Economic Commentary

Recession odds are rising

What is a recession?

There is a lot of talk about a recession in the financial press at the moment, but a recession can mean different things to different people. The most common definition is a period of declining economic activity in which there have been at least two consecutive quarters of negative growth in real gross domestic product (GDP). However, in the US, the National Bureau of Economic Research (NBER, a leading research organisation) defines a recession as “the period between a peak of economic activity and its subsequent trough”, which involves “a significant decline in economic activity that is spread across the economy and lasts more than a few months”¹.

The NBER approach takes into consideration a broad range of indicators, including measures of income, employment, household consumption and industrial production. In effect, there is generally a broad overlap between the two definitions when it comes to identifying recessions in the US. However, precise dating will vary and there are some exceptions. For example, the NBER declared a recession in 2001 after the bursting of the dotcom bubble, even though that year did not experience two consecutive quarters of negative GDP growth².

Is a recession looking likely?

A recession in several major developed economies is looking increasingly likely and some indicators suggest that the US could already be in a technical recession. The Atlanta Fed GDPNow tracker currently estimates that, based on monthly economic data releases, GDP in the second quarter will contract at an annualized rate of 1.5%, following an annualized decline of 1.6% in the first quarter³.

However, it is doubtful that the NBER criteria for a recession has been met just yet in the US. Inventory adjustments and net trade contributions have contributed to recent volatility in the GDP data, and gross domestic income (GDI, an alternative measure of economic activity based on all income sources) continued to expand during Q1⁴.

Significantly, the unemployment rate (3.6% in June⁵) has yet to tick significantly higher as is typically the case during recessions and the US economy created 2.7 million jobs during the first half of the year, including 372,000 in June⁶.

Looking forward, however, the combined impact of higher commodity/energy prices and tighter financial conditions suggests it will be difficult to avoid a recession in the US and Europe. Wage growth is generally failing to keep pace with multi-decade highs in inflation, with the result that real disposable incomes are falling for most workers. Unsurprisingly, consumer confidence has plummeted as a result, a development that has often preceded recessions⁷.

Business confidence is also deteriorating. According to the Conference Board (a research organisation), more than three quarters of global chief executive officers expect a recession in their primary region of business by the end of 2023⁸. Although companies in the service sector (e.g., hospitality, travel etc.) stand to benefit from post-pandemic pent-up demand, leading indicators in the manufacturing sector (such as the new orders/inventories balance) are flashing a recession signal⁹.

Against the backdrop of persistent price increases and elevated inflation expectations, there is a growing expectation that central banks will have to take monetary policy into restrictive territory and trigger a recession in order to restore price stability. In the US, interest rate hikes and hawkish forward guidance have resulted in higher government bond yields, wider spreads on corporate bonds and declines in equity markets this year. In turn, the US yield curve (the difference between long-term and short-term bond yields) has inverted¹⁰, a phenomenon that has heralded recessions in the past (see our commentary of April 2022).

Higher bond yields are translating into increased borrowing costs for households and business. By way of illustration, the US 30-yr mortgage rate has risen from around 3% at the start of the year to over 5.5%¹¹. As a result, several indicators of housing activity, including home sales¹², have turned down recently.

In continental Europe, it is the energy shock resulting from the war in Ukraine that poses the greatest recession risk. Amidst growing tensions between the west and Russia, there is concern that flows of Russian gas to Europe via the Nord Stream 1 pipeline will not resume after a scheduled closure for maintenance during July. With Russian gas accounting for around half of gas supply in Germany and around 40% in Italy¹³, a sharp contraction in economic activity is likely if President Putin turns off the taps. The Bundesbank estimates that cutting off Russian gas supply could reduce GDP in Germany by around 5%¹⁴. Given the knock-on effects and impact on supply chains, such disruption is likely to have a profound impact on activity in Europe. The European Commission reckons that if the next winter is cold and energy-saving measures are not taken, a halt to Russian gas supplies could reduce EU GDP by 1.5% .

How bad might the next recession be?

The recessions witnessed during the great financial crisis (GFC) of 2007-09 and the pandemic of 2020 were particularly severe (albeit relatively short-lived in the latter case). However, there are several reasons why the next recession might not be as bad. For a start, the finances of US households – a key driver of the US and global economy - are in pretty good shape. US households still hold around US$2.3 trillion of excess savings built up during the pandemic¹⁶. Although this savings pot is currently being whittled away by high inflation, it still provides a buffer against falling real wages. In addition, household debt to GDP ratio is considerably lower than prior to the GFC, at around 78% versus close to 100% in 2008¹⁷.

Moreover, with many households locking in lower long-term interest rates in recent years (the share of adjustable or variable rate mortgages is at a record low¹⁸), debt service payments currently account for around 10% of disposable income, compared with 13% prior to the GFC¹⁹. The fact that consumers do not currently appear overstretched raises hope that a sharp pullback in spending during the next recession will be avoided.

There is also arguably less scope for the property sector to have a deleterious impact on the broader economy. House prices have risen sharply during the last two years, but lending standards have improved markedly since the financial crisis²⁰. Moreover, the US market is currently characterized by undersupply, rather than the oversupply that preceded the GFC. Residential investment currently accounts for less than 5% of GDP compared with a level of nearly 7% during the mid-2000s²¹.

A healthier banking sector is another factor that might also limit the severity of the next recession. Banks on both sides of the Atlantic have bolstered capital buffers since the financial crisis and have passed rigorous ‘stress tests’ which gauge their ability to withstand severe economic and financial market conditions²²²³. In turn, a stronger banking system reduces the risk of a credit crunch which could exacerbate a future economic downturn. This said, following a long period of ultra-low interest rates, the combination higher borrowing costs and a weaker economy could lead to stress in other parts of the financial system.

A key determinant of the severity of the next recession will be the extent to which central banks need to dampen activity to rein in inflation. Former U.S. Treasury Secretary Larry Summers has argued that the US needs five years with the unemployment rate above 5%, or alternatively two years of 7.5% unemployment, in order to contain inflation²⁴. Such a prospect sounds scary. However, the truth is that nobody knows for sure the degree to which the economy will have to cool and unemployment to rise in order to bring inflation under control, let alone whether the monetary authorities will continue to prioritise taming inflation as the economy turns down.

The degree to which the Fed and other central banks maintain their inflation-fighting credibility is key in this regard; if inflation expectations become unanchored, the more the monetary authorities will have to bear down on growth to achieve price stability. Recent survey data showing a pull-back in US consumers’ long-term inflation expectations offer some reassurance in this regard²⁵.

There is little doubt that the global economy faces an uncertain and difficult outlook going forward. The combination of more aggressive monetary tightening and weakening leading indicators suggest a recession in the US and Europe will be difficult to avoid. Moreover, the fallout from the war in Ukraine remains a wildcard and poses downside risks. However, on the plus side, healthier finances on the part of the household and banking sectors, as well as enduring central bank credibility provide hope that the next downturn will be a relatively mild affair.

19th July 2022