Recession warnings are all the rage these days – being a bear is some semblance of fashionable again.
The list of factors contributing to market angst is long, but the threat of a downturn in global growth catalyzed and/or exacerbated by worsening trade frictions undoubtedly occupies the top slot.
Indeed, the latest edition of BofAML’s Global Fund Manager survey shows “trade war” took the top slot in the “biggest tail risk category” for July, and by a wide margin:
Trade tensions dominated the discussion at the G-20 meeting in Buenos Aires over the weekend and it certainly feels as though policymakers have become to a certain extent apathetic. It’s almost as if everyone has simply resigned themselves to another two years of bombastic rhetoric and protectionist policies from the Trump administration.
The official G-20 statement echoed the concerns of IMF Managing Director Christine Lagarde, who has variously warned that global growth may have peaked and that trade frictions threaten to exacerbate any subsequent deceleration.
All of this comes as the Fed is being forced to hike more aggressively than they otherwise might – a hawkish lean that comes courtesy of the Trump administration’s ill-advised decision to pile fiscal stimulus atop a late-cycle dynamic. Tariffs only increase the risk of a sudden acceleration in domestic prices.
Recent steepening notwithstanding, the relentless flattening of the U.S. curve is foreboding. Earlier this month, Goldman put the probability of recession at under 10% over the next year and just over 20% over the next two years. But that doesn’t mean they’re particularly sanguine, especially when it comes to the risk of financial contagion in a world where markets are just as interconnected as the global supply chains the Trump administration is so desperate to disrupt.
BNP went so far last week as to assess the odds of a trade war causing a global depression.
This is of course the second-longest expansion in U.S. history, but as Credit Suisse’s James Sweeney wrote earlier this month (in a note that took a look at the health of corporate balance sheets), two things you shouldn’t do if you’re interested in forecasting the next recession are: “1) Count the months since the last recession, 2) Observe postwar recessions and write down what patterns emerge just prior to most recessions”.
So what should one look at? Well, BofAML is glad you asked and they’re out on Monday with something called “Fantastic recession indicators and where to find them”.
The bank begins with the obvious (the 2s10s) and notes that “the rising cost of money has also started to add some pressure on lower US credit quality issuers, an early recession indicator.”
Having dispensed with the obligatory curve nod, the bank goes on to flag trade frictions and crude shocks.
The ongoing tit-for-tat tariff escalation creates risks to global trade, also an early recession indicator. Moreover, spikes in crude oil prices have historically been followed by both US and global recessions, another major macro risk given the upcoming Iran oil export sanctions.
Not surprisingly, BofAML finds that the odds of a recession in the U.S. are low, consistent with strong U.S. payrolls.
On our estimates, a multivariate logit framework currently places just a 10% US recession risk over the next 12 months. After all, the US yield curve has not inverted yet. Also, we find that the most significant predictor of a US recession is actually non-farm payrolls, followed by the UST yield curve.
They go on to write that if it’s recessions you seek (to predict), then single-variable analysis isn’t nearly as useful as their proprietary Global Financial Stress Indicator, which aggregates all kinds of signals from cross-asset volatility, credit spreads and the evolution of the cost of money, to paint a more comprehensive picture.
Investors shouldn’t place too much emphasis on purportedly prescient downturn alerts like copper and leading indicators, which the bank notes “do not show significance in our multivariate logit regression framework and only carry a loose connection to US recessions”.
But at the end of the day, it might all come back to one very simple thing: debt.
“According to academic literature, indebtedness levels and changes are crucial recession indicators”, BofAML writes, adding that there’s good news and bad news on that front.
The good news, according to the bank, is that “the debt cycle in the US and Germany seems to be heading into an expansion mode” as measured by the credit-to-GDP gap. Here’s the bad news:
Worryingly, the credit to GDP gap is now falling rapidly in China after a huge period of growth in the past 10 years. As we have previously highlighted, most of the increase in Emerging Market Debt in the past 10 years has come from China. But even the Eurozone feels vulnerable, particularly Italy, to the pressures arising from falling credit given its extremely bloated public sector debt.
It’s always the same story: what happens if and when the Chinese credit impulse rolls over?
Here’s hoping it is, as Ray Dalio would call it, “a beautiful deleveraging”.