By Darren P. Wurz, MSFP, CFP®

 

At the start of 2019, we face a very different reality than at the start of 2018. As we entered 2018, markets cheered the continuation of synchronized global growth and tax cuts to further stimulate the economy. As we enter 2019, the message is quite different. Now we’re facing a global slowdown. Tax cuts provided only a temporary boost to the markets, but no lasting effect.

Is the economy headed for recession?

Knowing the answer to that question would require us to answer another question first: is it possible to predict recessions? Economists and government officials are interested in the answer to that question for academic and public policy reasons. What is their track record?

Let’s start with government officials. First, understand the vested interest of government officials: avoiding recession. Governments around the world will take whatever action is needed to avoid recession. Recessions are bad for tax revenue, bad for re-elections and bad for public order. As it turns out, the government is not just bad at predicting recessions, they’ve never predicted one! At least publicly, that is. So when the European Central Bank says there is absolutely zero chance of recession and the Federal Reserve Chairman Jerome Powell says he sees no risk of recession, you have to wonder: are they just lying to us?

Well how about economists? Economists in general are terrible at predicting recessions. They don’t have a vested interest to lie to the American people, but their record of failure is astonishing. IMF economist Prakash Loungani has studied economists’ predictions of recession and found a record of almost complete failure. For example, virtually no one called the recession of 2009. Of 77 countries studied, 49 were in recession in 2009. Even by September 2008, with the housing crisis well underway, consensus predictions did not see a single country falling into recession. Woops.

The chart above shows how economists have done over time. The gray areas are actual recessions. In general, forecasters have not forecasted a single recession—at least not in the last 50 years. Woops.

So what can we trust? The markets? In general, the stock market usually does decline in advance of recessions and then continue that decline going into a recession. However, not every market correction means a recession is imminent. Markets have often corrected without any ensuing recession.

One measure that has been pretty good historically is the so-called yield curve—or the difference in the 2-year and 10-year treasury yield. Typically, longer yields are higher than shorter yields because it costs more to borrow money for longer periods of time. And so during economic expansions, we usually see the 10-year treasury yield higher than the 2-year treasury yield. However, there are times when the 2-year yield goes higher than the 10-year yield. This happens when there is stronger demand for longer term treasuries and investors buy 10-year treasuries, pushing the prices of these treasuries up. When prices go up, yields go down.

As you can see in the chart above, this kind of “inversion” typically precedes recessions. Currently, the 10 year and 2 year are flirting with inversion. They inverted briefly in December. Hmm. Makes you wonder, huh?

What about hard data like unemployment? Surely, a recession can be predicted by rising unemployment right? Wrong. In the chart below, you’ll see that recessions usually start near the bottom of the unemployment curve with the slightest uptick in unemployment just before. If anything, this chart shows that recessions come out of the blue and change economic conditions very rapidly.

So can we predict recessions? Government officials and economists have shown themselves to be absolutely inept in predicting recessions. Markets, on the other hand, can offer us some warning of the possibility of recession. For the most part, though, recessions are not predictable. Nay, they come out of the blue, unexpectedly, when the economy is humming along, unemployment is low and GDP expectations are positive. They happen quickly and viciously.

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Sources:
https://www.ft.com/content/70a2a978-adac-11e7-8076-0a4bdda92ca2