Macro Signposts | 13 August 2024
Unless explicitly stated, views expressed do not constitute official PIMCO views.
When Does an Economy Hit Stall Speed?
The recent triggering of the Sahm Rule has sparked discussions about a potential recession in the United States. For decades, the Sahm Recession Indicator, which is based on employment data, has unfailingly identified the start of each U.S. recession. But as we discussed in last week's Macro Signposts ("Data Suggest Downshift, Not Recession"), there are important differences in the recent unemployment rate drivers that suggest the U.S. economy is not currently in recession.
However, for markets and investors, current conditions matter insofar as they help shape the outlook. Hence, if the economy isn't currently in recession, the pertinent question is, "What are the chances of a recession in the near future?"
Last week, we explored this question, considering historical hiking cycles in the 20th and 21st centuries. We noted that developed market (DM) central banks have a limited track record of achieving a soft landing after an inflationary period, with only a 30% success rate in our sample of 140 hiking cycles across 14 developed markets. Still, because the current cycle has similar traits to historical soft landing hiking cycles, we argued that the near-term chance of recession isn't as elevated as historical analysis would imply, but also likely not as low as the roughly 15% average historical chance of being in recession in any given year.
This week, to dig deeper into the outlook for recession, we revisit an old recession forecasting adage - the "stall speed" concept - before discussing the signals coming from PIMCO's detailed recession models.
What is stall speed for the U.S. economy?
Stall speed is an economic concept that's been around for decades. It refers to the critical threshold of economic growth, measured in annualized percentage GDP, below which an economy becomes increasingly vulnerable to recession. Much like an airplane that risks stalling if its speed drops too low, an economy that grows too slowly may lack the momentum needed to sustain expansion, making it more susceptible to negative shocks and downturns.
To estimate stall speed, we devise a simple rule that is triggered when real GDP growth falls below a certain threshold for two consecutive quarters. We define this threshold as half the average annualized real growth rate of GDP over the last five years. For example, if the average real GDP growth rate were 2% over a five-year period, a real GDP growth of 1% or below (but still positive) on average for two consecutive quarters would trigger the stall speed rule. While there are other ways to estimate stall speed, this approach is appealing for its intuitive simplicity.
So, has the stall speed rule accurately forecast past recessions? We compared the frequency of recessions in the eight quarters following the trigger with the historical average recession frequency.
Applying the rule to U.S. data, the stall speed rule correctly identified five of the nine U.S. recessions since 1960, as defined by the National Bureau of Economic Research. The rule missed the recession in the mid-1970s and the second leg of the early 1980s double-dip; it also had a few false positives in the mid to late 1960s and in the sluggish recovery after the 2000s dotcom bubble. Overall, the rule was accurate about 55% of the time in predicting a recession within the subsequent eight quarters. Performing the calculation using U.S. real gross domestic income or final domestic demand instead of GDP improves the historical recession forecasting accuracy to roughly 70%.
Considering that the U.S. economy historically has had a roughly 15% probability of entering (or continuing) a recession in any given year (or 30% chance over two years), the data do support the intuitive notion that low growth is a decent indicator of recession.
Looking beyond the U.S.
Applying the same low-GDP-growth-based rule to six other DM countries also showed similarly elevated hit rates relative to the average historical frequency of recession. Specifically, in Germany, Italy, and Spain, the stall speed rule had hit rates above 50%, versus the 30%-40% average historical chance in any two-year span for those countries. Hit rates for France, Canada, and Australia were lower, between 35%-45%, but for Australia and Canada, the historical average chance of a recession occurring in any given two-year window has also been lower, closer to 20%.
All of this suggests there is some empirical support to the stall speed concept, although the cause might not be exactly akin to the airplane metaphor. Low growth periods may make economies more susceptible to negative economic shocks, such as energy price spikes in the 1970s and 1980s, the bursting of the tech bubble in the late 1990s, or financial crises like the Long-Term Capital Management blowup in 1998 - all instances where low growth preceded a recession. Nevertheless, we think the stall speed concept is a useful framework for assessing today's economic situation.
What do these simple indicators say today?
Not surprisingly, they say that recession probabilities are higher in DM economies outside the U.S. Mildly contractionary GDP performance over the past year has produced stall speed warnings in Canada, Australia, Italy, and France. Germany also hit the trigger in 2021, and by our assessment, the German economy entered a mild recession in 2023, although the official German recession dating committee has yet to confirm this. To be sure, we did get a U.S. trigger in the second quarter of 2022 (using final domestic demand as a signal). However, the subsequent eight-quarter window of our rule ended in the second quarter of 2024 without a U.S. recession, making this trigger a false positive.
What do PIMCO's more rigorous and detailed recession models say?
We like back test methods, such as the stall speed adage, for their simplicity, but they aren't the only recession models we run at PIMCO. Our fancier business cycle dynamic factor models, which incorporate hundreds of economic and market variables, also indicate that the likelihood of recession is higher in DMs outside the U.S. The average recession probability across a range of these fancier models places about a 30% chance of the U.S. entering a recession over the next 12 months, with notably higher (greater than 50%) chances estimated for other DM regions.
What's the bottom line?
Despite market jitters over the past few weeks, a survey of recession probability models, including historical stall speed triggers, suggests that the chance of a U.S. recession over the next 12 months is higher than the historical average but a far cry from assured, or even a coin flip. In fact, the generally poor economic performance over the last year in other DMs outside of the U.S. suggests that recession probabilities are much more elevated there. Even if low growth doesn't beget a recession, it does make these economies vulnerable to shocks.
Of course, U.S. growth could decelerate to stall speed. We do expect U.S. real GDP growth to slow notably from an above-trend pace over the next several quarters, raising the chances of a U.S. recession. This along with generally low growth trends across other DM economies and a slowing China makes the global economy susceptible to shocks. Couple this with escalating tensions in the Middle East and the outlook for global trade disruptions depending on the U.S. election, and we see several good reasons for the Federal Reserve to initiate its rate-cutting cycle and to move more quickly to neutral. However, other DM central banks, many of which have already begun cutting rates, arguably have more incentive to cut more vigorously.
Overall, even in the absence of immediate recessions in the U.S. or elsewhere, markets may become more reactive to negative news as last year's global economic resilience - led by the U.S.'s solid performance - gives way to a period of more fragile, below-trend growth. In other words, despite the recent market rally, the macro outlook suggests there is still a lot of value in owning bonds.
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