US recession risk hasn’t gone away

US recession talk has all but vanished lately but high-flying stock markets may be badly underestimating a risk that remains all too real, according to a new study authored by State Street Associates and MIT.

The authors of the paper, A New Index of the Business Cycle, created an index based on four economic variables – industrial production, nonfarm payrolls, one-year stock returns and the slope of the yield curve. Since 1916, this index has been a reliable recession indicator, with high readings indicating an increased likelihood of an imminent downturn.

Disagree

For example, when the index topped 60 per cent, a recession occurred 61 per cent of the time within six months; when it exceeded 70 per cent, the frequency of recessions was 70 per cent; and when it exceeded 90 per cent, recessions followed 91 per cent of the time.

In November, the value was 76 per cent – that is, current economic conditions have historically been associated with recession 76 cent of the time, and with robust growth only 24 per cent of the time.

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Most economists would disagree. A model by Bloomberg Economics estimates the odds of a recession within the next year to be 26 per cent.

Equity markets are even more relaxed; according to Pictet fund manager and bear Julien Bittel, US markets are pricing in a “ludicrous” 2 per cent chance of recession, indicating investors are very confident right now – too confident, if the State Street/MIT study is right.