Macro Perspectives

The Next Recession

Will it be shallow but long or deep but quick? We outline two possible scenarios.

Even though the U.S. economic expansion enters its ninth year this month, a recession over our six-to 12-month cyclical horizon looks quite unlikely. Our models put the probability at less than 10%. But recessions are notoriously difficult to forecast. And even if we stay clear of one in the near term, it is more likely than not that the current expansion crosses the great divide sometime over our secular horizon. The global economy is in a similar state, as we highlight in our recently published Secular Outlook, “Pivot Points.” If history is any guide, we believe the probability of a global recession sometime in the next five years is around 70%.

Given that recessions are usually accompanied by bear markets in risk assets and bull markets in bonds, it is worth exploring what could kill this U.S. expansion and how deep and long the next recession might be. To a large extent, the amplitude and length of the next recession will depend on initial conditions and on the forces producing it.

A recession could be caused by an external shock – think an implosion of the euro, a major geopolitical crisis or a supply-induced surge in oil prices. It would likely be shallow but prolonged, especially if the Fed hasn’t made much progress normalizing rates. By contrast, an endogenous recession caused by an overheating economy and/or hyper-exuberant asset markets that provoke a major Fed tightening would likely be deep but short. Pick your poison!

An aging but agile expansion

Much real and digital ink has been spilled to describe the unusual nature of the current economic expansion, the 12th since the Second World War ended 72 years ago. The deep scars from the global financial crisis, together with deteriorating demographics and debilitating debt levels, produced a lackluster expansion characterized by what we at PIMCO have called the New Normal and The New Neutral. Yet, despite – or because of – slow growth and very low inflation, this expansion has been long-lived: It is now in its 96th month and thus already the third longest in postwar history. Another year of uninterrupted growth will make it the second-longest expansion. If it is still alive by July 2019, it will have overtaken the record expansion of the 1990s, which lasted exactly 10 years. Rising longevity seems not only confined to us humans.

In fact, this expansion stands a good chance of climbing to second position in a year’s time, based on a qualitative assessment and quantitative models. The qualitative argument is that there are no obvious imbalances in the U.S. economy that would call for an unkind unwind any time soon: no overconsumption, no overinvestment, no overheating, no overkill from monetary policy. Slow and boring growth coupled with an almost complete lack of wage and inflation pressures, new neutral interest rate levels and only moderate excesses in asset prices bode well for more of the same over our cyclical horizon. And yes, politics in Washington D.C. are in chaos right now, but this reduces the risk of excessive fiscal stimulus, which could produce a boom-to-bust cycle, or disruptive protectionist policies that could spark a trade war.

Subjective assessments aside, PIMCO’s quantitative recession models also signal a green light for a continuation of the expansion over the cyclical horizon. On a daily basis, we monitor the output of our real-time recession-probability models (developed by Emmanuel Sharef and Vinayak Seshasayee of our Americas Portfolio Committee), which use a wide range of economic and financial market data to quantify recession risks. Our probit models track indicators that have usually signaled a recession in the past; our neural network models are agnostic and rely on algorithms to detect patterns and connections across a wide range of data.

These models, along with the qualitative judgments described above, helped us dismiss the recession fears that rattled financial markets in early 2016 (see “The Recession of 2020,” Macro Perspectives, March 2016). As of 30 May, the models suggest that the probability of a U.S. recession over the next 12 months ranges between 1.5% and 9.6% (rounded to avoid the impression of spurious precision). Given that the postwar U.S. economy has, on average, been in recession about once every six years, or roughly 16.7% of the time, this is relatively low.

Two tales of the next recession

Hold it, though: Before you start dancing on the table, recall that economists (and their models) have been notoriously bad at forecasting past recessions – so let’s all eat a huge serving of humble pie. Moreover, prudent risk management suggests that it is (kind of) OK to hope for the best but imperative to prepare for the worst. So how could we slide or nose-dive into the next recession, and how deep and how protracted could it be?

Having swallowed that humble pie, I know all of this is highly speculative, so I’ll keep it short and focus on two scenarios, while being deeply aware that the real-deal next recession could well be very different or a mix of the two.

Scenario 1

In the first scenario, the expansion remains lackluster, with growth bumping along at a 2% or so pace and inflation struggling to return to the 2% goal. The Federal Reserve, therefore, makes slow progress in normalizing rates and, potentially, current Fed Chair Janet Yellen gets replaced by someone inclined, ideologically or otherwise, not to use the Fed’s balance sheet weapon in the next recession. Politics in Washington, D.C. remain messy and distracted by a dysfunctional White House, so neither major fiscal or regulatory boosters, nor disruptive protectionist policies, get enacted.

But then a major external shock hits – consider another Korean War, a messy breakup of the euro, or a surge in oil prices caused by a supply shock. The U.S. recession, caused by the resulting plunge in asset prices and falling business and consumer confidence, would likely be relatively shallow because there would be no major domestic imbalances in the economy needing to be purged.

However, neither monetary nor fiscal policy would be able to respond in force. The Fed would have few basis points to spend in the form of rate cuts, as rate normalization wouldn’t have gone very far, and new Fed leadership may be more averse to ramping up the balance sheet yet again. Fiscal policy would also be stymied by a dysfunctional White House and/or a Congress that is opposed to a massive spending program. Thus, while the recession would likely be shallow, it could also drag on for longer than usual. And Larry Summers (who spoke at our Secular Forum in May) would make headlines by proclaiming a “secular recession.” In this scenario, investors who buy too early after the recession hits would be severely punished.

Scenario 2

The second scenario implies a V-shaped recession-recovery pattern. It would be caused by an internal buildup of imbalances and overheating in goods and labor markets and/or asset markets. These excesses could be prompted by a fiscal boost that comes at a time of (near) full employment and/or a spontaneous productivity surge that sparks private sector animal spirits and, eventually, overconfidence and overspending. This would force the Fed to raise interest rates above the (higher) neutral level, which would then lead to a recession.

The script for this endogenous recession would be very different from our exogenous shock-driven first scenario – it would likely be sharper and deeper. However, as the Fed would have built up “ammunition” in the form of rates above a higher neutral rate, and with higher inflation, the central bank would have plenty of (nominal and real) basis points to spend to promote recovery. In this scenario, investors who wait too long before re-engaging would suffer.

Final thought

Given the uncertainty over the timing and contours of the next recession, what should investors do? The answer, of course, will depend on an investor’s unique circumstances and goals. But as discussed in our recent Secular Outlook, “Pivot Points,” we advocate a few precepts:

  • Focus on valuation – lots of good news is priced in to markets.
  • Maintain focus on capital preservation.
  • Seek relative value in rates and credit.
  • Look to a global opportunity set, including emerging markets.

Bottom line: Enjoy this expansion as long as it lasts. However, don’t bank on the U.S. becoming the next Australia, where the last recession occurred a quarter century ago.

The Author

Joachim Fels

Global Economic Advisor

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