Countdown begins

The Business Cycle Index (BCI) model, which uses a range of economic and financial variables to estimate the strength of the U.S. economy and to forecast the probability of recession, has entered "risk-off" territory for the first time this expansion. Although short-term risks remain low, the BCI model at mid-year estimates the probability of a U.S. recession in 12 months at 32%, climbing above the warning threshold for leaning out of risky assets.  As a result, we’ve staged some initial cyclical downgrades on equities and risk-seeking fixed income.

Two key messages:

  • We should take this 12-month recession warning seriously.
  • However, the market’s fate is not sealed.

The elevated 12-month recession probability reflects the inverted 10-year/3-month U.S. Treasury yield curve and some deterioration in the macroeconomic data. An inverted yield curve—provided it’s of sufficient1 duration and magnitude—is historically one of the best predictors of recession. In the previous five economic cycles, a 10-year/3-month yield inversion preceded a recession by one year on average. The other watchpoint is the labour market, previously a pillar of strength. There is tentative evidence of cracks in the labour market, with the broad-based weakness in May 2019 payrolls. A potential pathway to recession is via a negative confidence spiral, where trade uncertainty and global slowdown causes a fall in CEO confidence. Businesses halt capital expenditure, hiring slows, consumer income slows, consumer spending slows, and the spiral continues until recession is underway.

In the past few months, we’ve observed slower global growth, lower CEO confidence, and lower capital expenditure. If the labour market fails, this may be a path to total organ failure. The BCI 12-month recession probability is over the warning threshold and should be taken seriously.

Not all hope is lost. The 12-month recession probabilities suggest elevated risk, but it is not yet at the pre-2008 levels. Also, the short-term recession probabilities are still low, suggesting recession is not yet imminent. Under our central view, if the Fed cuts interest rates twice and macroeconomic conditions do not deteriorate, the BCI recession risk could be pushed back under the warning zone and the economic expansion may continue longer.  In the meantime, our models recommend defensiveness.

1Historically, there have been false alarms with the 10-year/3-month yield inversion, when the inversion was very brief. For example, in September 1998, the yield curve inverted shallowly and sporadically for five days over a 25-day period but did not precede a recession.

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