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Standard Life Investments: Are the recession alarm bells ringing?

16 April 2016

In what has been a very topsy-turvy start to the year, are financial markets indicating increased recession risk?

By Alex Paget,

News Editor, FE Trustnet

Risk assets have had a tumultuous start to 2016, with various macro headwinds causing equity market falls and credit spreads to widen significantly in the first few weeks of the year.

The major drivers of the volatility have been very well-documented over recent months: ranging from China’s slowdown and currency devaluation to a further plunge in the oil price and increased geo-political risk.

However, though China was centre stage, there have been growing concerns that the US economy – which has been the leading light since the global financial crisis but has seen its industrial sector struggling – may enter a full-blown recession.

Though the panic has since subsided (for now) with equities and high yield bonds rallying back over recent months, the scale of the uncertainty is clearly demonstrated by the VIX index – which is an indicator of market volatility.

According to FE Analytics, the VIX reached levels seen during August 2015’s ‘Black Monday’ crash at the start of the year.

Performance of index over 1yr

 

Source: FE Analytics

Jeremy Lawson, chief economist at Standard Life Investments, says there were various forces that created this financial stress and that the best examples of it were widening credit spreads, increased volatility and a reduction in market liquidity.

Interestingly, Lawson points out that market participants can actually create the economic backdrop they fear so much by causing such volatility.

“Rising financial stress makes us nervous for a couple of reasons. The first is that building stress in equity and credit markets can dampen activity rates,” Lawson said.

“This comes through a range of sources: banks might become more cautious with their lending; firms hold back on investment and hiring; consumers are put off durable good purchases. The economic impact of the increase in financial stress depends crucially on how long that stress persists for and the reaction of policymakers.”

He says that though the recent financial stress wasn’t too long-lasting, it has still caused him and his team to “nervously consider” the rising recession risk within the global economy.


 

While he says the world isn’t recessionary at present, that doesn’t mean it is firing on all cylinders by any stretch of the imagination.

“Stress also makes us nervous because it can at times provide a leading indicator of increasing recession risks,” he said.

“Indeed, the combination of sluggish activity rates and acute market turmoil has triggered fears that the global economy could be heading for recession. Economists have a poor record of predicting recessions ahead of time but what we can say with confidence is that the global economy is not in a recession at present.”

“Economic indicators point to moderating but still positive growth outside of the commodity and industrial sectors.”

Performance of indices over 5yrs

 

Source: FE Analytics

Lawson added: “However, these data are lagging and the fear is that a recession could be nearing.”

Of course, numerous industry experts argue that the chances of a global recession have subsided greatly over recent months and that investors can afford to now take risk within their portfolios.

“We believe the latest bout of market turbulence is due to fear rather than fundamentals and sentiment has already improved. Despite a number of concerns in the global economy, we do not believe a more defensive stance is warranted,” Julian Chillingworth, chief investment officer at Rathbones, said.

However, Lawson says more ominous signals are coming from recession probability models based on financial variables and cites a paper published by John Kitchen (formerly of the US Treasury) earlier this year.

The research uses asset valuations as an indicator of turning points and concludes that the probability of recession has increased to around 20 per cent since the start of the year.

“The model extends back to the 1950s and shows that in every example bar one that the probability of recession hit these levels, it continued to rise and eventually led to a recession. Markets are more than taking these risks on board, pricing no rate hikes in the UK and US and a 10 basis point deposit rate cut in the eurozone,” Lawson said.

“US economist Paul Samuelson famously quipped that equity markets have predicted nine of the last five recessions. The risk of false alarms adds to the ambiguity that we face over the outlook at present. Certainly, we are seeing conflicting signals from markets and economic data.”


 

Though Lawson concludes that he doesn’t believe the world is heading towards a recession, he isn’t steadfast in his view and will change his mind if data suggests otherwise.

He added: “The risks to this view are tilted to the downside. Accordingly, we will need to monitor conditions very closely for signs that we are too sanguine.”

His thoughts are echoed by Nigel Cumming, chief investment officer at Canaccord Genuity Wealth Management.

Performance of index in 2016

 

Source: FE Analytics

Cumming says that global equities will struggle to make any real headway this year, following on from their volatile start to 2016, unless global economic growth picks up.

“Since sentiment has been damaged, markets may require evidence that recent recessionary fears were unfounded and will now need to consolidate. They are therefore likely to trend sideways, at best, in the short term,” Cumming said.
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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.