Is a recession imminent?
The answer to this is always yes...the problem is, we just don't know when. At the start of any given year, whether or not conditions in January are viewed as strong or weak, there's about a 20% chance of a recession beginning in that particular year. Since business cycles have tended to be in the 5-year range, give or take a few years, this is just based on a rough weighted average. Recessions are a natural and required part of the business cycle. Without moderate recessions happening on a regular basis, excesses would build up in a variety of areas—especially in credit or through inflation—that would result in unsustainable conditions resulting in an eventual worse blow-up down the road. Historical stats aren't always easy to tabulate, but it's estimated that the U.S. has experienced up to 50 recessions in its history (that ends up being about one every five years). The old Wall Street maxim says, 'No tree grows to the sky,' but that applies to economic growth as well. A more accurate description would be something like four steps forward, one step back.
To fine-tune the probability of recession, other criteria need to be considered. It starts with the question of where recessions come from. As noted above, they often result from the aftermath of the bursting of bubbles in credit and other economic excesses, where rapid growth conditions and exuberance reach a point of unsustainability; then they reach a tipping point and implode, causing a downturn and contraction ('negative growth'), as conditions revert back to a more normal, sustainable path. Other wildcards can also come into play. Historically, these have been bouts with unexpected inflation (late 1970s-early 1980s), burdensome changes in fiscal policy and/or a major geopolitical event that rattles growth or requires redirected resources, like a war. Geopolitical causes have often been accompanied by energy or other commodity price spikes from perceived supply disruptions; higher oil costs have done more damage than perhaps any other component in recent decades.
Often, the recession itself doesn't last long, and can be finished in a few quarters. The more exuberant the build-up and larger the credit bubble, the bigger the fall, which can take much longer to repair, as seen in 2008. Economists Reinhart and Rogoff noted in a review of deeper financial recessions over the last several centuries that a 5-10 year average recovery period was not uncommon, and such a model could be playing out. Downturns can also be exacerbated by a loss of consumer and business confidence, where it's easy to see how a downward spiral can take hold when purchases of capital goods and other items are postponed until conditions get 'better'.
Following the Great Recession, the economy has been rolling along growing at a slow rate, compared to long-term averages. This is partially demographic, which we've discussed before, and partially due to how severe the crisis was. Regardless, with the economy operating on less than all cylinders, there are fewer 'excesses' to be wrung out, which is one reason why the current business cycle has lasted for longer than average and chances of a recession (based on economist opinions) has been lower than average. Is it impossible? No, but less likely compared to similar periods in past cycles.
As for the wildcards, inflation has remained very low, in keeping with slow growth. Since it's usually measured on a year-over-year basis, inflation will likely increase as the more extreme crude oil price declines 'roll off' and are replaced with more normal rates of change, but inflation overall remains low and below central bank targets. Low energy prices have created issues for energy companies, but these serve as the opposite of a recessionary force for everyone else. That leaves other wildcards, of which the largest is China. Growth rates have continue to fall from the 8-10% of a few years ago to 6.8% in the past quarter, which was still well within range of many economist expectations. While not the extreme growth we've been used to, it remains among the highest in the world, a significant contributor to global growth—only a few others have been able to achieve it consistently. As the world becomes more integrated through trade linkages, and a variety of nations experience demographic shifts, it's possible that long-term overall growth rates could come down, and this may keep recession risks elevated as there's less of a buffer than there used to be. Then again, that could mean the excesses may be kept in check as well, which have the impact of causing recessions to be shorter and less severe on average.
U.S. manufacturing data has made a poor showing in recent months, not quite at but pushing near recession-like readings should it continue at this pace for several more months. However, services, which is a much larger part of the economy (several times over), seems to be holding up better at this point. This is a factor being watched more closely by economists due to historical relationships between deteriorating manufacturing numbers and higher recession risk.
There is another indicator, which has a fairly good track record, albeit not perfect. This is the inverted yield curve, meaning that short-term interest rates rise to a higher level than longer-term rates. Typical curves have a positive slope, as investors demand a risk premium of higher yields for taking on the uncertainty of longer maturities, among other reasons. In the case of an inverted curve, though, investors would expect the Fed to lower rates in the near future, which is usually done during periods of economic weakness—hence the unusual yield relationship. While the curve has flattened, we don't have anything close to an inverted curve now.
There's another element that's critical for investors to remember. Stock market results don't follow in lockstep with economic growth. Generally, equities can experience corrections during both economic expansions or contractions. Often, markets have corrected prior to troughs in economic growth during recessions and actually can perform well during them—due to relative expectations for improvement in the future. So, while stock sell-offs can occur prior to recessions, this isn't always the case, and shouldn't be taken as a precise predictive factor.
At any given point in an economic cycle, there are a fair number of pundits that feel a recession is on its way next month, while others think we're five years away. The truth is probably somewhere in the middle, but these often can't be identified until they occur, or after we're already more than half-way through.
Read our Weekly Review for January 25, 2016.
Read the previous Question of the Week for December 28, 2015.