The Next Recession Could Happen Sooner Than We Think
We are seeing the longest Standard & Poor’s (“S&P”) 500 equity market rally on record and key recession indicators suggest at least another two years of economic growth. But geopolitical risk is rising. Today, the International Monetary Fund cut its global growth forecasts, citing trade tensions. Could the next recession happen sooner than we think?
Right now, investors are shrugging off potential trade disruptions and the risk of an oil surge. Despite these significant geopolitical threats, such as when President Trump recently announced tariffs on an additional US$200 billion of Chinese products and warned he may extend to all, the S&P barely blinked.
We expect the U.S. to continue ramping up pressure on China and Iran, making for a tough 2019. If investors continue to ignore these geopolitical risks, that could lead to a fundamental miscalculation in predicting the next downturn.
How To Predict The Next Recession
Equity markets have historically struggled to reliably signal recessions. Over the last 80 years, in the final two years of a bull run, the S&P 500 has delivered an annual median return of 21%, or a cumulative 45%. In fact, the minimum cumulative return has been 30%. And the last year doesn’t end with a whimper: its minimum return has been 11%, with a median return of 21%. This late-cycle momentum explains why most investors stick with equities, even as economic fundamentals start to weaken.
So instead of relying on equity market signals, we use three other indicators that have shown impressive power in predicting recessions. When these indicators simultaneously show stress, they signaled the last seven recessions with an average lead time of five to six months. They seek to integrate the interplay of the business cycle, market dynamics and monetary policy.
First, changes in the Conference Board’s Leading Economic Index (“LEI”) captures the pulse of the business cycle, and has been a strong indicator of economic health. Second, the shrinking spread between the 10-year and the 3-month Treasury rate, particularly when it turns negative or inverts, has been an enduring market indicator in forecasting recessions.
Finally, tracking how far the Federal Reserve of the United States (“Fed”) Funds rate is above or below the neutral rate (the rate assumed to keep the economy at its optimal growth rate) is an important indicator of Fed policy. If the Fed Funds rate exceeds neutral, then this restrictive stance will likely slow growth and eventually trigger a recession. When rates are below neutral, the economy typically has room to expand.
Given the current levels of LEI, the yield curve slope and the Fed stance, it looks like the next recession won’t hit until well into 2020. But divining recessions is difficult and investors shouldn’t ignore that geopolitical tensions could derail economic growth sooner than expected.
Don’t Ignore The Geopolitical Risks
Economies are vulnerable to negative exogenous shocks, as they tend to amplify any emerging domestic weakness. Currently, potential trade disruptions and the risk of an oil surge are significant geopolitical threats that markets are shrugging off.
The U.S. trade dispute with China will continue to escalate. This may force China to move beyond tariff retaliation, as it has fewer imports to target. To match U.S. trade blows, it may choose to enact penalties on U.S. companies operating in China, boycott U.S. products, or withhold essential products like rare earth minerals that could disrupt production in a wide range of industries. As tariffs grow so does the risk of inflation, which may force the Fed to raise rates quicker than anticipated to cool its effects.
The U.S. standoff with Iran over its nuclear program is another percolating geopolitical risk. If the U.S. succeeds in keeping Iranian oil off the market, Iran could retaliate by disrupting Iraqi supply or interfering in regional shipping lanes. This would push oil prices up which in turn punish the U.S. and the world with higher gas prices. A combination of a restrictive Fed and surging oil prices could swiftly usher in a recession.
Knowing the unknown
Markets worry about recessions and for good reason. As growth falters towards the end of an economic expansion, fissures develop and market stress picks up. As recessions hit, most risky assets and in particular equities, significantly underperform.
The challenge with forecasting the timing and intensity of geopolitical impacts is that, unlike economic data, which typically has a reasonable path and trajectory, geopolitical events are driven more by power dynamics. This can lead to serious miscalculations, as each side can become entrenched in an unyielding position to burnish national pride.
For instance, the U.S. could easily overplay its hand, confident that “maximum pressure” worked in renegotiating the North American Free Trade Agreement (“NAFTA”) and in mitigating North Korea’s belligerence. But China is not NAFTA and Iran is not North Korea. Neither is likely to quickly concede to U.S. demands and both have enough leverage to strategically counterpunch and shock U.S. growth.
The rise of populism, less support for free trade and demands for closed borders is upending the post-WWII structure. As nationalism rises so does geopolitical uncertainty. The next recession could be triggered by this new abrasion and may happen sooner than we think.