Market-based recession indicators are flashing red. To some economists, they’re better left ignored.
At the moment that’s easier said than done. Among a slew of gauges maintained by JPMorgan Chase & Co., one based on stocks and credit spreads puts the probability of a recession in the next 12 months at 50 percent, though it was at 70 percent two weeks ago. Another, based on the gap between long-term and short-term Treasury yields -- the so-called yield curve -- puts the figure at 46 percent, according to economist Jesse Edgerton.
When it comes to predicting recessions, market-based models carry one clear advantage: Compared with hard economic data, they’re more forward-looking. But not only can markets get it wrong, they’re also prone to rapid reversal, undermining their reliability as the harbingers of doom.
“Financial markets are efficient, and they can be powerful predictors of future economic conditions, including recessions,” said Joseph Davis, chief economist at Vanguard Group, the mutual-fund giant. “That doesn’t mean they’re always accurate.”
Such caution may be warranted as the U.S. trade dispute with China and the partial U.S. government shutdown drag on. While each looms as a threat to economic activity that has been priced in to financial markets and affected measures of business confidence, neither has seriously damaged U.S. output, and could disappear before that happens.
“If we can get a resolution on just one of these fronts, some of the recession risks should subside,” Davis said.
Equity markets, in particular, are notoriously alarmist. As the late economist Paul Samuelson famously wrote in 1966, stocks had “predicted nine out of the last five recessions.” Its mistakes, he added, “were beauties.”
To its credit, the yield curve has been more reliable. The spread between three-month bills and 10-year Treasuries has inverted before each of the past seven recessions. But the usefulness of that signal is muted because the timing of subsequent recessions is so varied and unpredictable.
What Our Economists Say
“Economic data is backward looking, market data is forward looking. For that reason alone, we should pay close attention to what markets are saying about recession risks. At the same time, volatility and factors like the Fed balance-sheet unwind can make market signals difficult to read. At the present moment, we think the message from the economic data -- slowdown not meltdown -- is the right one,” said Tom Orlik, chief economist, Bloomberg Economics.