By Ian Woodcock
A recession in the US is not thought to be imminent, but economic analysts have recently suggested that a downturn for the world’s largest economy could occur in the next couple of years.
While recessions are notoriously difficult to predict, it is worthwhile for investors to consider the prospect of a downturn before the end of the decade.
The current economic cycle is almost 100 months old and the third longest on record, suggesting that a change may not be too far away.
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Other countries have seen much longer stretches of uninterrupted growth; Australia has not had a recession since 1991 so time is not necessarily the best indicator. The recent economic expansion seems to have used up much of the spare capacity generated by the global financial crisis, and if it can continue for the next year or two, it would be the longest on record. However all expansions eventually come to an end, and the expected rise in interest rates over the next few years will likely push the US economy into a mild recession before the decade is out.
The recent shift by the Federal Reserve to tighten monetary policy could provide one signal that a recession is due. While a number of factors contribute to a recession, the catalyst for every downturn over the past four decades has been increase in real interest rates to 2% or more, leading to sharp declines in investment and durable goods consumption, which in turn triggered the start of economic downturns.
It therefore stands to reason that this pattern will be repeated in the coming years.
So far the Fed has raised interest rates only four times during the current ‘cycle’ and in real terms, rates are still negative. But the neutral level of rates is lower now, meaning that the 150bp of rate hikes forecasted over the next two years may well be enough to generate a recession.
The Fed, under current chair Janet Yellen, has become more hawkish as it prepares to exit the post-financial crisis policies that helped support the economy as the financial system faced collapse. However, with inflation thought to be on the rise pressure to increase rates has increased. The last US recession between 2007-2009 lasted 18 months and saw a 4.2% decline in GDP, while 8.7 million jobs were lost as the global financial crisis posed one of the biggest challenges for the global economy since the 1929 Wall Street Crash. The average post-war US recession has lasted around a year, with GDP shrinking by more than 2% and employment dropping by 2.5 million.
Debt burdens have not risen markedly, house prices as a ratio of earnings or rents are in line with historical averages, and there are few signs of excess investment in the economy, so many economists believe any potential recession would be relatively mild. A potential vulnerability is the equity market, which appears to be overvalued on a number of metrics, but it would take a big fall in equity prices to deliver a meaningful hit to household wealth or investor confidence.
US equity valuations have been a source of concern with the S&P 500 index trading at higher valuations and the effects of the so-called ‘Trump bump’ following last year’s presidential election continue to be felt.
One of the biggest differences from past recessions, however, is the lack of room that the Fed has to loosen policy. If a recession hit before the Fed had a chance to rebuild its policy arsenal, there’s a significant risk that policy would end up stuck at the effective lower bound again. This would mean a longer period of weaker growth and inflation, along with an increased risk of asset price bubbles.
But there appears to be a silver lining, with key economists predicting that by 2019 the Fed should have the scope to counteract a mild recession. So in those circumstances, there would be every reason to expect damage from the next recession to be short lived, with patterns reversed fairly quickly.
The writer is Investment Consultant at Chase Buchanan: firstname.lastname@example.org