The art of calculating the odds of a double dip
Hopes for a "V-shaped" US recovery have given way to fears of a ‘double dip’ as US growth has lurched from 5% at the end of last year to just 1.6% in the latest quarter. We’ve looked at the leading indicators that have historically had the most success in predicting future recessions, and our analysis suggests a current 30% probability that the US economy dips back into recession. However, these quantitative models cannot capture policy changes, which could significantly alter the probability in either direction by either by becoming more expansionary or more restrictive in the coming months. We believe a return to recession will ultimately be avoided, but markets will continue to price it in as a significant threat.
Our analysis of a wide range of leading indicators found that the ECRI and the Conference Board leading indicators conveyed the most valuable information about the future growth of US GDP. For example, they both turned positive in April 2009, about two quarters before the US economy started recovering, but one month after the trough in the S&P 500.
So what probability of a new recession in six months time are these leading indicators currently suggesting? We define a recession as two quarters of negative GDP growth and use a series of models to analyse these indicators and capture the probability of a double dip in six months time. The indices signal significantly different probability of a recession by the end of the year. The ECRI, which recently fell significantly, points to around a 30% chance, while the Conference Board to less than 10%. To reconcile this discrepancy we look more closely at the constituents of the Conference Board leading indicator, as no information on the calculation of the ECRI is provided.
The Conference Board index is a composite of 10 macroeconomic indicators, one of which is the difference between the yield on US 10-year Treasuries and the Federal Reserve’s Fed Funds rate for overnight lending between banks. Research has shown that this indicator has been a very good predictor of future recessions; a downward slopping curve, whereby longer-term rates are lower than short-term rates, usually indicates an upcoming economic slowdown. Indeed, many analysts argue that the current very steep upward slope of the yield curve indicates an almost zero probability of recession in the following months.
We believe this is an invalid argument. The Fed has cut its target rate to an historically low level and used a series of unconventional measures to ease monetary policy further. This has kept the yield curve artificially steep and obscured its value as an economic indicator. Considering that there will probably be no rate hikes for the foreseeable future, in order for the yield curve to invert and predict a recession, 10–year Treasury yields would have to fall to an extremely low level that could only be justified if we were already in a deep depression.
Excluding the impact from the yield curve sub-component, the re-calculated Conference Board indicator suggests a 30% probability of the US economy going back into recession in the next 6 months, very close to what the ECRI predicts.
Economic theory also suggests that the yield curve may be irrelevant at the moment in determining the future path of the US recovery. A modern capitalist economy has three main participants; the government, households or private consumers and private corporations. In the past, the correction of large imbalances in the private sector preceded an economic recession. For example, before the 2001 recession corporations had invested heavily in new equipment using their cash reserves. When rates and cost of capital started increasing in 1999 they had to correct this over-capacity, putting downward pressure on growth. This "deleveraging" process usually finishes when debt comes back to "normal" levels and companies start spending again to support new expansion.
A steep yield curve is generally accommodative for corporations, as they can borrow more cheaply at the short end of the curve to finance their investment plans. However, currently US corporations have accumulated record high cash reserves and do not need to borrow to finance their expansion. Expensive cost of capital is not the reason that capex expenditure is currently low. Therefore, a steep yield curve will probably not trigger the usual resumption of investments that supports a strong recovery.
Parallel to the above, a steep yield curve has historically been very beneficial for the banking sector. Banks tend to finance their operations with short-term debt and invest in longer-term assets. We should therefore expect banks to report strong earnings, supporting the US recovery. However, the opposite was the case with investment banking profits declining in the last quarter. The reason is that deleveraging is a much stronger force. This time, banks have accumulated a large amount of assets – e.g. real estate – and are now in the process of disposing them, sometimes at sale prices lower than the initial cost. As this deleveraging process continues, banking profits are expected to be below historical norms.
Like banks, households were heavily exposed to falling house prices and have historically high debt burdens. The downward trend in savings that started in the 70’s was abruptly reversed by the 2008 recession. Private consumers, comprising 70% of the economy, increased their ratio of savings to income from 2% in 2007 to around 6% currently. The trend seems to have stabilised, but the higher level of savings, which translates to lower consumption, will be a drag on the economy in the coming quarters.
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