Confessions first: I’m actually not predicting a recession in 2020. Everybody knows that it is impossible to forecast the ups and downs of the business cycle several years ahead. Even six to 12 months ahead, it is extremely difficult to call a recession correctly – in fact, most economists forecast a recession only after it has started. At PIMCO, we are adamant about revisiting our near-term outlook every quarter, for humility is essential to our business – let’s face it, economists are masters of hindsight, but perhaps closer to apprentices at foresight.
So whence the title? One reason is to entice you to read yet another piece on the risk of recession. The more important reason is that while financial markets and a rising number of pundits now place a very significant probability on a U.S. recession later this year, I still think it is much more likely that the next recession occurs in, say, 2020 – or any other year of your choice in the intermediate future – than in 2016.
Of course, this is not to say that the risk of a recession over the cyclical horizon, i.e., the next six to 12 months, is negligible. Even if you just returned from an extended excursion to Mars and haven’t had a chance yet to watch CNBC or study the recent economic statistics, you would have to attach an unconditional probability of about 15% to a recession over the next year. After all, the U.S. economy has on average been in recession in one out of six years since 1945.
Neither would I dispute that the risk of a 2016 recession has been on the rise in recent months, for two reasons. First, initial conditions matter a lot, and there is no denying the loss of growth momentum in the course of 2015 and going into this year. U.S. GDP growth decelerated from an above-trend pace of 2.5% in 2014 to 1.9% over the four quarters of 2015, with Q4 growth falling to only 1.0% (the seasonally adjusted annual rate) – not exactly a great starting point into 2016. Somewhat encouragingly, the available data so far suggest Q1 GDP growth is tracking in a 1.5% to 2.5% range, but such estimates are highly uncertain this early in the quarter. And to re-emphasize the point about initial conditions: In an economy that’s cruising close to stall speed, the risk of a plane crash is inevitably higher than otherwise.
Second, financial conditions have tightened further since early December as the Federal Reserve hiked rates for the first time in more than nine years, equities sold off, credit spreads widened and the broad trade-weighted U.S. dollar appreciated further. Lower bond yields have helped, but this only partially offsets the deterioration in other asset classes. Our proprietary PIMCO U.S. Financial Conditions Index (FCI) has tightened by close to 50 basis points (bps) since early December (see Figure 1). If sustained, this would shave about one-quarter of a percentage point from GDP growth over the course of the year, according to our simulations with the Fed’s FRB/US macro model for the U.S. economy. However, models like this are unable to capture potential non-linearities that may well be present in the current environment of global and domestic uncertainty – just think of the vagaries of China’s economic policies and the uncertainty about the U.S. presidential election outcome.