James McCann, Senior Global Economist, and Jeremy Lawson, Chief Economist at Standard Life Investments, delve into the murky waters of recession forecasting. Here’s what they have to say: ‘Understanding whether economies are in the early, middle or later stages of their business cycles is critical for investors. Each business cycle has four phases – expansion, peak, contraction and trough. Expansion is measured from the trough of the previous cycle to the peak of the current cycle, while recession is measured from the peak to the trough.
The part of the business cycle that receives the most attention is naturally a recession. However, the definition of recession is itself not straightforward. The much-cited example of two quarters of negative gross domestic product (GDP) growth is too simplistic and tells us little about the scale or breadth of the downturn –it can even cause false alarms. That’s why we’ve built our own definition based on identifying shifts in economic momentum that increase disinflationary forces and force widespread policy responses. You can read more about how we define a recession in Standard Life Investments’ Global Horizons – When will the music stop? Dating the global business cycle
According to James McCann and Jeremy Lawson: ‘business cycles are, unfortunately, hard to age – this is partly because the phases don't occur at regular intervals and partly because no two cycles are exactly the same. Let’s take the current expansion – almost nine years since the global financial crisis struck, the recovery remains slow, bumpy and uneven by historical standards. Low inflation and the widespread monetary easing that took place in 2016 suggest that we’re still in the early stage of the cycle; however, small unemployment gaps and elevated asset prices tell a later-cycle story.
Low inflation and the widespread monetary easing that took place in 2016 suggest that we're still in the early stage of the cycle; however, small unemployment gaps and elevate asset prices tell a later-cycle story.
And if ageing a business cycle is hard, predicting the timing of recessions with accuracy is even more difficult. Indeed, economists have a notoriously bad reputation for calling recessions ahead of time, or even after they’ve started. For example, in its regular April forecasts the IMF missed every one of the 220 instances in which a growing economy contracted in the next calendar year.
IMF missed every one of the 220 instances in which a growing economy contracted in the next calendar year.
‘With these challenges in mind, our experts at Standard Life Investments have sought to identify more robust empirical frameworks for mapping business cycles, and identifying when these cycles might draw to a close.’
So how do you predict a recession?
Using advanced analytical and econometric techniques, the strategy team at Standard Life Investments has identified a range of economic and financial indicators that help them to age the global and national business cycles – as well as estimate the likelihood that individual economies will experience recessions over different time horizons. James and Jeremy summarise their process:
'Step 1 - We begin by developing a clear understanding of cycles and their different phases, drawing on the insight that business cycles do not die of old age but instead usually end thanks to the forced or spontaneous unwinding of large economic and/or financial imbalances.
'Step 2 - We identify the economic and financial indicators that have provided reliable signals about the cyclical position of economies over time. We can then normalise and aggregate these indicators to build global and country business-cycle heat maps so that we can identify where economies are currently placed in their cycles.
'Step 3 - We use these data to build short and longer-term recession probability models, based on Bayesian Model Averaging techniques that sort through thousands of combinations of models to identify those with the strongest predictive performance.
'Cycles and recessions by their nature are difficult to forecast because some of the factors that dictate turning points are themselves hard to predict and even quantify. That’s why we’ve developed a framework that we think adds more rigour and discipline to business cycle analysis. Using advanced analytical and econometric techniques, we’ve identified a range of economic and financial indicators that help us to age the global and national business cycles, as well as estimate the likelihood that individual economies will experience recessions over different time horizons.
'For a much more detailed explanation of Standard Life Investments’ recession forecasting framework take a look at Global Horizons – When will the music stop? Dating the global business cycle .’
What's the current outlook
The experts at Standard Life Investments offer their views: ‘at present, our analysis suggests that the global cycle has further to run as it’s displaying more middle-stage than late-stage characteristics. Indeed, when we estimate the probability of recessions across different time horizons, our models imply that for the major advanced economies the risks are currently relatively low. Of course, there are limitations to these signals, and we’ll need to monitor their evolution and the broader macro and geopolitical environment with care.
‘For now though, our analysis suggests that investors should feel more confident about extending their investment horizons.’
Our models imply that for the major advanced economies the risks are currently relatively low.
We’ll keep you updated on the latest views from the investment strategists at Standard Life Investments. Also look out for the monthly market reviews from Andrew Milligan, Head of Global Strategy at Standard Life Investments.
Content in this section is provided by Standard Life Investments. It does not constitute any financial or other professional advice or recommendations. Please remember that the value of your investment can go up or down, and may be worth less than you paid in. Information is based on our understanding in July 2017.