It has been six months since we published Forecasting the Next Recession, which laid out the analytical basis for expecting the next recession to begin in the late-2019 to early-2020 timeframe. With several policy developments since then, and based on the evolution of incoming data, we maintain our view that a recession is likely to begin in this timeframe, though the probability has risen that the recession occurs in the latter half of this period, i.e. 2020. We update the dashboard below, shifting the assumed recession start date to February 2020, aligning it with the middle of our forecast range.
Scott Minerd and Brian Smedley provide context and commentary to “Forecasting the Next Recession.”
Our Recession Probability Model, updated below, ticked down across all three time horizons in the first quarter of 2018. This occurred as growth in the Leading Economic Index accelerated and monetary policy became modestly looser as the real fed funds rate dropped due to higher inflation and the estimated natural rate of interest rose. However, our projections of model probability (shown by the dashed lines) continue to signal a marked increase in recession risk over the next year, driven by our expectations for an overheating labor market, tighter monetary policy, and a flattening yield curve.
Recession Outlook Summary
- Our Recession Dashboard and Recession Probability Model suggest a recession is likely to begin sometime in late 2019 to mid-2020.
- Recent developments in fiscal policy, the labor market, and the neutral interest rate suggest that the expansion could extend into the latter half of our recession range.
- Investors should continue to upgrade credit quality in fixed income, while stocks likely have several more quarters of gains ahead.
Near-Term Recession Risk Is Low, but Longer-Term Risks Are Rising
Model-Based Recession Probability
Hypothetical Illustration. The Recession Probability Model is a new model with no prior history of forecasting recessions. Actual results may vary significantly from the results shown. Source: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 3.31.2018. Shaded areas represent periods of recession.
Fiscal Boost, Monetary Offset
The most notable development since we first published our recession forecast has been the evolution of fiscal policy, including the passage of the Tax Cuts and Jobs Act and the Bipartisan Budget Act of 2018. This combination of tax cuts and higher government spending will provide a sizable boost to economic growth in the near term, with the impact peaking in 2019 at more than 50 basis points. This fiscal boost should offset some of the private sector slowdown and could extend the expansion by several months, all else equal.
However, the impact of fiscal changes on the length of the business cycle should not be overstated for several reasons. First, the fiscal impulse is frontloaded into 2018 and 2019, with our projections showing that fiscal policy will turn into a drag on economic activity beginning in 2020 as government spending caps kick in. Political dynamics also come into play here, as it is beginning to appear increasingly likely that Democrats will take control of the House in the November 2018 midterm elections. Such an outcome would reinforce our expectation that fiscal policy will be less supportive in 2020, as Democrats could see it as advantageous to reinstate the spending caps ahead of the presidential election in November 2020.
The other reason that fiscal policy only marginally changes our recession outlook is our view on the future response of monetary policy. At a time when the unemployment rate is well below full employment and inflation is accelerating, the Federal Reserve (Fed) is already on a course to tighten policy in order to cool the economy. Fiscal stimulus has only served to elevate concerns about economic overheating, meaning that the Fed will likely lean harder against much of the boost from tax cuts and government spending in the form of higher interest rates.
One other policy development worth noting is trade policy, which has come back into focus with the announcement of steel and aluminum tariffs and plans to target China. While we anticipate further U.S. actions on trade, at this point a recession-inducing trade war remains a tail risk scenario, and is not in our baseline forecast.
Extra Runway for the Economy?
The data outlined in our Recession Dashboard has evolved largely as expected over the past few months, with a tighter labor market, Fed rate hikes, a flattening yield curve, and no imminent signs of an inflection point in economic activity.
One notable development has been the stability of the unemployment rate, which has remained unchanged at 4.1 percent for the past six months through March. This leveling out has occurred not because job gains have slowed, but because labor force participation has picked up. Most encouraging has been the rise in the “prime age” 25–54 year-old participation rate, which has risen by 50 basis points since October, a historically strong increase. The combination of rising participation and still-moderate wage pressures suggests that the labor market has some additional room to run, although we expect the unemployment rate will soon resume its decline and will end the year at 3.5 percent.
One other factor suggesting the economy may have some extra runway (making a recession more likely in 2020 than 2019) is the evolution of the natural rate of interest, also known as r-star or r*. The natural rate is the real interest rate that is neither contractionary nor stimulative for the economy, so a higher natural rate means that the Fed has some additional room to raise rates before slowing the economy. We believe that the estimated natural rate is likely to rise from its current level of near-zero, due to the combination of higher fiscal spending, a modest tax cut-induced productivity boost, a stronger global economy, and some easing of financial regulation.
Our assessment of these changes suggests that the Fed may be able to raise rates by an additional 25–50 basis points relative to our prior view, which again points to early 2020 as a more likely recession start date compared to late 2019. Consistent with our expectation for a longer expansion and larger hiking cycle, we now see the terminal fed funds target range at 3.25–3.50 percent, with the Fed likely to deliver four 25 basis point rate increases in both 2018 and 2019. There are signs that the market’s estimate of r* has also risen, as seen in the rise in long-term forward rates in recent months. This has helped keep the three-month 10-year Treasury yield curve, a key input in our recession model and dashboard, relatively stable since our last publication.
While there has been a lot of good economic news in recent months, we still believe the economy is in a late cycle phase, with a recession likely to begin in approximately two years. We expect the yield curve to continue to bear flatten in coming quarters, with the rise in yields being led by the front end of the Treasury curve amid quarterly Fed rate increases and large increases in short-dated Treasury supply.
As we laid out in our previous report, now is the time to begin upgrading credit quality, given the asymmetry of risks that tight corporate bond spreads represent with the next downturn approaching and the historical tendency for corporate bond spreads to trough before equities peak. Indeed, 2018 should be a strong year for stocks, as is typical in the penultimate year of an expansion. Investors should turn more cautious in 2019, however, as equity market peaks typically occur several months before recessions begin.
Guggenheim Investments’ Recession Dashboard
The six indicators in our Recession Dashboard have exhibited consistent cyclical behavior that can be tracked relatively well in real time. We compare these indicators during the last five cycles that are similar in length to the current one, overlaying the current cycle. Taken together, they suggest that the expansion still has room to run for approximately 24 months.
Unemployment Gap (Unemployment Rate – Natural Rate of Unemployment)
Real Fed Funds Rate – Natural Rate of Interest (r*)
Three Month–10 Year Treasury Yield Curve (Basis Points)
Leading Economic Index, YoY % Change
Aggregate Weekly Hours Worked, YoY % Change
Real Retail Sales, YoY % Change
Source all charts: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 3.31.2018 for real fed funds rate less natural rate and aggregate weekly hours worked, 4.30.2018 for others. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.
—Scott Minerd, Global CIO; Brian Smedley, Head of Macroeconomic and Investment Research; Matt Bush, Director
Important Notices and Disclosures
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This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC.
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Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management.