholesale-retail sales. A look at the past six recessions shows three exogenous price shocks, one linked to rising oil prices and a domestic policy shock, one due to an inventory correction linked to the tech bubble, and a third related to the “Great Recession” in the wake of the collapse of the housing bubble. All three triggered significant declines in growth, income, employment and sales.

So where are we now? The current business cycle is on pace to be one of the longest expansions in the post-World War II era. While growth remains slow by historical standards, the risk of a recession based on the proximate causes of the past six recessions remains low. The following is a quick synopsis that underscores our estimation that the current expansion will continue through 2016 and into 2017.

Policy: The primary policy risk remains firmly rooted in the path of interest rates. While the central bank increased the federal funds rate by 25 basis points in December, recent testimony by Fed Chair Janet Yellen, and the January Federal Reserve Open Market Committee minutes make it clear that rates may move higher at a very slow pace. At this time, the market is pricing in one 25 basis point rate hike this year, which is below our forecast of 50 basis points. Due to the policy polarization in Washington, there is little risk of a fiscal shock that could cause a recession this year.

Inventory correction: Historically, the two most likely indicators of recession are inventory overhangs in the auto and housing industries. Through the end of the year, the major auto producers had about 61 days of inventory in showrooms (65 days is considered equilibrium), which implied a pickup in production early this year. The housing sector is actually experiencing an inventory shortfall as the building community is having problems finding enough workers to build new homes and there simply aren’t enough existing homes on the market to meet demand.

Exogenous shocks: Sharp increases in oil prices caused recessions in 1973, 1981 and 1990. Currently, the United States is experiencing a positive supply shock thanks to an increase in the extraction of oil linked to the domestic use of hydraulic fracking. Meanwhile, falling gasoline prices have resulted in an increase in real income for U.S. households. Sustained low oil and natural gas prices should result in cheaper costs of production for domestically-based industries.

Asset bubbles: The greatest risk of recession is clearly linked to the recent sell off in U.S. equity markets. The Standard and Poor’s 500 index is down 9.73 percent from its cyclical peak of 2,130.82 in May of last year. The rotation in portfolio exposure away from China, energy, commodities and financials may be quite noisy but isn’t enough on its own to cause an economic contraction. Meanwhile, the linkages between asset markets and the real economy is quite limited. 

Fundamentals: Declining unemployment, rising wages, a noticeable increase in inflation-adjusted income and solid wholesale-retail sales all suggest that there is more than enough economic activity to offset the contraction in the manufacturing sector. Moreover, the January industrial production report indicated a modest rebound in factory orders, and production excluding motor vehicles are consistent with our forecast for a mild recovery in the manufacturing sector this year. While it is still early in the quarterly data cycle, GDP is tracking near 2.7 percent in the first quarter of the year, which suggests a strong rebound after last quarter’s slowdown and is consistent with our preferred recession probability model which implies a low risk for recession.

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