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Are markets overestimating the risk of recession in the US? Probably yes

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Mr. Dhananjay Sinha

Head of Research, Economist & Strategist

04 Jan 2019

With the US treasury curve flattening to 20 bp spread after the last Fed rate hike to 2.5 per cent for Overnight-10 year yield, and latest data prints signalling weakness on the manufacturing side, markets are abuzz with a heightened perception that the US economy could be going into recession.

But, is there any real threat of a looming US recession? Probably not.

While many have scaled down growth estimates for 2019, with the expectation for a sharp deceleration in H2, most estimates for 2019 are above 2 per cent, i.e. above the estimated potential growth of 2 per cent. This cannot be considered recessionary.

Increased traction in expectations for a recession has added fuel to the view that the Fed might have tightened more than needed, which looks strange given that the real Fed rate is just 0.5 per cent, Fed balance sheet is still in excess of $4 trillion despite the small rundown over last year, and most financial condition indicators are at comfortable levels.

However, keeping aside market debates, the estimated probability of a US recession is far lesser. In fact, anxiety levels are far lower broadly. For instance, Google trend charts show worldwide searches on US recession were much higher in 2004 when the Fed decided to lift off from the earlier low of 1 per cent. The estimated probability of a recession went to a high of 11 per cent in September 2005, as per the Fed estimates. But, in retrospect, we know that it was a false signal.

While the 2008 GFC was indeed characterized by higher probability of a recession (100 per cent) and coincidental high global anxiety seen in Google searches (100 per cent), there have been several occasions after 2008 when markets were worried about perceived recessions. For example, amid the PIIGS crisis in 2011, after Bernanke announcing Fed tapering in May 2013, and during the decline in crude prices in 2014-16.

In the current scenario, the market perception of a recession is fuelled by a host of factors, including the fading impact of fiscal stimulus in 2019, trade conflicts with China and the Fed rate normalisation. These perceptions are also fed by concerns about the late cycle syndrome.

Ironically, while there is certainly a possibility of some growth softening in the US, persistent tightness in US labour market (now also visible in Europe and emerging in Japan), positive output gap, narrowing spare capacity and strong household conditions indicate that the situation is far from the conditions that forebode a recession. On the contrary, the decline in crude prices can boost household consumption by enhancing real income. Note that during 2014-15, real personal consumption growth had improved to 3-4 per cent following a decline in fuel prices.

Hence, the perception in the financial markets of a looming US recession is in sharp contrast with the low anxiety in the wider economy or the estimated probability of 0.13 per cent, on average, during 2018.

In our view, there is a fair chance that markets (and also Trump) may be considerably overstating the recessionary concerns to push the Fed into abandoning its normalisation path and turn dovish. As of now, it appears that the Fed is not playing ball with either of them.