Understanding U.S. recessions
Short recessions, long expansions
- The National Bureau of Economic Research (NBER) in the U.S. is seen as the authority in defining economic recessions. Its traditional definition of a recession is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months”. The NBER does not agree with a popular recession definition of two consecutive quarters of negative gross domestic product (GDP) growth.
- The left chart shows the length of expansion and recessions. We can see that recessions are typically short, and usually followed by a prolonged period of expansion.
- Post World War II, the average length of an expansion is 5 years, while the average recession lasted less than a year.
The right chart illustrates the length and severity of recessions. The recessions during the 2008/09 financial crisis and the 2020 COVID-19 pandemic were two of the most severe recessions since World War II. The 2008 recession was prolonged due to the damage to the financial system. The 2020 recession was sharp, but brief, due to the aggressive monetary and fiscal stimulus applied to the economy, and the rapid bounce back in activities as the pandemic came under control.
- Investors may be tempted to use the most recently lived experience of the COVID or global financial crisis as what the next recession will look like, but this could overestimate the potential contraction of the U.S. economy.
Most recessions were led by private investment
- This page covers the different economic components and their performance in the 12 economic recessions after World War II.
- The colors illustrate what sector of the economy was the biggest detractor within each recession (horizontal not vertical).
- The 2020 COVID-19 pandemic recession was unique since the drag from personal spending outweighed the impact from private investment contraction. This is unsurprising since the pandemic essentially stopped consumption of services for several months.
- Normally, private investment, especially corporate capital expenditure, is more sensitive to economic cycles. This could be brought by weaker business sentiment to invest for the future, or higher borrowing costs from Federal Reserve policy tightening or investor risk aversion. We also see companies reducing their inventory to protect their profitability.
- Personal consumption is typically more resilient. Out of these 12 recessions, consumption registered positive growth in five of them. Some spending are essential, such as food, housing and utilities.
- Hence, corporate spending intentions and hiring plans should be one area where investor should closely monitor when gauging the risk of economic recessions.
Monitoring recession risk
- We have selected six economic indicators that gauge recession risk in the U.S. These indicators cover broad economic activities in the leading economic and credit index; consumption behavior via the consumer confidence index and Institute of Supply Management (ISM) non-manufacturing, or service, index; corporate spending behavior in ISM manufacturing new orders; and the job market via the non-farm payrolls.
- A recession flag appears when that indicators fall to a level consistent with the start of a prior recession.
- Currently, there is one flag indicating that the ISM manufacturing new order is showing signs of elevated recession risk. Other indicators have also shown signs of moderation. We will be updating this chart regularly.
Market implied recession probability
- In addition to economic indicators, we also look at financial indicators to gauge what the market is telling us in terms of recession probability.
- The index we use here consists of the shape of the yield curve (3-month versus 10-year and 2-year versus 10-year) and also Financial Condition Index (FCI).
- The FCI consists of a few key market indicators including the funds rate, the 10-year treasury yield, credit spreads, the U.S. dollar and changes in the S&P500. This is important since it reflects investors’ opinion on the economy. For example, credit spread widening reflects expectations of weaker economic growth and higher risk of corporate default.
- We have calibrated these indicators to estimate what the market indicates in terms of recession probability.
- It is saying markets are pricing in a significant pickup in recession probabilities in the next 12-24 months given the tightening in financial conditions and the inverted nature of some parts of the yield curve.
Gauging economic excesses and vulnerabilities
- The severity of recessions is partly determined by excesses in the economy. For example, the 2008/09 financial crisis was driven by excess leverage by both the household and corporate sector, alongside with an overheated housing market.
- Hence, understanding some of these vulnerabilities can help to anticipate the pain points of the next recession.
- Household debt leverage is moderate and savings rate is high. This helps to protect consumption in case the job market deteriorate.
- Corporate leverage is high and borrowing costs have risen since the start of the year. This implies that corporate spending could be cut back and businesses could also slow down hiring.
- A piece of good news is that the banking sector is more resilient now than in 2008/09. Leverage ratio is below average and banks have a low loan-to-deposit ratio.
Our estimate of economic cycles and asset return
- Based on the indicators from our economic monitor, here is our estimate of different phases of the U.S. economic cycle and, based on this estimate, the performance of asset classes during different phases. Each phase of the cycle is color coded from best to worst.
- It should be noted that the contraction phase does not necessarily coincide with NBER’s recession periods. For example, the 2000 Dotcom bust saw a sharp market correction but the impact on the economy was relatively modest, especially on consumption. Also, not all countries would be at the same stage of their economic cycles, which explains the variations on returns.
- The latest data suggests we are probably running into the late cycle. The table above shows that risk assets are still able to generate respectable return during this phase of the economic cycle. If the economy does fall into a contraction, then fixed income, especially high-quality corporate debt, government bonds and mortgage-backed securities, are likely to play an important role in generating return for investors. Chinese equities have also shown a low correlation with U.S. and global equities. Investors should also note that there are significant variations in sector performance across different stages of the economic cycle.
Most bear markets were triggered by recessions
- Looking at U.S. equities, many of the bear markets are linked to economic recessions. Those bear markets that are not liked to recessions, such as in 1961/62 and 1987, the market downturns were typically short-lived.
- Looking at the current market performance, we would argue that the threat of a recession is not fully reflected, but a sizeable part of the economic challenges are reflected in the price. There could be more valuation de-rating, especially if earnings outlook becomes more challenging in the near term.
- Just like the economic cycles, bear markets are typically shorter than bull markets in the U.S. This means investors should not lose faith in the long-term prospects of U.S. equities despite the near-term volatility.
The role of government bonds to provide return
- Despite the challenges facing U.S. government bonds, in 1H 2022, the current bond yields should provide investors with protection in case economic growth decelerates sharply.
- On the right chart, we illustrates the different scenarios of 10-year U.S. government bonds’ total return depending on its yield at the end of 2022 and 2023. Since a recession should see government bond yields lower, this should imply a positive total return, over the period of weaker growth. This should offset the possible volatilities in risk assets, such as equities.
High yield credit spreads during recessions
- For fixed income, the biggest threat is for credit spreads to widen, which would create pressure on bond prices. This would be partially offset by decline in Treasury yields, or risk-free rates. .
- For U.S. corporate high yield bonds, credit spread typically widened to 900-1000 basis points (bps) ahead of the recession, compared with the current spread of 650bps. This could be a challenge for investors that are sensitive to bond price movements. Investment grade corporate debt could be a better option for these investors.
- For long-term investors that are less sensitive to bond price movements, high yield corporate bonds are still expected to outperform in the long term. Its credit spreads should tighten when economic recovery takes place. The overall maturity profile for the high yield market is not particularly challenging for 2023 and 2024.