Where the risks of recession really lie

There are different ways to try to determine whether a recession is likely. One, is to use indicators that have been useful in the past. An example of this is yield curve inversion; another, in the US at least, is the so-called Sahm rule that suggests an economic recession is in progress once the unemployment rate rises by a certain amount over a one-year period.

It seems to us that it is these sorts of indicators that are being relied upon by a growing number to justify the idea that the US could enter a recession, or may have even started one already. But we don’t like these sorts of indicators for the simple reason that we do not believe that things that might have worked (at predicting recessions) in the past will necessarily work going forward. This is because the context is always different.

For instance, yield curve inversion in the US has not worked in predicting a recession so far, and that’s possibly because interpreting the consequences of curve inversion in today’s world of massive central bank balance sheets is likely to be very different from that of the pre global financial crisis world. And, as for the Sahm rule, any use of the unemployment rate as a recession predictor right now has to be weighed against the fact that the labour market has been a very different animal in the post-pandemic world; something that could render past relationships between the unemployment rate and recession unreliable.

For the Standard Bank’s part, it would rather base any recession forecast on clear indications that consumer and business expectations are deteriorating markedly. But on the latter, it saw the July survey from the US National Federation of Independent Businesses (NFIB) yesterday that put business optimism at its highest level since February 2022. Admittedly, the survey did also suggest that uncertainty has increased, but that’s to be expected ahead of an all-important presidential election in November. Of course, this is only one survey but we think it is an important one as 99.7% of US firms are defined as small businesses (with under 500 workers). They account for close to 50% of the private labour force and around 44% of GDP.

Other surveys of US businesses and consumers do not appear consistent with a recession either. Clearly this could change in the future and it might turn out that some of these other indicators, like the yield curve or the Sahm rule, will come good in the end. But, right now, we think it is wise to treat such recession calls with caution. The same, however, cannot be said of Germany as the second business survey that was released yesterday was the ZEW survey, and this continues to show a notable decline in expectations for the future.

Again, this is only one survey and, as Germany has just about been able to avoid a technical recession since the pandemic-inspired downturn in the first half of 2020, there may be hope that it can continue to do so. But we have our doubts. Of course, a recession in Germany need not spell a similar downturn across the euro zone.

Nonetheless, the Standard Bank said that this focus on the possibility of a recession in the US risks missing the real recession risk which lies in Germany, and possibly elsewhere. But does this matter when it comes to financial market performance; possibly not. That’s because a US recession is clearly of far more significance to global markets than that one in Germany or even one across the whole euro zone, especially if it provokes a dramatic policy response from the Fed. Hence, even if Germany slides into recession while the US economy stays above the waterline, it dares to say that it won’t materially damage the euro because the market has got it into its head that the US is at risk and that the Fed could respond aggressively.