U.S. economy will bend, not break

March 17, 2016

 

Part of Vanguard's Global Macro Matters research series

Understanding the current—and potentially future—state of the global economy helps investors put market movements into context. To promote that understanding, researchers from Vanguard Investment Strategy Group examine the economic trends that affect the investing environment in this new series. Below are their latest insights into Global Macro Matters.

All recessions come with a stock correction, but not all stock corrections lead to recession

Since the start of 2016, investors have grappled with market volatility spurred by concerns about China, oil prices, the strength of the U.S. dollar, and Federal Reserve policy. The recent equity market correction has raised concerns about the risk of a U.S. recession.

However, global equity market corrections tend to produce false recession signals, and we believe the current market volatility was such an occurrence. History shows a mixed track record for the market in predicting recessions, with as many hits as misses since 1960.

Yield curve is still a reliable indicator

Perhaps the best-known market-based indicator for predicting downturns is the slope of the U.S. Treasury yield curve (that is, the yield spread between long-term and short-term Treasuries). Past U.S. recessions have been preceded by a significant "flattening" of the yield curve, in some cases as early as 18 months before the recession begins.

Contrary to conventional wisdom, it is the "flattening" of the yield curve itself, rather than its inversion, that is most predictive of a recession. With short-term rates near 0%, the 10-year Treasury yield would need to drop below 1% to signal a forthcoming recession, or well below current yield levels.

Overall, financial markets-based models tend to assign higher probabilities of recession, but have much lower predictive power than macrofundamental models such as Vanguard's.

A U.S. 'growth scare' is likely, but not a recession

Vanguard's recession model (see the second chart above) combines financial variables with proprietary leading economic indicators, a coverage that tends to produce a more reliable signal. Today, the Vanguard model puts the probability of an outright U.S. recession over the next six months at roughly 10%. This outlook is less bearish than is indicated by the financial markets, given the underlying momentum in the labor market. Our model does detect elevated odds of a "growth scare"—a slowdown in job growth—later in 2016.

This is one of the reasons we anticipate the Fed to raise rates to 1% this year and then pause as the pace of U.S. job growth cools. This view is not currently priced in by the U.S. bond market, which sees little if any further tightening in 2016.

Growth scare par for the course?

As the U.S. labor market closes in on full employment, we expect the pace of job growth to slow and approach demographic trends of approximately 150,000 or fewer jobs per month. If this view is correct, we would anticipate some weaker-than-consensus jobs reports in 2016. We would see such short-term deviations as par for the course as the economy returns to lower trend job growth, rather than a sign of an imminent recession.

Market volatility will surely increase, should such events unfold, but our baseline view remains that the U.S. economy is unlikely to break and fall into recession in 2016.

Note:

  • All investing is subject to risk, including possible loss of the money you invest.
 

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