Just days ago Citi pronounced, [6] much to the chagrin of the status-quo-hugging Fed faithful, that given the turn in corporate profits (and concerns over margin sustainability) that the chance of a recession in the US had risen to 65% (and on that basis had a bearish outlook for US equities). Now, as other major sell-side shops jump on the equity un-bullish narrative, JPMorgan's Michael Feroli warns that in the past, a low unemployment rate, rising compensation, falling margins, and elevated durables investment have historically signaled an elevated risk that an expansion is nearing its end... and puts the probability of a US recession within 3 years at 76%. Of course, you do not need to worry, because Janet Yellen said this is not true (though failed to provide here reasoning).
As Citi recently noted [6] the cumulative probability of a recession in the next year rises to 65%.
In the US our chief concern is margin sustainability. Corporate profits as a share of GDP have been at all-time highs, which is just another way of saying the rewards to labour have been at all-time lows. But change may be afoot in the form of modest labour market tightening in the US.
[7]
It is too soon to see this show up in core (ex Fins, Energy and Materials) margins in the US but that may be where things go. Modest nominal wage acceleration combined with global disinflation (price taking by US firms) and lack of productivity growth may mean margins come under pressure from labour costs.
And now, JPMorgan's Mike Feroli raises a red flag warning that:
Our longer-run indicators, however, continue to suggest an elevated risk that the expansion is nearing its end, and our preferred model now puts the probability of recession within three years at an eye-catching 76%.
As he details...
We recently developed two sets of models for assessing the risk that the next recession will start within given horizons. One was focused on high-frequency indicators and aimed to measure the probability of a recession starting within six months. The other aimed to capture longer-run cycle indicators that suggest an elevated background risk of the expansion ending within horizons of one to five years.
Table 1 updates our models’ assessments of the probability of recession beginning within six months from our recent note. When we first wrote, only manufacturing sentiment was signaling an above-average probability of imminent recession. But recent weakening in the Richmond Fed services survey and the ISM nonmanufacturing index have now pushed the nonmanufacturing sentiment probability up somewhat as well. Nonetheless, estimates that combine signals from multiple indicators continue to predict little overall recession risk, and we conclude that the chance of a recession beginning within sixmonths is 5% or less.
[8]
In our work on longer-term risks, we found that a low unemployment rate, rising compensation, falling margins, and elevated durables investment have historically signaled an elevated risk that an expansion is nearing its end.
Figure 8 shows that probabilities of recession within 1, 2, and 3 years predicted by models based on these four variables have recently moved up to 23%, 48%, and 76%, respectively.
[9]
Although all four variables have moved in the direction of increased risk in recent years, the particularly sharp moves in predicted recession probabilities since mid-2014 have been driven most prominently by our measure of the decline in margins (which we define as the decline in the 4-quarter moving average of nonfinancial corporate net operating surplus as a percent of net value added, as a fraction of its peak in the current expansion). Figure 9 shows the history of this variable over the postwar sample period. Indeed, on most (but not all) of the occasions when this variable fell to its current level, a recession began within a few years. Although continued expansion remains our baseline forecast, we will more carefully investigate the risks of recession emanating from the corporate sector.
[10]
* * *
So first Citi, and now JPMorgan warn that there is a significant and growing chance that the US economy contracts next year? According to Janet Yellen, who was asked precisely this question during her hearing in Congress today, there is no risk: according to her, she doesn't see the recession risk as "anything close" to 65%. She did not provide a number which she thought is more appropriate.
She also said that the FOMC would only raise rates as long as policy makers think U.S. will "enjoy at least some above-trend growth" that would result in improving labor market..
Her conclusion: if the rate hike results in "unintended consequences" the Fed can always just lower rates. Which incidentally is precisely what the Fed did in last 1936 when it, too, erroneously decided the economy was strong enough to sustain a tightening of financial conditions...
[11]
... only to cut immediately. The collateral damage? The Dow Jones plunged 50% the next year...
[12]
... and unleashed a severe recession in the second half of 1937, followed a few year later by the start of World War II.
This time is not different.
