Recession: what are the professionals saying?

Matthew Peter, Chief Economist

The year that was has been remarkable for the sharp shifts in sentiment around the prospects of the global economy. The year began with optimism around US corporate tax cuts and buoyant China growth, but this optimism has given way to fears about impending recession. The shift in market sentiment has been expressed most clearly in bond markets. In the space of a couple of months, US 10-year sovereign bond yields have fallen by 34 basis points (bps) and the yield curve has momentarily inverted and remains very flat (particularly the 2y/5y “belly” of the curve).

An inverted yield curve has often preceded a move of the economy into recession. Was the optimism around the economy that characterised the start of the year misplaced? Has growth disappointed? Have the professional forecasters changed their views on the outlook for the global economy? Let’s review what was being forecast for the global economy at the start of 2018. According to the forecasts of the panel of experts reported by Consensus Economics, the US economy was expected to grow at 2.7%, the euro area economy at 2.2%, Japan at 1.4%, the UK at 1.4%, Canada at 2.1%, China at 6.5% and Australia at 2.7%.

Almost 12 months on (with the bulk of the data for the year already reported), Consensus expectations for 2018 are a little stronger for the US (2.9%), China (6.6%) and Australian (3.0%) economies, the same for Canada (2.1%) and a little weaker for the euro area (1.9%), the UK (1.3%) and Japan (0.9%). So, despite all the disruptions to the global economy to do with trade wars, the rise of European populism, Brexit, rising interest rates etc, growth expectations were generally realised over the year. In addition, all countries, except for the UK, will likely experience above trend growth over 2018 for a second year in a row.

Increasingly, commentary has been focusing on the length the current phase of expansion in the global economy and the risk that we are at the end of the cycle (late cycle). Late cycle concerns and the slowing pace of growth in the second half of 2018, from a break neck pace of growth in the first half, has resulted in the emergence of a recession narrative that is more a story for 2019/20 than 2018. However, the recession sentiment does not come from a downgrade in the outlook by the economic forecasters. Consensus Economics data show that there has been little change in expectations over the performance of the major economies by professional forecasters. Forecasts for 2019 have been upgraded marginally for the US and Canada, downgraded marginally for Europe and remain unchanged for Japan, UK, China and Australia.

While the forecasts are for a slowdown in growth from their above-trend 2018 levels, the slowdown is to trend: a long way from recession. If forecasters were not surprised by developments in the economy, were they surprised by developments in financial markets? As with the economy, the evidence is that forecasters largely anticipated market movements over the year. For example, commentators expected the 10-year US bond yield to be at 3.0% by now, not far from its current level of 2.9%. Elsewhere, interest rates are where commentators thought they would be at the start of the year.

In equity markets, a sign of a late cycle moving towards recession would be misses in company earnings expectations. However, earnings have sharply outperformed expectations. In the US, S&P 500 earnings were expected to grow by 10% at the start of the year, whereas they look like they will grow by over 20%. This is an outcome playing out across the major markets, if not quite as spectacularly as in the US. Ongoing robust earnings provides a fundamental floor to the size of correction in global equity markets. Based on expectations of a modest 7% growth in US corporate earnings over 2019, current S&P 500 Price/Earnings multiples (at 15.9) are very close to their long run average indicating the market is close to fair value.

Our view, shared by the majority of professional forecasters, is that we are some distance from recession. Rather, the data is indicating convergence of the global economy towards a longer term sustainable growth path: where economic activity is slowing from above trend to trend; where excess capacity in product and labour markets is being eliminated and inflation and wage growth are shifting gradually to trend levels; where central banks are responding by moving away from ultra-stimulatory monetary policy and where asset valuations are repricing to be in line with fundamentals.

 

Table 1: Financial market movements, 6 – 13 December 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,650.5

-1.7%

US

2.91%

1.8 bps

US Dollar Index (DXY)

97.06

0.3%

Nikkei 225

21,816.2

1.5%

Japan

0.06%

-0.7 bps

USD-JPY

113.63

0.8%

FTSE 100

6,877.5

2.6%

UK

1.29%

4.3 bps

GBP-USD

1.264

-1.1%

DAX

10,924.7

1.1%

Germany

0.29%

4.9 bps

EUR-USD

1.136

-0.1%

S&P/ASX 200

5,661.6

0.1%

Australia

2.47%

1.5 bps

AUD-USD

0.723

-0.1%

Source: Bloomberg

 

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