It looks like the recession probability is falling, but is it really? It may be more accurate to say that economists and investors are beginning to be convinced that a recession isn’t imminent, which is certainly good news for the market. With the mixed state of the economic data that’s come out over the last couple of months, sentiment can be a factor into whether a mediocre but fragile economy is plunged into recession.
What sparked talk of recession?
In fact, investors were so concerned that they caused almost a pseudo-recession in the equity markets last month by ratcheting up volatility, which in turn caused consumers to become less confident, thus weighing on the latest Consumer Confidence Index reading. Other numbers, however, like the personal saving rate, suggest that U.S. consumers may not actually be doing as poorly as they believe. Wells Fargo Securities Chief Economist John Silvia suggests other possible sources of all the recession talk as being the manufacturing and mining sectors, both of which have been stressed of late.
The S&P 500 Index has declined by more than 5%, while the Commodity Research Bureau’s Index has tumbled by more than 15%. The ISM-Manufacturing Index in particular has slumped by more than 10% over the last year, while industrial production slipped 0.7% after seeing negative growth in eight of the last 13 months. Further, the Leading Economic Index recorded negative growth for both December and January, which has only happened at one other time since the Great Recession, Silvia notes.
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Where do we peg recession probability?
But talk of a recession and the probability of one happening continues in the markets with numerous economists and well-known investors weighing in on whether we’re in one already, whether we’re about to be in one, or whether we’ll go at least 18 months without one.
So what’s the current recession probability look like right now? Some have estimated recently that the markets are pricing in a 50% probability or so, but most economists agree that it’s probably much lower than that. Silvia pegs the recession probability at about 23.5% in the next six months. One thing that must be mentioned here is that different gauges of recession probability peg it at different percentages but based on different timeframes, with some mentioning a longer timeframe of 12 to 18 months rather than only six months. This is key to understand when comparing percentages.
To set his gauge of the recession probability, Silvia uses the Probit modeling framework for predicting a recession, plus seven other Probit models. Interestingly, the highest probability was assigned by the IP, S&P 500 Index and CRB Index at 76.2%, although he reports that this model has produced several false positives in the past. In other words, investors were really doing a number on the economy just by worrying so much about a recession that may or may not happen. The lowest reading was 3.6% using a yield spread model, Silvia said. The average from all eight of the models he used came out to 37.3%.
Wells Fargo’s official model is calculated using the Leading Economic Index, S&P 500 Index and Chicago-PMI Employment Index, which is where the 23.5% comes from.
Market volatility as a leading economic indicator?
It’s understandable why consumers became less confident as a result of the recent market volatility as it is commonly seen as a leading indicator of the overall economy, Silvia explains, and this is why that volatility has been such a huge factor fueling the recession concerns. At the end of January, the VIX’s closing value was at 20.2, which is higher than the 16.2 two-year average. Also the S&P 500 declined 6.6% in January, and when looking at the VIX and the S&P, the Wells Fargo economist came up with a higher recession probability at 35% (see above graph), but this too is lower than the 50% threshold.
Silvia notes that the VIX model has predicted all of the recessions that have happened since 1980, although it brought some false positives, just as his model using the Leading Economic Index has had as well.
Recession not dismissed entirely
As a result, he doesn’t expect a recession in the next six months because he says the warning threshold is anything higher than 50%, although he’s not dismissing it entirely.
“However, given that recession probabilities based on our official model and the average of all models are somewhat elevated relative to the past few years, it is not wise to dismiss recession risk,” he wrote. “It will be crucial to closely monitor the upcoming data in the coming months to judge where the U.S. economy is heading—stay alert!”