In March 2016, PIMCO published a report by Joachim Fels called “The Recession of 2020: A U.S. recession this year is much less likely than a recession in, say, 2020.” Fels was not identifying 2020 as a specific year in which recession is likely; rather, he was noting that the rising risk of recession in 2016 was insufficient to predict an imminent downturn. Fels stresses the uncertainty associated with forecasting the timing of economic cycles, explaining that forecasts are more often an assignment of relative probability across different years.
Loss of economic growth momentum, commodity market turmoil, global macroeconomic instability, interest rate hikes, U.S. dollar appreciation and financial market distress are all legitimate sources of recession risk that changed unfavorably in late 2015 and early 2016. However, the extremity of these factors was not reminiscent of the conditions that triggered recent historical recessions, leading Fels to conclude that the most pessimistic forecasts are not appropriately considering the qualitative and quantitative evidence.
The Likelihood of Recession Is Increasing
Fels recognized that several factors contributed to the increasing likelihood that a recession could take place in 2016. The U.S. economy grew in 2015, but at a slower rate than in 2014, falling to 1.9% in 2015 from 2.5% the year before. A declining gross domestic product (GDP) growth rate is often a negative signal, and a slowdown that occurs seven years into an expansion phase raises genuine concerns that positive movements will soon give way to contraction.
The Federal Reserve rate hike is another potential factor that could exert downward pressure on GDP growth. The Fed announced plans to begin normalizing rates slowly through 2016, which caused some outflows from U.S. equity markets and caused the dollar to appreciate relative to world currencies. Many central banks around the world were targeting currency depreciation in 2016, causing problems for multinational firms based in the United States. Higher rate expectations also generally provide less incentive to invest, so the rate hike created more risk that businesses would halt the expanding economy.
Fels noted that weak energy prices, the strong dollar and unstable global macroeconomic conditions hurt the Standard & Poor's 500 Index, and that corporate earnings entered a recession mode in 2015 and 2016. While corporate earnings for large firms are not always indicative of real economic expansion in the U.S., poor financial market performance can have feedback effects that lead to economic instability or contraction.
A 2016 Recession Is Still Unlikely
Fels made several qualitative arguments that a recession is more likely to occur further into the future than in 2016. Notably, the extreme circumstances that triggered historical recessions were not present in early 2016. Leading up to 2008, consumers were overspending and demand for housing was unsustainable. Before 2001, businesses were excessively bullish on growth prospects, and over-investment drove capital expenditures to a level of unsustainable excess. Though many investors pointed toward Fed tightening as a risk factor early in 2016, the central bank temporarily retreated from its already modest forecasts, keeping rates at historically low levels. As of April 2016, interest rates and planned hikes were still substantially less restrictive than prior instances that contributed to recessions.
Quantitative Models Support these Observations
Quantitative analysts on PIMCO's team have developed models that support Fels' outlook. Portfolio managers Vinayak Seshasayee and Emmanuel Sharef analyzed a broad range of indicators in two different models, and both concluded that while the risk of recession is rising, it is still lower than in the periods directly preceding past recessions. The findings also showed that financial indicators are having a larger downward impact on the model than economic indicators, suggesting that markets may be overreacting to weaker conditions. However, Fels noted that poor financial market performance can have an impact on real economic output.
