The S&P is up almost 12% this year, hitting record highs almost daily. But Capital Economics warns that the next recession in the US is only a couple of years away, correlating with a bear market in 2019. The cause? Rising interest rates.
“We expect the current economic expansion to continue for the next year or two, by which time it will be the longest on record,” according to Capital Economics’ Michael Pearce. “But all expansions come to an end, and the rise in interest rates we expect over the next few years will push the economy into a mild recession before the decade is out.”
Capital Economics has a 2,500 year-end target for the S&P 500 (^GSPC) for both 2017 and 2018. Though they expect the index to tumble 14% to 2,150 by the end of 2019.
Pearce noted that every recession in the past 40 years was preceded by a rise in real interest rates, and he sees that playing out this time.
“The Fed has raised interest rates only four times so far this cycle and in real terms, rates are still negative,” Pearce said. “But the neutral level of rates is lower now, meaning that the 150 basis points of rate hikes we forecast over the next two years may well be enough to generate recession.”
In other words, even the Fed’s gradual pace of policy tightening would be enough to push the economy into recession and could lead to a significant market correction.
The impact of rising interest rates
The current economic expansion is nearing 100 months old, making it already the third longest on record in the US. That alone doesn’t necessarily mean a recession is overdue.
But, Pearce said the expansion seems to have used up much of the “spare capacity” generated by the financial crisis.
“A number of factors contribute to a recession, but the trigger for every downturn over the past 40 years has been an increase in real interest rates, typically to a level of 2% or higher,” he said. “As economic expansions mature, the Fed becomes determined to raise interest rates, either to squeeze out inflation, or because they are worried that a rise in inflation is just around the corner.”
Higher real interest rates hit spending. Pearce explained that the most sensitive areas, durable goods consumption and residential investment, contribute about half of the decline in output during a recession (even though they only make up 15% of GDP combined). As spending in those areas starts to decline, firms cut back on investment and inventories fall. That leads to drops in production and employment, along with business and consumer confidence, leading to a recession.
Sizing up the recession and bear market
Pearce said the recession should be a “mild” one compared to the average post-war recession, which has seen GDP shrink by more than 2% and employment decline by 2.5 million jobs. Specifically, Pearce sees a drop this time of 1 to 2% in GDP, consistent with net employment falling by 1.5 million.
“Debt burdens have not risen markedly, house prices as a ratio of earnings or rents are in line with historical averages, and there are few signs of excess investment in the economy,” Pearce explained.
That said, even the relatively mild recession has big implications for financial markets, Pearce said. Pearce pencilled a 14% correction in the stock market, which would wipe around $5 trillion off households’ net wealth, or 35% as share of their disposable income.
In the past, most major corrections in the market have occurred during and in the lead-up to recessions, as shown in the chart from Capital Economics below.
The difference from past recessions is that the Fed will have less scope to loosen policy, Pearce wrote. In the six recessions since 1973, the Fed has cut interest rates by an average of almost 5% points.
“The biggest risk this time around is that the economy falls into recession before the Fed has had a chance to normalize monetary policy, leaving it with insufficient firepower to boost demand and inflation,” Pearce said.
Pearce added that if Congress passed the long-awaited tax cuts, it would increase policymakers’ room by boosting growth and buying the Fed time to raise rates and wind down its balance sheet.
“A deficit-financed tax cut would help to prolong the existing economic expansion and boost inflation and thus encourage the Fed to raise interest rates further,” Pearce said. “By late 2019, the boost would have faded and the economy may well be very close to falling into recession. By that point, we would expect rates to be close to 3%, if not higher. That should just about prove adequate to fend off the next recession.”
Nicole Sinclair is markets correspondent for Yahoo Finance
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