Dealing with recession risk

Amid the confidence shock of war, the cost-of-living crisis and yield curve inversions our economists are increasingly being asked about the probability of recession. To answer this question, we first have to define ‘recession’: we stick with the traditional ‘two consecutive quarters of declining GDP’.

From a market perspective, this should not be seen as a binary event as the impact on asset prices will hinge on the depth, diffusion and duration of the recession. We also need to consider that as trend growth has declined in several countries, meeting our definition of recession becomes easier. For Japan or Italy, a mild contraction in GDP probably will not lead to much of a rise in unemployment or reduction in profits. Sharp movements in these two variables are what most people really mean by recession.

Europe’s energy woes darken the outlook

With these caveats in mind, let’s discuss the risks. For the near term we are much more concerned about recession in the euro area than in the US. The euro area is suffering a far greater rise in natural gas prices than the US, which has its own abundant supply, leading to a greater squeeze on real labour incomes. The probability of recession would be even higher than 40% in the second half of this year, but there is still scope for a further normalisation of services activity assuming concerns around the pandemic fade.

For the US, the near-term risk is only marginally higher than a naïve assumption around the chance of recession in any random year. The low unemployment rate raises the risk, but offsetting this is strong near-term momentum helped by the inventory cycle and households with a strong savings buffer. Further out, the probability of recession rises as the Federal Reserve, according to our forecasts, will be forced to address its persistent inflation problem by raising rates well above its estimate of neutral next year.

Late-cycle equity positioning

Despite the economy slowly but surely moving through the phases of the cycle and with recession risk re-appearing on the radar screen, our immediate reaction is not to sell equities. The historical baseline is that equities deliver strong returns in the late-cycle phase and on average 15% in the last year of a bull market*. Historically, the S&P 500 has peaked on average around six months before a recession*. So, our view on yield curve inversions and our economists’ recession probabilities is they offer a warning sign rather than a sell signal.

But although we don’t immediately hit the ‘sell’ button, in this macro environment our approach to risk-taking becomes increasingly tactical and that means sentiment and positioning, how bullish or bearish the market is, are more important drivers of our risk appetite. So far, however, our indicators are not yet signalling great bullishness in markets or a sell signal, so we maintain a constructive stance on equities.

* Source: LGIM analysis as at 7 April, 2022. Assumptions, opinions and estimates are provided for illustrative purposes only.