U.S. Recession Risk Risen, but Not at Critical Level
By Roubini EconoTeam
Recent data out of the U.S. have fueled a global surge in risk-off sentiment, but broadly speaking, these figures are consistent with our previous view that the economy is in a mid-cycle slowdown rather than headed toward recession.
Ironically, continued strength in the jobs numbers amid weak output data has added to recession concerns, not eased them, since the Fed continues to emphasize labor-market gains as grounds for continued rate increases. In our view, this worry oversimplifies the Fed’s decision-making process; the Fed is unlikely to raise rates further until both the economic data and signals from the financial market have improved.
Rebound From End-Of-Year Slump Not to Emerge in Q1
That turnaround may take a few months to materialize. Our current tracking for 2015 Q4 GDP growth lies just under 1% q/q annualized, which is well below the freshly minted Bloomberg consensus forecast of 1.6%, though some analysts predict flat growth or even a small contraction. Some early indicators for Q1, such as the New York Fed’s Empire State manufacturing survey, were also weak, reinforcing our view that a rebound from the end-of-year slump will not emerge in Q1.
Indeed, the Empire survey suggests the national ISM could slip to 47.5 in January from 48.2 in December. Given that 47.0 historically has been the level below which the economy has entered recession, it is no surprise investors have become so unnerved.
Adding to that worry is the fact that previous slumps of this magnitude usually prompt the Fed to cut rates—an option the Fed really does not have now, with rates just barely off the zero bound.
To be sure, most of the weakness in the recent data have come from the oil and traded-goods sectors. In contrast, the non-manufacturing ISM remains at a lofty 55.3 as of December, suggesting the non-traded sector is broadly doing well. However, experience suggests the non-traded sector is not completely immune to global forces and will slow with a lag. Indeed, the non-manufacturing ISM has dropped steadily since July and past ISM cycles suggest it will continue to ease through at least H1 2016.
As to the “official” recession indicators cited by the National Bureau of Economic Research’s business cycle dating committee, industrial production is the only one that has peaked. Even the decline in industrial production is narrowly based. Much of the most recent industrial production decline is the result of good weather pulling down utility use. Over the past year and a half or so, the minerals and mining sector has also been a drag, reflecting the slide in commodity prices.
Employment growth has been quite strong, ending 2015 with a surge. We think warm weather and a rebound in hiring after the Q3 slowdown drove Q4 hiring strength. After accounting for those distortions, the trend in hiring remains quite strong, though it is slowing gradually.
The vast majority of hiring has been in private services, while the source of weakness in U.S. output data has been mostly in the industrial sector, with the services side of the economy doing well. That pattern in employment and output growth makes sense, though it does imply a pretty slow pace of productivity growth. The worry is that the goods sector, which still leads turns in the economy, can eventually drag on service-sector growth, even though it is a smaller part of U.S. output now than in earlier periods and therefore may trigger less of a spill-over effect.
Financial Frictions Could Still Damage the Economy
While the data do not yet scream “impending recession” in our view, if the recent financial-market turmoil persists, the negative feedback loop into the economy could intensify. Given that growth is already extremely shallow, a sizable financial shock—particularly one that the Fed cannot counteract with a large dose of stimulus—could easily push the economy into recession.
The correction in the stock market and widening in credit spreads are already raising the cost of capital for firms. Banks, still skittish about preserving capital, would not take much prompting to pull back on credit availability. In addition, business investment in capital and labor is heavily driven by sentiment.
Our calculation suggest that a full 20% bear market correction in the equity market could prompt a 10 percentage-point (pp) cut in capex outlays in the current quarter and shave 0.6 pp off GDP growth. Job growth would also take a hit, slowing by 60,000 per month to around 175,000. Since job growth is virtually the only thing supporting household spending at present, personal consumption expenditure growth could slow by 0.5 pp and in turn take a further 0.3 pp off GDP growth.
Scenario Analysis: What Happens if Things Stay This Bad? (or Get Worse, or Recover)?
We have assessed the risk of recession based on three scenarios. Our base case is that the recent deterioration in both market conditions and economic performance dissipates over a period of a few months. The “negative case” assumes that recent market stresses persist but do not worsen, with a resulting deterioration in economic conditions. The “worst case” involves continued deterioration in both financial market conditions and economic performance.
Our analysis shows that, in the base case, the odds of recession remain above zero, but are quite low (13%). In the negative case, in which the recent rise in financial stress persists, recession risks rise to roughly even odds (55%). In the bear case, the odds of recession approach 100%.