The financial markets have experienced a solid recovery this year, despite growth figures in the global economy — and principally the advanced economies – extending to head downward. With activity forecasts (the prognosis of the present, the near future and the very recent past) continuing to dive, and manufacturing sectors weaker than at any point since 2012, markets may have become overly confident about recession risks.
In the final quarter of last year, market behaviour was consistent with two economic shocks operating in tandem. The crash in global equities and a downturn in break-even inflation forecasts in the bond market pointed to a negative demand shock to the world economy. A concurrent upsurge in real bond yields and a soaring dollar were characteristic of a bellicose stance in monetary policy, markedly from the US Federal Reserve. These two shocks were perhaps almost equally significant in demonstrating the crash in risk assets last year. Since the turn of the year, both components have altered. There has been a diminished revival in China: monetary aggregates indicate that expansionary domestic strategy is gaining traction and market risks are slackening.
The estimate for China has jumped from a low of 4.0 percent in mid-December to 5.2 percent now. With China turning the corner, markets seem eager to disregard the continuing stagnation in the advanced economies, which has taken the latest growth rate to only 0.8 percent, 0.9 per cent below trend. This is perceived as good news because it will lessen the probability of higher interest rate increases. The dovish turn in US monetary policy has been endorsed by an unexpected volte-face in policy direction by the Fed leadership in the space of a few weeks. As recently as mid-December, the Federal Open Market. The committee hinted that policy rates were expected to advance by 75 basis points before stabilising. By the conclusion of January, the FOMC had almost eliminated its direction towards further rate hikes.
A move on this scale appears only during the outset of a downturn. Yet markets are working on the premise that recession risks remain modest, with growth expected to rebound back to trend. This chapter of the cycle is apocryphally described as the “Goldilocks zone”, in which growth is neither too hot nor too cold.
In this phase, bad news on growth can generally be positive news for markets, as it has been lately. This stage in the cycle can last several years, but the statistics require careful watching, notably while the position in several big economies is still worsening.
Meanwhile, growth is nevertheless strong enough to indicate that the risk of outright recession in the next 12 months remains close to zero. The model, thus, still suggest that growth in the Goldilocks zone is feasible and markets have rallied on this situation.
In the Eurozone, the theme is different. The prospect of steady expansion has dwindled to a slim 10 per cent. The anticipation of a cyclical recession (characterised as two quarters in which the growth rate is over one standard deviation below trend, suggesting gross domestic output growth at -0.5 per cent annualised) has grown.
A so-called “technical” recession, in which growth dips below zero for two quarters, is now predicted to be 25 per cent possible. These results signify that while the US is still adhering to the middle of the Goldilocks zone, the Eurozone is toying with the tail edge of its zone. Any further deterioration would show a substantial surge in the prospect of a European recession this year. With the Japanese economy already in the negative zone and Asian trade flows headed downward, the markets may not overlook much more deficiency in the world economy.