Revisiting the Risk of Recession

Authored by Bloomberg's Simon White

It is time to once again turn our attention to the potential risk of a US recession. The soft, survey data is beginning to show signs of weakening, while the hard data is already fragile. The current expectations of a downturn are low, but these could rapidly shift. Stocks, which usually experience their worst drawdowns during recessions, are not currently priced for such an outcome. Meanwhile, yields are expected to be lower in the coming months.

The Nature of Recessions

S curves are nature's way of illustrating a binary on-off switch. They appear in various contexts, from brain neurons to disease progression, population growth, and the adoption of new technologies. They also depict how recessions evolve. Economies are generally thought to develop linearly, transitioning from a non-recessionary to a recessionary state. However, they actually do so in a highly non-linear manner, with recessions often occurring abruptly. The risk of a downturn is typically either low or high within the next 3-4 months, but rarely anything in between. This is similar to the shape of an S. This is why most standard recession models don't make much sense, as they assume the risk of recession can evolve smoothly. However, it is essentially pointless to discuss the likelihood of a recession increasing from, say, 45% to 50%, when we acknowledge their regime-shift nature.

Current Recession Risk

At present, we are at the lower-left side of the S, with a low risk of an imminent recession. However, recent data suggests we could soon move to the right and onto the steep upward section of the curve. This means the probability of a recession could quickly climb much higher, making a recession more likely than not over the next 3-4 months. Stocks are currently behaving as if a soft landing or no landing is expected. They are consistent with the Federal Reserve's first rate cut of the year, which is the most likely move if rates change this year, occurring without a recession. However, rate cuts that occur during a slump have historically led to a worse outcome for equities, both before and after the recession, than currently priced.

Recession Risk Six Months Ago

Six months ago, I wrote that a US recession was unlikely through most of 2024. This could still be the case, but if we are shifting along the S curve, investors should be prepared for an environment that could quickly appear more recessionary, even if an actual downturn doesn't occur for another six months. It's important to remember that stocks sell off before the onset of a recession, and even longer before the National Bureau of Economic Research (NBER) finally announces the economy is in one.

Recent Data and Recession Risk

The need to upgrade recession risk has been prompted by the recent weakening of soft data, coinciding with fragile hard data. The manufacturing Institute for Supply Management (ISM) is one of the most important data points for the economic and stock outlook. The headline survey dropped below 50 in April, led by the new orders-to-inventory ratio, which is turning lower and slipped below the important level of one, where orders are expected to match inventory.

Forecasting Recessions

As much as it's unhelpful to be a perma-bear and constantly expect a recession, it also doesn't make sense to assume there will be no recession at all. One can only have a reasonably accurate view on a downturn occurring over the next 3-4 months, and that view is likely to change abruptly, not smoothly. Adding to the difficulty in forecasting recessions, the goods and services economies have fallen out of sync in this cycle. Normally, the goods sector leads the rest of the economy into a downturn, which is why so many traditional recession indicators over-emphasized the risk of one last year. However, at some point, the economy is likely to resynchronize.

Why Vigilance is Needed Now

It's particularly important to be more vigilant now because services might also be noticeably slowing, as indicated by the services ISM also slipping below 50 in April; it has only done so twice before outside of a recession. The usual caveats apply. The ISM is quite volatile, and the PMI services survey is still above 50, even though it is also turning lower. But this drop in important soft-data points comes at a time when hard data is showing signs of fragility too.

Recessions and Data

Recessions occur when both hard and soft data are contracting at the same time. Using the inputs to the Conference Board's Leading Index, growth in leading hard-data has been turning higher, but is still contracting, while leading soft-data is close to slipping into the contraction zone. That would be ominous for recession risk. Revisions will also be key to monitor. Typically, data sees its biggest revisions before and after a recession. Data can be revised lower very quickly, which is why recessions can happen faster in revised time than in real time.

Implications for Investors

This leaves stocks more vulnerable. As the chart below shows, even though equities see a sharp drawdown after a recession begins (which, remember, we don't know when that is until after the fact when the NBER announces it), they begin selling off beforehand. Moving to the right of the S curve means more volatile stock prices with a bias lower, even if it does not ultimately mean a full recession-like decline and an end to the bull market. It also means bond yields are more likely to see some retrenchment in the coming months. But with elevated inflation in the background, bonds are primed to not rally as much as in non-inflationary recessions. Moreover, yields are still structurally biased higher due to waning interest in owning US Treasury bonds at current prices, and an inundation of supply.

Investing and Recession Risk

Investing is about gauging forward probabilities. The probability of a near-term recession is currently low, but in a month's time, it could be much higher. That would be a lot of new information asset prices would have to quickly digest. A more nimble investment stance is advised at this trickier part of the cycle.

Closing Thoughts

The risk of a recession is a complex issue to navigate, with various factors at play. It's crucial to stay informed and vigilant, especially in such unpredictable times. What are your thoughts on this matter? Do you agree with the analysis presented in this article? Feel free to share this article with your friends and discuss it further. Don't forget to sign up for the Daily Briefing, which is delivered every day at 6pm.