To recess, or not to recess, that is the question

To recess, or not to recess, that is the question

There’s a saying on Wall Street that central banks keep pushing until something breaks. In other words, if central banks want to reduce inflation, they have a tendency to keep raising interest rates until some part of the economy gets into trouble.

Since the middle of last year, economists, strategists and experts of all stripes have been putting forward a bewildering array of seemingly contradictory arguments as to why Australia, the US, Europe and pretty much every economy in the world, is either eventually going to fall into recession or should somehow narrowly avoid it.

Quite simply, if a central bank keeps raising interest rates, eventually the cost of credit, which is the lifeblood of a modern economy, will reach the point where consumer spending falls in a hole and businesses are either unable to pass on the additional cost or can’t justify new borrowing based on potential return. That’s when an economy slides into recession, with the slowing of growth and usual rise in unemployment having the effect of reducing inflationary pressures, until the cycle goes the other way and central banks desperately try to revive growth by lowering interest rates.

After June’s surprise rate rise, the governor of the Reserve Bank, Philip Lowe, said he believes Australia “remains on the narrow path” to a “soft landing”, or avoiding recession. Mind you, in the next breath he warned there’s more work to be done to make sure inflation comes back to the target zone of 2-3 per cent, which can only mean more rate rises.

Investors generally loathe uncertainty, so it can be frustrating that something so fundamental as whether the economy will grow or not looks to be a guessing game. The Commonwealth Bank and HSBC Australia are both perched on the fence, placing the odds of a recession at 50 per cent. Meanwhile, UBS reckons it’s a 25 per cent chance, AMP is at 45 per cent and Westpac is punting we won’t.

It’s the same in the US, where in October last year Bloomberg Economics placed the odds of a recession within 12 months at 100 per cent. Then by April this year another survey of economists placed the likelihood at 64 per cent, but with predictions ranging from as high as 94 per cent to as low as 30 per cent. Recently the New York Fed put the odds of recessing at 70 per cent, and for good measure, Goldman Sachs rates it a 25 per cent chance.

As the saying goes, if you’re not confused by that then you don’t understand it.

So how much faith should you place in economists’ forecasts? In case you haven’t already guessed, not much. In 2018 the IMF reviewed forecasts covering 63 countries over the 22 years to 2014 and found only 3 per cent of economists correctly forecast a recession 8 months ahead and only 9 per cent just 3 months ahead.

On top of that, economists will always use history as their guide to forecasting current outcomes, but this time the inflationary event was preceded by many governments, including Australia’s, injecting massive fiscal stimulus to offset the effects of COVID lockdowns. Much of that money continues to slosh around economies and is a big reason why unemployment is running at multi-decade lows.

Also, in the US, somewhat ironically, the rise in interest rates has meant the federal government’s interest payments have risen to about $950 billion, increasing the deficit to a hefty 8 per cent of GDP. Combine that with the low unemployment and it’s perhaps not surprising the US economy is proving resilient.

Bearish forecasters argue a recession will whack company earnings and markets, especially share markets, will have to fall. The bulls argue share markets have already factored in the likelihood of a recession and, as usual, are looking to the future.

Smart investors need to weigh up whether they think economies will recess and, if they do, whether it’s already in the prices. If that sounds as difficult as it actually is, then there’s a good argument for remaining invested in shares, but maybe retaining an allocation to cash or fixed income both as a defensive strategy and to pick up a bargain should one come along.