BAD JANUARY HAS ‘R’ WORD ON ECONOMISTS’ LIPS.

Trio of indicators increase chance of recession

Big stock market declines are often lead indicators for recession, and global markets are heading into their last week of trading for the month with the risk of seeing one of their biggest ever January declines.

Despite a big bounce in markets Friday, which saw the S& P 500 rise two per cent, fear is in the air. Bank of America Merrill Lynch economists said in an update Friday that they now see a 20 per cent chance that the U. S. economy will slip into a recession this year, up from the 15 per cent chance they predicted in December.

The rising chance of recession is due to three indicators t hat have t urned negative in recent months: Industrial production, corporate profits and the U. S. stock market are all sharply down, and in past decades, a uniform drop among all three have tended to signal economic contraction.

U. S. industrial production has slumped in 10 of the past 12 months, while profit margins have shrunk in the past quarter, weighed down by major declines among the oil companies.

The S&P 500, meanwhile, is off seven per cent for the month, even with the strong bounce Friday. It is currently on track for its second-worst performance in the past 40 years, with only the 8.6 per cent decline in 2009 being worse, notes Doug Porter, chief economist at BMO Capital Markets.

He also notes that the third- worst decline ( 6.9 per cent) was seen in 1990, also a recession year.

For the moment, economists note t hat even as chances of a recession have grown, it is certainly not the “base case.”

Nevertheless, global markets are in sell- off mode as investors have begun to price in the heightened risks.

“Markets are resetting valuations amid a less generous Fed and a continuing cooling in the medium- term global growth outlook ( centred around China in particular),” Porter said.

“And that reset process is sometimes going to be messy and volatile, not just for equities and commodities, but also for yields and currencies.”

It has certainly been a brutal reset. Global stock markets have seen nearly US$ 8 trillion of wealth wiped out this month alone, while investors last week poured more into government bonds — a traditional safe haven investment — than at any time in the past year.

What is also spooking investors is the fact that if the U. S does slip into recession again, the Fed is very limited in what it can do to help the economy. Policymakers have already ballooned the central bank’s balance sheet with a trillion dollar quantitative easing program and interest rates continue to remain near record lows, even following a 25- basis- point rate hike in December.

“We cannot rule out a recession in the next year,” said Bank of America Merrill Lynch economists Ethan Harris and Emanuella Enenajor in a note to clients. “Accidents will hap- pen, and we are concerned about the lack of policy ammunition to deal with a major shock.”

Recession fears have markets now betting that the Fed will not move as quickly on interest rates as was projected last year.

While economists had expected as many as four quarter- point rate hikes this year, futures markets are now betting that chairwoman Janet Yellen will only hike once in 2016, and not until the second half of the year.

If there’s any good news to take away from the current environment, it’s that the sharp decline in oil prices could stoke growth further down the road says Robert Kavcic, senior economist at BMO Capital Markets.

“A supply- driven plunge in oil prices, while causing an immediate cutback in related capex, will ultimately drive higher output and employment in the U. S., while leaving interest rates lower and non- energy corporate profits higher than they otherwise would be,” he said.

If that does play out, it could spell a bounce back for global markets and the U. S. economy.

“The sudden nature of the drop in oil prices is rightfully causing a tremendous shakeup in financial markets as investors calibrate to a new macro environment, but the U. S. economy, U. S. equities and, dare we say, non- energy Canadian equities should come out clean on the other side,” he said.