Economic Outlook: The Risk of Recession is Real
Last September I wrote, “I see the economy slowing down. By the end of 2019 there could even be a recession. That is quite a contrast to where we are now.”
So how did my outlook go? Not too well. I found out why nobody forecasts recessions. I got calls from people complaining that no one else is saying recession so it can’t be right. One said, “you must be going blind, business is great.” Others repeated the wisdom of former Fed Chair Janet Yellen who said, “expansions don’t just die of old age.”
Fair enough. But also remember that you cannot outgrow your shell. While the economy is expanding and appears to have room to grow, remaining space is limited. Readily available skilled workers, land, materials, and capital continue to become scarcer and more expensive. Incremental growth comes at increasingly higher costs. Instead of real economic growth, we may end up with rising inflation and any number of events could trigger a recession.
Well, now it looks like we might have that trigger: tariffs. A large majority of economists view tariffs as damaging to the economy, yet President Trump has implemented tariffs. If Trump continues to raise tariffs as he has threatened to do, the economy possibly, if not probably, will gradually slide into recession.
The outlook of economists with a penchant for forecasting hinge on the President’s commitment to tariffs. Here is where we may be allowing our hopes to become the father of our thoughts. Most forecasts expect trade tensions to somehow dissipate before the midterm elections this November. Is expecting multiple trade deals with different countries in three months realistic or just hopeful?
The recent economic outlook put out by Citigroup, which employs some of the best economists in the industry, is typical of what I’ve been reading. Citigroup observes that, “U.S. trade actions have been brutal and unilateral and have punctured the trust built up over decades of good-faith agreements.” They continue, “Our best case is for negotiations to continue and for trade deals to be done ahead of the November U.S. elections.” Many other prognosticators also maintain the assumption that the U.S. will settle trade disputes by Election Day. But should they? Only time will tell.
What about recession indicators? Can they offer any guidance? Consider two leading indicators for recessions: the “2s to 10s spread” and the Chicago Fed National Financial Conditions Credit Index. While neither is foolproof, they are right more often than not and at the moment, neither red light is flashing.
The “2s to 10s spread” is the premium (spread) the federal government has to pay to borrow money for 10 years compared to borrowing for just 2 years. Normally the spread is positive since long-term interest rates must be higher than short-term rates to compensate investors for risk. When it goes below zero, short-term rates are higher than long-term rates which signals tight credit conditions that typically trigger recessions.
This chart shows the spread since 1976. Recessions are shaded in gray. Each time the spread fell under zero, a recession followed. Currently the spread is 0.25 percent. It is still above zero, but barely so. The Fed says it will raise short-term interest rates later this year and that could push the spread under zero.
Figure 1: The 2s to 10s Interest Rate Spread on U.S. Treasuries
For those who scoff at the thought of a recession, this second indicator offers hope. When the Chicago Fed National Financial Conditions Credit Index is over zero it means credit is hard to get. If the index jumps up, it means that consumers and businesses that once found it easy to qualify for credit suddenly find it difficult. Consumer spending and business investment contract in response to the lack of credit and the economy goes into recession. Since 1971 this scenario played out six times. Fortunately, this index shows easy credit conditions now and does not signal a recession.
Figure 2: Chicago Fed National Financial Conditions Credit Subindex
What should we expect in the meantime given the mixed signals? The economy could continue at a slower pace as supply conditions tighten. However, if tariffs come on full-force and/or interest rates spike, we could see a recession gradually develop. The recession risk is real.
Given this risk, what should you do? If you’ve reaped the benefits of the recent bull market in stocks and real estate, take a second look at your allocations and make sure they are balanced between growth and capital preservation investments. You always risk selling an asset that continues to go higher, but consider the advice given 200 years ago by Nathan Rothschild, the 19th century banker. When asked the secret of his success, he replied, "I never buy at the bottom … and I always sell too soon." In other words, don’t try to perfectly time markets. Make sure you have enough to cover you in a downturn and remember what happened in the aftermath of the last recession.
We are naturally hopeful and hopeful forecasts are much easier to present (believe me), but don’t lose sight of lessons from the last recession. When the economy is growing nicely for years, we are inclined to forecast (hope) for it all to continue. Psychologists call this ‘recency bias’ or ‘recency effect’. However, as the famous research on prediction by Peter Tetlock of the University of Pennsylvania revealed, people who consider multiple explanations and balance them together when making a prediction perform better than those who rely on a single big idea. So keep an eye on both indicators.
 Press conference of the Chair of the Federal Open Market Committee. December 16, 2015.
 “Citi Says Trump ‘Brutal’ on Trade but Sees Deals by Midterms.” Hellenic Shipping News Worldwide.” July 16, 2018.
 This chart is available from the Federal Reserve Bank of St. Louis’ website at https://fred.stlouisfed.org/series/NFCICREDIT
 King, Max. “Remember Canada, the Forgotten Market.” The Daily Telegraph (London). July 30, 2005.
 Lahman, S. and Forgas, J. “Recency Effect.” Encyclopedia of Social Psychology.
 Frick, W. “What Research Tells Us About Making Accurate Predictions.” Harvard Business Review. February 2, 2015.