How likely is a recession in 2016?

Over the last six months, we have taken decisive steps to preserve capital. The volatility and uncertainty we anticipated late last summer is playing out now, and several markets are moving closer to pricing in a recession.

In February, our models turned bearish for the sixth consecutive month. Only six other times in the history of our models has this occurred: 1990, 1992, and 1994-1995, 2000-2001, 2002-2003, and 2007-2008. Such a signal in and of itself is not necessarily an indicator of a real decline versus a head fake. The key question is whether something more sinister is coming down the pike. It is very difficult to predict whether a recession will occur. In the fourth quarter of 2015, our paper “Making Sense of It All? What Capital Markets Will Tell You Before Economists Will” outlined three indicators we are watching that may be a canary in the coal mine to something more sinister: commodities, credit spreads, and the slope of the yield curve. While we are still carefully monitoring these, this article takes a broader view. According to CNBC, markets closed out Friday, January 31 the worst January on Wall Street since 2009 but the best single day since September. We believe this erratic behavior stems from uncertainty, as contradictory data points confuse markets. Of particular concern is the tendency of policymakers to take a more positive outlook in the beginning of potential crisis situations such as these, especially during an election year. However, just because the consensus and policymakers articulate optimism and confidence does not mean they have better insight to the data. After all, reassurance from the Federal Reserve in the early stages of the Global Financial Crisis turned out to be little more than false hope.

Our look at the data leads us to believe that the equity market is currently understating the chances of a recession. While one factor on its own is not likely enough to tip the US into recession, recessions typically stem from either financial crisis or a perfect storm of multiple concerns:

  • Self-fulfilling negative wealth effect on further weakness in asset prices
  • The domestic fallout from oil crash
  • Emerging Market debt and currency crises resulting from international fallout from commodity declines
  • Credit weakness, both in high yield spreads and credit availability
  • Chinese hard landing
  • Understated impact from a slowdown in manufacturing and/or a slowdown in services.
  • The labor market is weaker than people currently estimate and begins to weaken further

To reiterate, recessions are extremely difficult to call. However, if markets continue to be too optimistic relative to reality, we may take measures to take build in even more downside protection and have dry powder on hand to capitalize on resulting opportunities.

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