Six of the last four recessions
Financial markets are signalling the risk of a recession. They might have cried wolf before, but it is still worth paying attention to them.
On Christmas Eve the global equity markets were down about 15% compared to a year earlier. Since then the markets in the US have rallied, but not in the eurozone. Worryingly, all of the recessions that I can remember were accompanied by declines in equity markets like those experienced in 2018.
There is at least one problem with that statement: what about all the times the equity markets declined without there being a recession? After all, none other than the man who literally wrote the book on economics, Paul Samuelson, once quipped “The stock market has predicted nine of the past five recessions.”
And, indeed, years before I knowingly experienced my first recession, I had already experienced my first market crash. It was ‘Black Monday’ in 1987. The Dow had declined more than a fifth in a day, which remains the largest percentage drop on record. My Dutch family lived in the US at the time and I watched more cable news than was probably healthy for a twelve year old, so I was all too aware of the situation. I vividly remember confiding in my father that I feared we might be on the cusp of a new Great Depression. As it turned out, there were a few more years of growth before a (relatively mild) recession kicked in. Equity markets had affirmed their reputation for crying wolf in spectacular fashion … and I was off to a bad start as an economic forecaster.
Perhaps that was why in the late ‘90s, when I started working as an economist, I didn’t initially have much interest in financial markets. But financial markets did have an interest in economists, so I ended up working on Rabobank’s trading floor. During my time there, every major correction in the equity markets did precede a recession. Partly as a result, I became fascinated by the interaction between financial markets and the economy.
After taking time off to finish my PhD, I worked at the New York Fed and later the Bank of England. Most of the analysis I did in those years was directed at figuring out what useful information financial markets could tell policymakers. To do that we looked not just at one market, but at all markets together. Declining equity markets are more likely to be a signal of a recession when they are accompanied by declining government bond yields, falling commodity prices and rising credit spreads. That pattern accompanied the recession in the euro-zone 2012, but proved a false alarm in 2016.
So, to sum up along Samuelson’s lines, since the late ‘80s, equity market declines of the scale experienced in 2018 have ‘forecast’ six of the last four recessions in the US or Europe (see figure 1). Equity markets tend thus tend to be too quick in signalling a recession. Interestingly, that is exactly the opposite mistake economists make. According to a recent IMF paper, they tend to cut their forecasts too slowly in recession years. The recent decline in equity markets, government bond yields, commodity prices and rise in credit spreads may prove to be the markets crying wolf again. But it still wise to pay attention …. and, in related news, we have updated our growth forecasts for the euro area after the recent spate of weak economic data.