Investing

Never tell me the odds

What exactly do we mean when we say “recession probabilities are elevated”?


Our Top Market Takeaways for the week ending December 6, 2019.


Markets in a minute

Working off the tryptophan

The S&P 500 is still working off the tryptophan. The index has dropped -1.1% since its all-time high reached the day before Thanksgiving. The proximate cause for the drop is that the trade war is back. (Or did it ever leave? We’re having trouble keeping track.)

The latest trade headline whipsaw went like this: President Trump announced that the White House would reimpose steel tariffs on Brazil and Argentina on Monday, and the U.S. Trade Representative also announced that it was considering placing import taxes on $2.4 billion of French goods like Champagne and handbags (right before Christmas party season?! C’mon). Then, on Tuesday, the President stated that a trade deal with China might have to wait until after the 2020 election, and Commerce Secretary Wilbur Ross stated that the next round of tariffs targeting around $160 billion worth of mainly consumer goods (like smartphones, laptops and toys) would go into effect on the 15th of December if a deal can’t be reached. There was a more conciliatory tone by Wednesday, and the stock market could bounce into the end of the week.

We’re trying to look through the noise, but the details of a “phase one deal” have always been fuzzy.

We’re trying to look through the noise, but the details of a “phase one deal” have always been fuzzy. We have a hunch it is all about China’s need for soybeans, and we do not expect a full deal before the 2020 elections anyway. However, it seems like markets are expecting a “mini-deal” to be inked before the end of the year.

Despite the noise, it turned out to be a pretty quiet week. The VIX Index (a proxy for S&P 500 volatility) has risen from around 12.75 (low volatility) to ~14.5 (slightly higher but still below average volatility), U.S. 10-year Treasury yields are basically back to where they started (1.81%), and the S&P 500 is a touch lower. So far, this selloff looks like a milder setback than the other trade flare-ups in May, August and September, and this is probably because the two other major market movers (the economic cycle and the election) are still trending in a positive direction for risk assets. Still, the recent market action is a good reminder of a point we made a few weeks ago: When stocks don’t have strong earnings growth behind them, headlines and sentiment can drive price action. Over the long term, this should wash out in favor of our fundamental outlook. In the short term, it presents opportunities when sentiment shoots too far in one direction or another.


Spotlight

Never tell me the odds

What exactly do we mean when we say “recession probabilities are elevated”?

Wall Street has a funny way of tossing around buzzwords without being clear on their definitions. “Recession probability” is one that comes to mind.

For now, let’s put aside the ambiguity surrounding what a recession actually is (we’ve covered that in the past and it’s a whole ’nother story). Rather, let’s focus more on the conceptual framework that can lead to the conclusion that the probability of a recession happening soon is high or low.

Like most things, the first point to consider when you hear a phrase like “recession probabilities are elevated” is the source of the information. Is an economist saying this? Or is it a market strategist or investor? This distinction is crucial because it’s likely they are all talking about different things.

Recession probability to an economist

Economists are kind of like doctors. A doctor will never tell a patient exactly when a heart attack will occur. But a doctor can consider various “background factors”—high blood pressure, high cholesterol, obesity, etc. —that result in the patient having a higher than normal risk of a heart attack occurring in the future. This is how most economists go about building recession probability models: They are looking for various background factors that make the business cycle at a higher than normal risk of ending in the next couple of years.

Today, there are plenty of these factors out there, which is why most economists will say, in a general sense, “recession probabilities are elevated.” Probably the most common and important factor to note here is that the labor market is tight, which is contributing to higher labor costs for businesses, thereby eroding profitability.

Line graph shows the unemployment rate and the average hourly earnings as a percentage year-over-year change with periods of past recessions highlighted from 1987 through October 31, 2019.

Line graph shows the economy-wide corporate profit margin from 1979 through June 30, 2019, with periods of past recessions highlighted.

For example, our economist colleagues in the Investment Bank use precisely these factors (including a few others) to create models that estimate “longer-run recession risk.” Currently, their assessment suggests that there is close to 100% chance of a U.S. recession in the next three years! That seems a bit too high to us—if we had to put a subjective number on it, we would say it is closer to 50%—but we agree that the background risk is elevated.

Line graph shows the probability of a recession in the next three years from 1955 through November 30, 2019, with periods of past recessions highlighted.

An important point to stress is that the “background risk” of a recession likely isn’t going to fall until the next recession hits. In other words, and stated more technically, it is monotonically increasing as a function of the labor market getting tighter and tighter (absent an acceleration in productivity growth).

Now to a market strategist or an investor, this probably seems quite strange. After all, if near-term risks are reduced (like if the United States and China agree to a “phase one” trade deal), shouldn’t that lower the probability of recession?

Recession probability to an investor

When a market participant talks about the probability of recession, they are less likely to be referring to slower moving background factors and more likely to be referring to potential “causes” or “triggers” of the next recession. Indeed, every recession has its cause, and more often than not the cause is different from one cycle to the next.

Sometimes recessions are caused by the bursting of asset price bubbles (e.g., in housing or the stock market). Sometimes an inflation imbalance and the ensuing monetary tightening to cool it can cause a recession. Sometimes external supply-side shocks cause recession. The point is, investors are more concerned with identifying the trigger of the next recession, and precisely understanding the timing of it, as opposed to generalized statements about background risk contributing to a recession at some point in the next couple of years.

How does this all relate to market performance this year? 

When we understand the distinction between recession probabilities produced by economists versus by strategists/investors, we can start to wrap our heads around how risky assets have managed to perform so well this year even as economists continue to raise their recession odds.

Let’s take a look back. If the U.S. economy had slipped into recession over the last 12–18 months, it most likely would have been because of two separate shocks: Either the Fed would have raised rates much more than the economy could handle, or the trade war could have gotten out of hand (toward tariffs on consumer products, sanctions and/or boycotts, which could have resulted in lower stock prices and wider credit spreads irrespective of Fed policy).

Fast-forward to today: On both fronts, risks seem to have diminished. The Fed made a historical pivot and effectively eased financial conditions, and while the U.S.-China trade war is still very much alive, it is at least encouraging that it isn’t escalating seemingly uncontrollably, as it was earlier in the year.

To be sure, trade uncertainty is still very real, and we need to be hyper-focused on what happens to the December 15 deadline for additional tariffs on consumer products. But a more general point to be made is that it seems the Trump Administration is now aware that if the trade war is pushed too hard ahead of the 2020 elections, it could jeopardize the President’s chances for re-election. That’s an important safety valve.

For these reasons, it’s likely that recession probabilities to an investor have fallen this year, or are on the verge of falling, depending on the outcome of trade. In this context, it’s not terribly surprising that risky assets have had a great year.

It’s very difficult to be precise about the recession probability to an investor, but among the various estimates out there, we think that the macro team at Bloomberg does a good job incorporating more of the high-frequency and market data (while also downplaying the signal sent by the yield curve due to historically low term premia). Right now, its estimate of a U.S recession unfolding in the next 12 months is around 25%, down from close to 50% earlier in the year.

Line graph shows the probability of a recession in the next 12 months from 1992 through September 30, 2019, with periods of past recessions highlighted.

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