2 reasons why recession fears are unjustified

In the latest instalment of Simply Put, where we make macro calls with a multi-asset perspective, we defy market fears of a recession.

 

Need to know Markets are fearful that central-bank hawkishness could trigger a recession. But history shows that short recessions are not typically followed by short expansions. Costs and long-term interest rates remain remain low, indicating that this cycle has longer to run.

 

 

Market fears

In recent weeks, markets have started to anticipate that the current cycle may end sooner rather than later. The combination of higher inflation, wage increases, supply-chain issues and hawkishness among central banks have made investors apprehensive. For two reasons, we think these concerns are overblown.

 

Reason #1: the expansion-recession mismatch

First, markets are assuming that short expansions lead to short recessions. Yet history shows that no such relationship exists. Figure 1 shows that in the US, long recessions are usually followed by shorter periods of expansion. Indeed, an economy enduring a long period of hardship will find it difficult to bounce back and create a sustained expansion. High unemployment, low volumes of investment and sub-par production over a number of years are hard to turn around. On the other hand, short recessions are shown to yield to expansions of variable durations.

With this in mind, we believe current market fears are misplaced. During the covid-19 shock, unemployment surged but was reined in quickly as vaccination campaigns brought the virus under some control. The recession was also short due to immense fiscal and monetary stimulus. Such short recessions tend to be a bump in the road of economic growth, whereas recoveries from longer recessions can be more of an uphill battle.

 

FIG. 1. US economic expansion duration as a function of recession duration

 

 

Source: Bloomberg, LOIM as at November 2021.

 

Reason #2: costs and long rates are low

Second, interest rates often rise significantly before a cycle turns downward. Figure 2 shows US long-term growth, a proxy for economic gain, and the US 10-year real rate, a proxy for economic cost. In the past, when gains and costs have converged, a recession has followed. In other words, when costs become greater, the economy slows to the point of contraction.

This happened in 2001, when the dotcom bubble burst, and in 2008 before to the Global Financial Crisis broke out. In both instances, investment declined as the economic reward became less than the funding cost. Currently, costs are close to their lowest ever level while gains remain solid and are being supported by the extraordinary consumption growth that we expect will continue to develop in the coming quarters.

Taking this into account, real rates would need to increase by a large margin before recession fears gain real credibility, in our view. At present, only short rates are rising, and companies and households do not fund their investments with short rates. It is only when long-term rates rise that we should really start to worry that the expansion is ending.

 

FIG. 2. US 10-year real rate versus real potential output growth

 

 

Source: Bloomberg, LOIM as at November 2021.

 

Healthy economies attract hawks

Finally, it is worth remembering that tighter monetary policy is first and foremost a positive economic signal. If a central bank decides to taper its quantitative easing programme and raise rates, it believes the economy is solid. Unemployment is currently low, inflation should start normalising in 2022 as supply-chain disruptions ease, and companies are posting strong earnings. In our view, developed economies are well positioned to withstand rate hikes without blinking – and they actually need this to happen for expansion to prosper.

Simply put, because short recessions are not typically followed by short expansions, and long-term rates would need to rise substantially to signal a likely downturn, we believe recession fears are unfounded.

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