People incorrectly predicting the next recession has been something that has gone on for the last few years as the historically long economic recovery has plodded along, but this year that chatter has appeared to pick up.
At this stage in the cycle, it is natural for some particularly bearish investors to call the next recession and with indicators of slowing global growth and tightening monetary policies from some of the world’s largest central banks, the discussion has broadened out on whether the global economy has peaked or will continue to grow into next year.
While it is difficult to say when the next recession will happen, most experts agree that it is likely to reach its peak in the next couple of years.
It then comes down to what will cause the recession. Will it be a trigger event just as the collapse of Lehman Brothers was the trigger event for the financial crisis in 2008, or will it be something completely different?
For Fidelity International global economist Anna Stupnytska, the biggest risk to the global economy at the moment is the US.
She said the US, which has been the “growth engine” of the global economy, is likely to start slowing down going into the last quarter of 2018.
Stupnytska said: “While the US economy has been powering on thus far, there are now signs it may be running out of room.
“The economy is close to hitting capacity constraints - both in labour and product markets. And as labour market conditions continue to tighten, cost and wage pressures are building up.”
The US Federal Reserve is well underway in its process of monetary policy tightening through interest rate rises and quantitative tightening as we are near the end of the ‘easy money’ scenario we have been in since the financial crisis.
US Federal Reserve interest rate hike projections (dot plot)
Source: US Federal Reserve
Pair this with a stronger dollar, which has come off the back of trade war rhetoric from US president Donald Trump, and an emerging markets rout and global growth is starting the feel the effects, said Stupnytska.
According to the economist, the Fed will stick to its two further rate hikes this year and bring the 2018 total to four.
But she is worried that when you add three more planned hikes next year, continued quantitative tightening and treasury issuance we will get a “triple whammy” for markets.
“We believe that something will have to give - and we don’t think it will be fiscal! The biggest risk to global growth is the risk of the Fed doing too much,” she said.
It is the level and pace of the Fed’s tightening that will determine how much global growth is affected, added Stupnytska.
“We need to see much more tightening in financial conditions, and at a faster pace, to start worrying about serious growth implications,” she said.
Another risk to global growth from the US is the country’s high levels of corporate debt, which “stands out as one of the biggest imbalances in the system”.
“Debt as a percentage of GDP is now in-line with previous cycle highs of around 45 per cent, although the pace of increase has been more measured relative to the last two episodes in 2001-2002 and 2008-2009,” said Stupnytska.
She said the size of this debt could cause a recession but it is unlikely to be the “epicentre of another crisis” for the time being.
Indeed, there aren’t any flashing lights just yet, according to the economist, and while the US economy is heating up, it is not overheating.
A well-used indicator to judge when a recession will occur is by looking at the yield curve – the spread between long-term and short-term US Treasury yields.
In the past, when the yield curve inverts, where the 2-Year Treasury yield becomes higher than the 10-Year Treasury yield, a recession has typically occurred one or two years after.
Currently, the spread between the 2-Year Treasury and 10-Year Treasury notes sits at 24 basis points and has been flattening for some time.
Stupnytska said: “While we don’t think that a US recession is imminent, we cannot dismiss the yield curve signal completely.”
Away from the US, investors are getting more concerned with China over slowing growth in the country.
Performance of MSCI China over 10yrs
Source: FE Analytics
While Stupnytska agrees that China’s economy is slowing down, she did say there were still some positive economic indicators coming out of the country with stable PMIs (Purchasing Managers’ Index), strong imports, robust house prices and healthy PPI (Producer Price Index).
The Chinese government is also taking steps to create more liquidity through fiscal loosening measures such as tax cuts alongside other measures.
However, she said: “Overall, while we believe these measures are better than nothing, their magnitude still seems small and the numbers are unlikely to be game-changing.”
Conversely, the negative economic indicators coming out of the country seem to be more prominent.
“Investment, especially infrastructure, is very weak, and real estate construction is negative,” she said.
“Plunging retail sales volumes stand in contrast with second quarter GDP that was supported by a huge boost from consumption; this suggests that growth is materially weaker than the official number.
“All these factors indicate that the direction of travel has undoubtedly been downward.”
Aside from the two global superpowers, Stupnytska said there are other risks that could have the potential to cause the next global recession including the trade war, a break-up of the euro and a spill over from the Turkey crisis.
“The situation in Turkey may yet represent a systemic shock that could lead to global contagion,” she said.
“But for major central banks to react, it has to spread to other emerging markets (EM) and dramatically tighten global financial conditions. In a sense, the situation has to get much worse before a significant global policy response.”
Performance of global indices YTD
Source: FE Analytics
Emerging markets have been hit more than most this year as a result of several factors that include higher US interest rates, trade wars and a stronger dollar, as well as Turkey, with the MSCI Emerging Markets index down 2.38 per cent year-to-date.
But she commented that other factors including the Erdogan-Trump politics, interested parties such as China and Russia and hidden exposures can make the situation in Turkey less predictable, alongside a synchronous global tightening.
“Maybe it’s time to dust off that classic EM crisis handbook?” said Stupnytska.