The financial markets have enjoyed a strong recovery this year, despite growth rates in the global economy — and particularly the advanced economies — continuing to head downwards. With activity nowcasts (the prediction of the present, the very near future and the very recent past) continuing to plummet, and manufacturing sectors weaker than at any time since 2012, markets may have become too complacent about recession risks.
In the final quarter of last year, market behaviour was consistent with two economic shocks operating in tandem. The collapse in global equities and a drop in break-even inflation expectations in the bond market pointed to a negative demand blow to the world economy.
A simultaneous rise in real bond yields and a rising dollar were characteristic of a hawkish stance in monetary policy, notably from the US Federal Reserve. These two shocks were probably almost equally important in explaining the meltdown in risk assets last year.
Since the turn of the year, both factors have begun to reverse. There has been a moderate recovery in China: monetary aggregates indicate that expansionary domestic policy is beginning to gain traction and trade risks are abating. The Fulcrum nowcast for China has bounced from a low of 4.0 per cent in mid-December to 5.2 per cent now.
With China apparently turning the corner, markets seem willing to overlook the continuing slowdown in the advanced economies, which has taken the latest growth rate to only 0.8 per cent, 0.9 per cent below trend. This is perversely seen as good news because it will reduce the likelihood of further interest rate increases.
The dovish turn in US monetary policy has been confirmed by an unusual volte-face in policy guidance by the Fed leadership in the space of a few weeks. As recently as mid-December, the Federal Open Market Committee suggested that policy rates were likely to rise by 75 basis points before stabilising. By the end of January, the FOMC had almost deleted its guidance about further rate increases.
Normally, a shift on this scale occurs only during the onset of a recession. Yet markets are clearly operating on the assumption that recession risks remain very low, with growth likely to bounce back to trend.
This phase of the cycle is often described as the Goldilocks zone, in which growth — like the heroine’s porridge in The Story of the Three Bears — is neither too hot nor too cold. In this phase, bad news on growth can often be good news for markets, as it has been lately.
This phase in the cycle can last several years, but the data need careful watching, especially while the situation in several big economies is still deteriorating. Goldilocks can all too easily get eaten by one or more of the three “bears”: recession, financial instability or inflation.
The boundaries of the Goldilocks zone cannot be precisely defined, but the Fulcrum nowcasting system can give some guidance (see box).
According to the nowcasts, the probability of “strong expansion” (that is above trend growth) in the US this year has fallen from 80 per cent to only 20 per cent as the economy has slowed recently. This has reduced the probability that strong growth rates will breach the Goldilocks zone in an upward direction, implying a hawkish Fed.
Meanwhile, growth is still high enough to indicate that the risk of outright recession in the next 12 months remains close to zero. The model, therefore, still implies that growth in the Goldilocks zone is likely and markets have rallied on this development.
In the eurozone the message is somewhat different. The probability of strong expansion has fallen to a negligible 10 per cent. Furthermore, the probability of a cyclical recession (defined as two quarters in which the growth rate is more than one standard deviation below trend, implying gross domestic product growth at -0.5 per cent annualised) has started to rise. A so-called “technical” recession, in which growth dips below zero for two quarters, in now estimated to be 25 per cent probable.
These results imply that while the US is still clinging to the middle of the Goldilocks zone, the eurozone is flirting with the bottom boundary of its zone. Any further decline in the nowcast would see a large increase in the probability of a European recession this year.
With the Japanese nowcast already in negative territory and Asian trade flows headed sharply downwards, the markets may not be able to ignore much further weakness in the world economy.
The Fulcrum nowcasting system (see February report here) can gauge whether the advanced economies are remaining within a Goldilocks comfort zone, where activity growth is neither threatening an imminent recession nor facing hostile action from the central banks.
Growth in the advanced economies slowed from 2.3 per cent in November to 0.8 per cent now — too far below trend for comfort. Furthermore, there is no sign yet that the downward momentum is beginning to improve.
The nowcast framework provides estimates of the probability of above-trend growth, or “strong expansion”, in the next 12 months, and also the probability that a cyclical recession will be experienced. If neither of these events occur, then growth is likely to remain within the Goldilocks zone.
In the US, the probability of strong expansion has fallen sharply in recent months, but the model still reports that recession risks are low. There is, therefore, a high probability that Goldilocks remains intact.
However, in the eurozone, the probability of strong expansion has plummeted, while the likelihood of recession has begun to increase. Although a Goldilocks scenario is still reported to be the most likely outcome, it would require only a small further decline in the nowcast for recession risks in the continental European economy to rise sharply.