Future recessions are likely to be less frequent and shallower than those of the past, according to research by JP Morgan Asset Management (JPMAM), although investors can expect the following recoveries to be weaker.
The asset management house’s Long-Term Capital Market Assumptions report, which is now in its 23rd edition, examines the outlook for economic growth and more than 50 asset classes over the coming 10 to 15 years.
The research focuses on the US economy (partly because US recessions have tended to spark downturns in other countries – each recession in the US since 1965, aside from those in 1970 and 2001 has corresponded with downturns in Europe, the US and – with the additional exception of 1980-81 – Japan) and concluded that it has gradually become more stable over time.
“The US economy has gradually seen slower growth, along with increased stability. However, simulation models suggest that, in predicting the frequency of recession, diminished macro volatility is more important than diminished average growth,” the study said.
“This in turn suggests that recessions should occur less frequently than in the past and be milder than the average historical experience. It also, however, implies that future recoveries will be less robust.”
While Massachusetts Institute of Technology economist Rudi Dornbusch famously quipped that post-war expansions “were all murdered by the Fed” but – as the table below shows – there have been several reasons for the US economy contracting over the past 70 years.
US post-war recession statistics
Source: US Bureau of Economic Analysis, JP Morgan Asset Management. Data as at 30 Sep 2018
“The causes of US recessions have been multi-faceted and are not perfectly understood, even in hindsight. That said, each of the 11 post-war recessions since 1947 has some evident contributors.
“The first two, beginning in 1948 and 1953, seem to have been affected by demobilisation and peacetime adjustment following, respectively, second world war and the Korean war. For the following nine recessions, a series of other factors all played contributing roles. The cause of one recession, the downturn that began in 1990, remains less clear.”
In addition, the remaining two recessions were caused by financial shocks. The downturn of 2000–01 followed the bursting of the dotcom bubble and was one of the shallowest since the second world war while the financial crisis of 2007-10 resulted in the deepest recession since the Great Depression.
However, the numbers show that US economic growth has become more stable over the seven decades since the end of the second world war. Several factors have contributed to this on a quarter-by-quarter basis, including smarter and smoother inventory management by companies (which means firms can adjust production capabilities more rapidly through just-in-time management), a decline in housing sector cyclicality and a reduced reliance on government spending helped make the economy more stable.
JPMAM’s analysis also highlighted several ‘ultimate causes of stability’, where the effects play out over the long term and lead recession if they become imbalanced. Some of these ultimate contributors to past recessions have faded in their relevance in the recent past and the group argued that it is this change that is most relevant to the potential frequency of future recessions.
It noted that inflation is one of the most important determinants of the frequency and severity of a future recession: “Today runaway inflation seems unlikely to force a rapid tightening of monetary policy; over the last several decades, US CPI has not only declined in magnitude but also grown less cyclical.
“Secular explanations range from the increased credibility of central bank inflation targets to the declining significance of labour unions and the offshoring of jobs. The increased sophistication of monetary policy also means that the Fed is less likely to tighten too aggressively in response to any threat of future inflation acceleration.”
US core CPI by expansion, % of GDP year-on-year
Source: US Bureau of Labor Statistics, NBER, J.P. Morgan Asset Management. Data as at 30 Sep 2018
The asset management group also singled-out credit as another ultimate cause of stability where changes appear to have made recession less likely. While an expanding level of credit does pose its own risks, easier access to revolving consumer loans has smoothed household consumption and added a degree of stability to the economy.
But how does JPMAM believe recessions will look over the coming 15 years, given that the economy appears to be more stable?
After constructing a model of recession dynamics looking at the pattern of real GDP growth over time, the group said that the chances of a recession starting in any given quarter are about 4.3 per cent. Assuming that the second half of 2018 will not see a recession emerge, the simulation suggests that the probability of recession starting 15 quarters from a given point exceeds 50 per cent.
“However, the economy has become more stable over time. Estimating these parameters over the past 20 years versus the 50 years before that should yield a lower probability of recession,” the research continued.
“This is, in fact, the case. Running the same equation over the past 20 years and using those parameter estimates to run simulations over the next 15 years result in a lower probability of a recession starting in any given quarter, with a 50 per cent chance of the expansion surviving for another 17 quarters.”
Furthermore, the bank argued that its simulation model can hint at two other interesting things about future recessions.
Firstly, they should be less deep. The average recession from 1948 to 2018 saw real GDP hit with an average decline of 1.9 per cent. But based on GDP behaviour over the last 20 years, a hypothetical future recession could involve a decline from peak to trough of just 1.4 per cent.
But it also showed that economic recoveries are likely to be weaker. In the three years following the 11 post-war recessions, the economy grew by 13.9 on average; however, a hypothetical future recovery could involve just 7 per cent growth in the first three years, based on the last 20 years of GDP volatility.
JPMAM’s research concluded: “All in all, these effects mean that recessions are less likely to occur than in the past, both in the US and abroad, and will likely be milder. When they do occur, recoveries will unfortunately be slower and market cycles could still be as violent as in the past, particularly if a more stable macro environment fosters the growth of asset bubbles.
“Overall, however, while investors will find trend economic growth slower than in the past, they should be able to take some comfort in a global economy that will likely also be steadier.”