What causes recessions?

Predicting recessions is notoriously difficult. What are the causes?

The US economy has now grown for 106 months in a row. As the world’s largest economy, this has helped boost the profits and lift the share prices of companies across the globe. This is the second-longest run of uninterrupted US economic growth on record. The longest period without experiencing a month of falling growth was between 1991 and 2001 when the US economy grew for 120 consecutive months.

The start of the current run began after the recession that was caused by the global financial crisis in 2008. Since then, the global economy has picked up steadily. A recession is normally defined as two consecutive quarters (i.e. two-times three months) of declining economic growth, as measured by gross domestic product (GDP).

Falling economic growth tends to have a negative effect on company profits and share prices. So knowing when a recession is coming would, in theory, enable investors to sell assets before they suffer from a downturn in growth. Unfortunately, predicting recessions is notoriously difficult, but there are growing concerns that we might experience one in the coming months or years.

If nothing else, this is for the simple reason that things have been so good for so long. It is worth considering the reasons why the US and global economies have performed so well since 2008.

Economic stimulus

A major reason could be the good judgement of governments and central banks, such as the Bank of England and the US Federal Reserve which launched economic stimulus measures in the wake of the crisis in the form of “quantitative easing”. This involved buying government and corporate bonds that were being held by investors. The intention was that investors would then put this money to work in potentially more lucrative parts of the financial system, such as the stock market, thereby stimulating economic growth.

Although no one was sure whether this would work, with hindsight the measures seem to have induced a slow but steady recovery.

In addition, governments introduced new regulations to help prevent financial companies from repeating the mistakes that led to the crisis. This has helped renew confidence in the financial system, though there is a tendency for such good lessons to be forgotten all too soon.

However, there has also been an element of luck. The US hasn’t been hit by any unexpected shocks, such as property price crashes or oil price spikes, which contributed to recessions in the 1970s and 1980s.

As the US economy heads towards that all-time growth record in 2019, what could bring it back down to earth? And are we capable of predicting the end before it’s upon us?

Risks of interest rate rises

One of the biggest risks is rising interest rates. Central banks raise interest rates to help keep inflation under control. This makes it more expensive to borrow money, so businesses cut back on investment and consumers have less to spend. Demand for goods then slows and prices increase less quickly.

Rises in interest rates occurred in the three years preceding every US and UK recession during the past 58 years. This pattern follows the one laid out in many economic textbooks. In theory, the slowdown in activity, intended to slow inflation, often ends in recession.

So by considering how much interest rates are likely to rise and how quickly this could happen, we might be able to assess the likelihood of a recession.

Importance of inflation

As inflation tends to be the main concern for central banks when setting rates, looking at the prospects for rising inflation is a key interest rate indicator. Potential inflation can be assessed by looking at a number of factors, including surveys of firms’ price-setting behaviour and households’ inflation expectations. But this is not entirely sufficient.

We live in a world where inflation might have become more subdued for long-term reasons to do with “casualised” labour markets (e.g. zero-hours contracts) and an “Amazon effect” (the rise of e-commerce, making price comparisons easier), which have helped keep wages and prices low. So we need to monitor other aspects of economic behaviour as well.

We have therefore incorporated a number of other factors, including borrowing levels, mortgage payments and corporate profit growth into our analysis of recession risks. Our models suggest that there is currently little pressure from these factors, but this could change as we look to the future.

While our analysis suggests that there is a 66% chance that the next recession will strike between January 2020 and June 2023, there is a 95% chance that it could happen any time over the next seven years. However, such broad timescales are not particularly informative when it comes to making investment decisions.

Bond yields low

Fortunately, there are some other good indicators of recessions. We can also look at the yield provided by bonds. This approach had fallen out of favour, but recent research by the San Francisco Federal Reserve suggests that bond yields remain a strikingly accurate predictor. When investors are nervous they buy bonds that will provide a long period of guaranteed payments, often up to 30 years. As yields move in the opposite direction to bond prices, a sharp fall in the yields of these types of long-term bonds indicates that they are in high demand because investors are feeling particularly nervous.

Every US recession over the past 60 years has been preceded by a sharp fall in the yield of these long-dated bonds. At the moment, yields are low by historic standards (around 3%), but not low enough to show that a recession is likely. So for now, we do not think the US economy is heading for recession. Instead, we believe that there is a good chance of it setting a new record for uninterrupted growth in 2019. This is potentially good news for equities and one of the reasons that we currently prefer equities to bonds.

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