In our broad discussion about the inevitable turning of the credit cycle yesterday, we noted that the current expansion is now the second longest in US history and will become the longest if it survives another year, even as investor concerns grow that 2020 is the year when the next recession finally hits, with some starting to take proactive measures.
Still, according to some the recession risk remains somewhat overstated. Take for example, Goldman, whose recession model, which uses economic and financial data from 20 advanced economies to estimate recession odds, puts the probability of recession at under 10% over the next year and just over 20% over the next two years, below the historical average, while the bank's recession risk dashboard — a collection of the most valuable leading indicators drawn from our research and academic studies—also continues to send a comforting message.
And yet, even Goldman admits that its rosy outlook on the US economic future is starting to look somewhat shaky, noting that while the bank does not "see recession as the most likely outcome" it cautions that "by 2020 we expect growth to have dropped off sharply from its current 4%+ pace to a level somewhat below our 1.75% estimate of long-run potential growth" and gives three key reasons behind the slowdown in growth forecasts:
Fiscal growth impulse set to fade: according to Goldman economists, the boost from Trump's fiscal policy is set to diminish from +0.7pp in 2018 and +0.6pp in 2019 to a slightly negative contribution in 2020, "a passive tightening that
would become more likely if the Democrats take the House of Representatives in the midterm elections."
Tightening in financial conditions: while so far financial conditions have remained remarkably loose, Goldman expects that the recent tightening in financial conditions "should begin to slow growth later this year and through 2019, and the additional rate hikes we expect that are not yet reflected in market pricing would imply further tightening that would slow growth into 2020. These first two factors are worth a total of roughly -¼pp in 2020" as shown in the chart below.
Labor market constraints: the third key negative factor is that the natural deceleration from tighter supply constraints as the labor market moves further beyond full employment is worth another -¼pp to GDP.
Taken together, these effects suggest a growth rate roughly ½pp below potential, resulting in Goldman's 1.25% 2020 GDP forecast as shown in the chart below.
Needless to say, but Goldman does so anyway, the lower potential projected growth implies higher recession risk under the definition of negative growth, and clearly a sub-potential 1.25% growth baseline in 2020 provides even less room for error, which leads Goldman to admit that the odds of a recession, if only on paper, have risen substantially starting some time in 2020:
Historical consensus growth forecast errors a bit more than a year ahead suggest a roughly 25% probability of a 1.25pp downside miss. This implies that a recession, at least a technical one, is much more likely in 2020 than over the next year, but not the base case.
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Goldman then touches on two additional topics that have gained prominence in recent months as potential recession catalysts, namely trade war and foreign spillovers, in an attempt to downplay the potential impact from each.
Addressing the trade war risk, Goldman notes that whereas as much as an additional $200BN in additional China tariffs may be implemented, the bank does not expect further tariff rounds, "implying that the trade war will only amount to a 1.5% increase in the effective US tariff rate" and adds that "the limited decline of our China-exposed US equity basket—down 6% relative to the broader market since its May peak—suggests the market largely agrees." As further evidence that trade war will have a limited impact on the US economy, Goldman notes "little evidence that the trade war has hurt US growth so far. The most trade-dependent sectors have not underperformed, and business sentiment surveys
show only modest concern."
As a tangent, Goldman also looks at the overall Economic Policy Uncertainty Index, which while still subdued, the same can not be said for its trade policy component—which is quite elevated. However, here the bank notes that in the one previous episode in which the trade policy uncertainty index truly spiked, during the NAFTA negotiations in the early 1990s, investment in factories dropped off temporarily, but overall investment was not unusually low. Here it is worth noting that Goldman discounts the potential impact of Smoot-Hawley - an example of a major trade war - on the Great Depression, although it does admit that "tariff-related fears appear to have contributed to the stock market decline."
What about the risk of "foreign spillovers", which is just another way of calling emerging market contagion, or - better yet - "importing a recession". Here too, Goldman is dismissive, noting that it sees "little risk so far: our global CAIs show that growth remains above potential in most of the world, and we remain cautiously optimistic on emerging markets. Historically the US has been fairly immune to foreign spillovers. According to our analysis of the historical causes of US recessions, it has been about a century since the US last “imported” a recession via weak global demand or financial contagion."
Yet even here, Goldman concedes that the bigger risk than a mere EM economic slowdown, is contagion via financial channels, pointing to research that global equity markets in particular have become more synchronized in recent decades, largely due to co-movement of risk premiums.
The surprisingly strong reaction of the US equity market to growth fears in China in late 2015 and early 2016 offered a reminder of this trend.
How would this look in practice? Goldman's sensitivity analysts shown below lays out how a foreign slowdown coupled with a US equity market sell-off might affect US growth. And while Goldman's estimates show that importing a recession would need to involve a significant equity market correction - something to the tune of a 30% drop in EM markets coupled with a 2.5% drop in EM GDP to slice off 2% in US GDP - it cautions that with its baseline for growth at 1.25-1.5% over the next couple years, "it would not take an extreme combination of events to knock the US economy into at least a technical recession." Incidentally, the bank also notes that its rule of thumb is that a 10% decline in the US equity market reduces GDP growth by about 0.5%.
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So if the seeds of the next recession aren't planted abroad - assuming, of course, that China's economy doesn't careen into the abyss, dragging down the rest of the EM world with it and snuffs out the world's credit-fueled growth dynamo, a clear risk in light of the record drop in China's shadow loan creation as discussed previously...
... what are the major recessionary risks, in Goldman's view.
The answer: there are two, both of which are completely home-grown, and are a function of the Fed's policies: the textbook "recession from overheating" and what Fed Chairman Powell has called the “financial excess” variety.
In regards to the potential of the US economy overheating, Goldman writes that "overheating recessions have occurred historically when the economy moved past potential, a tight labor market boosted wage growth, and elevated demand caused energy and other commodity prices to spike, leading to accelerating inflation and an aggressive tightening response by the Fed." And while Goldman says that it wouldn’t downplay this risk too much - "after all, we expect the unemployment rate to fall to its lowest level since the Korean War next year" - it notes that overheating risk is straightforward to monitor and looks limited for now.
Meanwhile, as based on the Fed's own imprecise metrics, core inflation remains below target, as does labor cost growth, and both household inflation expectations and market-implied inflation compensation are below average, "but going forward, both a historically tight labor market and the trade war pose upside inflation risks."
Which brings us to the final topic covered by Goldman: a good, old asset bubble - such as the one observed in both stocks and bonds on the back of some $20 trillion in central bank liquidity - bursting? Here Goldman includes recessions caused by both boom-bust cycles in asset markets "as well as their real economy analogue, cycles of unsustainable debt growth to finance investment and consumption followed by protracted deleveraging." (for a tangential discussion, see The "Only Question That Matters: "Is The Credit Cycle About To Crack" - Here Is The Answer")
Not surprisingly, Goldman is complacent here as well, writing that its financial excess monitor tracks both elevated valuations and risk appetite in asset markets, as well as financial imbalances and vulnerabilities in the household, business, banking, and government sectors, whose combined resulted are shown as a heat map in which blue indicates restraint and red indicates elevated risk.
The main reason for Goldman's lack of concern is that the four main zones of risk which were flashing red in 2007, namely the housing and commercial real estate markets, as well as household and financial business debt, are seemingly far more subdued now than they were in 2007. Of course, the main trigger for this is the lack of high interest, which in turn is a function of emergency monetary policy and bloated central bank balance sheets, but for some odd reason, this did not make Goldman's risk heatmap.
Which brings us to Goldman's conclusion, which is in two parts. The first one, predictably is the optimistic one, and where Goldman suggests that fears of a recession in 2 years may be overblown:
The expansion is now just a year away from becoming the longest in US history. The good news is that age alone has not been a great predictor of recession risk, and that in any case the age of this expansion looks much less extreme when compared to the broader set of post-war developed market business cycles. In addition, we have some important advantages today, including both a lack of financial imbalances and monetary policymakers who have benefited from the lessons of past cycles.
So what's the bad news? Well, as Goldman warned up top, after the current sugar high to US economy fades, GDP in two years is set to slide substantially, dropping as low as 1.25%. Furthermore the output gap and especially the unemployment rate have been very strong predictors of how soon US expansions will end,
With job creation still running at double the breakeven pace, the unemployment rate—already ½pp below our estimate of the sustainable rate—is likely to fall significantly further."
This is a major problem for the Fed, which is already facing a record low, 4% unemployment, because for the expansion to continue "for many years", the Fed will first need to stabilize the unemployment rate and "eventually to nudge it somewhat higher without setting off a recession."
And here is the biggest risk according to the bank's economists: to avoid a recession will :
This is certainly possible in principle, but it is something that the Fed has never achieved before and in fact that few advanced economy central banks have achieved. The further the overshoot extends, the longer the economy will have to operate somewhat below potential to return to a sustainable place.
This, to Goldman, "implies an increasingly narrow runway for a soft landing", which coupled with an identical outlook facing the slowing Chinese economy, puts the odds of a near-term recession far higher than the S&P500, which closed above 2,800, would suggest.