US equity crash points to heightened risk of 2023 recession
The stock market is signalling a heightened risk of a US recession in mid 2023 assuming no recovery in equity prices over the rest of this year. This is earlier than the signal from the more reliable yield curve, where economist estimates and market pricing of interest rates point to a heightened risk of recession in late 2023/early 2024 according to Coolabah's recession forecasting model. This suggests that while the Fed thinks a mild economic slowdown can contain inflation, financial markets are focused on the risk of a recession in the second half of next year to bring consumer prices under control.
The slope of the yield curve – combined with the Fed funds rate – continues to point to a low risk of recession in the US in the short term, although extended forecasts based on economist estimates and market pricing of interest rates currently point to a heightened risk of recession in late 2023/early 2024 based on our modelling.
The most widely-used, but less reliable, alternative to the yield curve as an indicator of the risk of recession is the stock market. The main problem with using equity prices is that they send more false signals of recession, as made clear by economist Paul Samuelson’s famous quote that, “the stock market has predicted nine out of the last five recessions”.
The other issue is that stock prices provide only a short lead on the risk of recession, unlike the 12 month lead provided by the yield curve.
With these qualifications in mind, the chart below shows the risk of recession in the US in six months’ time based on a simple model of growth in US stock prices.
Using monthly data, stock prices have fallen sharply and are now off ~19% from the end of last year. This suggests that the risk of recession in the US based on the signal from equity market is about 20% in six months’ time, which is similar to the signal provided on three previous occasions in recent years, one of which was near the 2020 recession.
However, on the assumption that there is no recovery in stock prices over the rest of this year, our model suggests that the risk of recession would rise to around 35% by the middle of 2023, which historically would be a strong recession signal from the stock market (the signal would naturally be stronger if equity prices continue to decline and fail to rebound later in the year).
Given that the forward estimates from our yield curve model pointed to a heightened risk of recession in late 2023/early 2024, the combined signal from the equities and bond markets suggests the risk of recession should be most apparent in the second half of 2023.
Although the Federal Reserve is forecasting that it will contain inflation by engineering a mild economic slowdown as the impact of pandemic-related disruptions on consumer prices fades, financial markets - including both bonds and equities - are signalling that the Federal Reserve may end up with a recession as it brings inflation under control. Coolabah has consistently warned investors about the risk of large equity and bond losses since the first half of 2021. You can read a summary of this research and our prior warnings here.
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