On Monday, Goldman was the first bank to go ahead and hike its recession odds for the US from 30% to 40% (needless to say assigning probabilities to a non-linear outcome is utterly ridiculous but we'll play along), additionally saying that both France and Germany will enter a recession shortly. Promptly, Wall Street followed. Yet despite the glaringly obvious, still nobody dares to assign a majority probability to a recession in America. Until today. French bank SocGen is once again the trailblazer in telling the truth, with its economics team being the first to make the bold (for a bank) claim that America now has not only a majority, but a two thirds chance of recession. To wit: "the recent financial shock, if it continues, is already large enough to derail the cycle prematurely. Our financial conditions index is at a tipping point and, all else equal, suggest 65% probability that the economy will enter recession in the next 12 months" (and to all those who point to record corporate profitability as the strawman which will never allow the US to enter a recession, SocGen has this response: "the recession that began in December of 2007 occurred in the face of very strong corporate profitability.").
In an effort to capture the ‘new normal’ in our recession variables tied to consumer leverage. Even so, the models continue to point to low recession odds over the next year. Simply put, this cycle is too young to die a natural death. This does not mean that a recession cannot happen, but it is unlikely to originate organically within the US private sector. A recession needs a trigger. Unfortunately, the recent financial shock, if it continues, may already be large enough to derail the cycle prematurely.
Financial conditions are already at mild recession levels. Our financial conditions index (FCI), which is constructed to have a mean of zero and a standard deviation of one, now stands at -2.25 which is a new cyclical low. With the exception of 1998, shocks of this magnitude put the US economy in recession with a relatively short lead. 1998 was the exception, but that shock occurred in the context of robust economic growth which provided a strong buffer. Needless to say, there is no buffer in place today. Converting the FCI into a recession probability using the probit model suggests 65% probability of recession in the next 12 months. This is a significant risk to our stall-speed scenario. With no improvement in conditions in the next month, we may be forced to revise our forecasts down further.
It is important to note that next year’s outlook is also highly sensitive to the fiscal situation. At the moment, we assume no new stimulus beyond extending payroll tax cuts and emergency unemployment benefits. Failing to agree on these measures would almost certainly put the US in a recession; however there is also the possibility that we may see stimulus if President Obama manages to push through at least a portion of his jobs plan. We will continue to monitor fiscal developments in the next two months and adjust our forecasts accordingly.
And on that note: short squeeze on.