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The Return of the Dreaded ‘R’ Word

Since the beginning of the year, market volatility has returned with a vengeance. The Canadian benchmark S&P/TSX Composite Index, which ended 2015 down 11.1% on a price basis in local currency terms, has since dropped a further 7.7%.

Of course, Canada is hardly alone. Fears about slowing global demand, particularly in China, have created turmoil in most of the world’s major stock markets.

The S&P 500, for instance, was essentially flat for 2015, declining 0.7% on a price basis. But it, too, is now in formal correction territory, down 10.5% since the start of the year and off 14.1% from its trailing-year high last May.

The question that market watchers are grappling with is whether the tumult in the financial markets will ultimately flow through to the real economy. After all, as economist Paul Samuelson once famously quipped, the market has predicted nine of the last five recessions.

Meanwhile, most of the world’s major central banks are currently in easing mode. And even the U.S. Federal Reserve, which is nominally in a rate-hiking cycle, is expected to hold back until the situation shows signs of improving.

As evidence of the dramatic shift in sentiment, traders now see just an 11.2% chance of another Fed rate hike between now and February 2017. Yesterday, that number topped out at around 37%.

And as recently as mid-December, traders’ bets were more or less in line with the Fed’s own forecasts for interest rates, with four rate hikes predicted this year. Of course, traders could make equally dramatic adjustments to the upside if the markets finally settle down.

In contrast to the Fed, the Bank of Canada is widely expected to cut its overnight rate by another quarter-point, to 0.25%, possibly as soon as April, which would bring the benchmark rate back to its low during the 2008-09 downturn.

Some central banks, such as the Bank of Japan, are already implementing unconventional monetary policy, while other central bankers, including Fed chief Janet Yellen, are talking up the various unconventional monetary policy tools they have at their disposal.

Although there is some debate over whether the world’s central banks, which have remained extraordinarily accommodative since the Global Financial Crisis, have run out of ammo, it’s hard to dismiss cheap money’s ability to support asset prices.

In Canada’s case, the country already suffered something akin to a recession during the first half of last year, when gross domestic product (GDP) declined for two consecutive quarters.

However, economists generally did not characterize that period as a recession since the contraction was not accompanied by a similar deterioration in other key economic factors, such as employment. Consequently, the country’s stock market largely shrugged it off, declining just 0.5% on a price basis in Canadian dollar terms during that six-month period.

Right now, the consensus forecast among institutional economists is for Canada’s economic growth to moderately accelerate to 1.8% this year from a projected 1.2% in 2015–we’re still waiting on the government’s bean counters to finish crunching the numbers for the fourth quarter, which won’t be released until March 1.

Nevertheless, such forecasts often include a number of assumptions that can be quickly undone by fast-moving markets, especially when it comes to financial assets and commodities.

For instance, a number of market observers are unnerved by widening bond spreads, the difference between risk-free government bonds and higher-yielding corporate debt. That indicates investors are piling into the former and abandoning the latter.

In assessing whether the real economy faces the threat implied by the financial markets, some data-driven intuition may be warranted, especially in the short term.

To that end, CIBC economists have devised a proprietary Canadian Recession Probability Indicator. It’s based on a model that incorporates employment trends, wages, monthly GDP, and the slope of the yield curve, and compares these data against where they stood at varying points during past recessions.

Right now, the indicator shows the probability of a recession in Canada stands at 10%. So while there are plenty of worrisome data out there, the bank’s economists aren’t “yet ready to wave a red flag.”


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