The severity of the collapse in markets late last year was quite surprising, given that global gross domestic product continued to grow very close to trend in the fourth quarter. Many global markets, including the major risk assets, the yield curve and credit spreads, are now pricing a probability of recession of at least 50 per cent within 12 months.
This recession risk seems far too high, especially in the US. The strength of the American labour market, and the recent indications from the Federal Reserve that it will pause its rate increases, should protect the economy from a severe setback this year. As goes America, so goes the developed world.
With investors too pessimistic about immediate economic prospects, risk assets may continue to recover from present depressed levels. An alternative, however, is that asset price turbulence will return, setting in train a tightening in financial conditions that independently causes a recession.
The inter-relationships between recessions and bear markets are complex and not very well understood. It is clear that they tend broadly to coincide in their timing. However, it is far from clear which causes which.
Economists often assume that recessions are basically caused by economic fundamentals, with the financial markets reacting when these fundamentals deteriorate.
Sometimes investors may be able to discern rising recession risks before they actually appear in hard economic data, in which case the onset of the bear market may precede and apparently “predict” the official start of the economic downturn.
Notwithstanding these varying time lags, the main direction of causation in these examples is from the economy to the markets, not the other way round. Understanding this mechanism is one of the main justifications for employing economists in the financial markets in the first place.
However, in recent cycles, leverage in the financial system has generated such large gyrations in asset prices, liquidity provision and risk appetite that it has independently caused recessions in the real economy.
Recent work by Claudio Borio at the Bank for International Settlements, has argued persuasively that, since the mid 1980s, the financial cycle has operated with a much longer amplitude than the economic cycle, and that it has predicted the onset of economic recessions.
There is no doubt that a collapse in the financial cycle was the dominant force during the recession of 2008-09. Fortunately, the current state of the financial cycle is not pointing to severe vulnerabilities in the US and other advanced economies, though many emerging markets, including China, seem very overstretched (see appendix).
An ambitious objective for macro-economists would be to develop models that are capable of understanding and forecasting financial and economic variables within a single, all-encompassing system of equations. However, even the most advanced macroeconomic models currently in use in the central banks are some distance away from such an achievement.
This uncertainty about the appropriate model has fostered different interpretations about the present economic conjuncture, even among mainstream new Keynesian economists who usually agree on the main economic issues:
Bear markets and recessions occur as terrible twins, but each can cause the other, and they may interact to make each other worse.
Optimists think that advanced economies are safe from a severe downturn, mainly because inflation is still very low and the financial cycle is not over-stretched. Meanwhile, pessimists think that stagnationary forces will prevail, perhaps triggered or exacerbated by an unpredictable financial shock, and they fear that policymakers will be unable to stabilise imploding aggregate demand. They also point to extremely advanced financial cycles that may be ready to implode in China and other emerging markets.
In my opinion, the optimists probably have the weight of evidence on their side for now, especially since the Fed has revealed its true, dovish colours. Recessions and bear markets may both be avoided in 2019. But there are no certainties in this field, just informed guesses.
US Financial Cycle Indicator Estimated by the BIS