The likelihood of a US recession was one of two main fears, the other being the European sovereign debt crisis, which drove equities much lower during August. The dive abated somewhat last week on the news that at least Federal Reserve Bank Chairman Ben Bernanke doesn’t see recession as a prime scenario so far. Nevertheless, the question whether the US and other regions are heading back to a recession will haunt us for the next couple of months.
The common definition for a recession is two quarters in a row of negative gross domestic product (GDP) growth. While this definition is also used in the US, identifying “official” recessions is actually the responsibility of the National Bureau of Economic Research (NBER). To do so, it uses a battery of statistics reflecting not only real GDP but also employment and real income. Since identification is a cumbersome procedure, it usually takes between 12 and 18 months for the NBER to declare the beginning or the end of a recession.
Assuming that the US entered a recession in July or August 2011 would mean that the NBER would declare that condition by fall 2012 at the earliest. Hence, the NBER approach is not very useful for investors, who want to know whether we are in a recession now or are heading into one within the next couple of months. Fortunately there are several techniques to estimate at least the likelihood that we are in a recession. These compile a bunch of current business cycle statistics and deliver a probability that we are in a recession. Such models are now giving probabilities between 0% and 40%, depending on the statistics included or excluded. On average the result is roughly 30%, not enough to make it our central scenario but still enough to be considered rather plausible.
With recession risks rising to uncomfortable levels, elevated corporate earnings expectations could bring equity markets down further. During recessionary periods, earnings expectations are massively reduced, creating negative pressure for share prices. Given present historically high corporate margins, this downside is considerable in a potential recessionary outcome. The good news is that current valuation levels are long-term attractive, meaning the downside is not as severe as usual – but we think investors should rather search for safety while uncertainty remains so high.
Specifically, we recommend investors who see the recession case as central to reduce their cyclical equity exposure further and move it to cash, corporate bonds or defensive and high dividend yielding equities, depending on their risk profile. We would not regard government bonds as the best safe haven alternative at the current stage of low yields and rising government debt levels. Exposure to broad-based commodity indices should also be reduced.
We don’t know for sure, whether we are in or will head into a recession, but we know that the risks are not negligible. Hence it is paramount to at least stress-test your portfolio for such a scenario. Markets will remain volatile until the answer becomes clearer.
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