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A Funny Thing Happened on the Way to Recession

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At the beginning of the year, fears were widespread that recession was heading toward the U.S. — and, indeed, the rest of the world. Even the perennially optimistic Wall Street Journal survey of economists put the odds of recession in the coming 12 months at 21%, twice the level anticipated a year earlier and the highest reading since 2012. On balance, I believe the pessimism over the economic outlook and in financial markets was overdone early this year — but so too is the more recent euphoria.

Early this year, major country central banks and world leaders in effect acknowledged the impotence of monetary policy in what I call “the age of deleveraging.” They called for labor market and other structural reforms, infrastructure spending, and more business-friendly tax structures. For China, they recommended shutting down zombie companies such as steel mills wallowing in excess capacity, and slashing the huge stockpile of excess housing.

Investors, meantime, were worried about big unknowns including whether the Fed would keep raising interest rates, whether China would continue to devalue the yuan, whether the U.K. would leave the European Union, and whether the next U.S. president would be Donald Trump on the extreme right or Bernie Sanders on the far left.

I’ve never been shy about forecasting recession when the conditions are ripe, as I did emphatically during the dot com bubble of the late 1990s and in 2007 as the collapse in subprime mortgages began to unfold. But this year, I simply didn’t see a trigger for a business downturn (although I did allow that if crude oil prices dropped to my target of $10 to $20 per barrel, the resulting financial fallout would probably precipitate a global economic downturn). Instead, I noted that recessions have typically resulted from substantial Fed interest rate hikes or major shocks.

Sure, the Fed raised interest rates in December and planned four more hikes in 2016; but it had cried wolf so many times about accelerating growth and a resurgent labor market that if it did nothing last year, its credibility would have been further eroded.

Then a funny thing happened on the way to that widely-forecast recession. China didn’t massively devalue the yuan and turned, as it has in the past, to infrastructure spending to stave off a collapse in economic growth, despite the predictable result of more debt and more excess capacity.

And with inflation running well below the Fed’s 2% target and deflation still a danger, the U.S. central bank scaled back its rate-raising plans. At the March 16 meeting, it halved the number of expected quarter-point rate hikes this year to two, and reduced its 2016 year-end inflation forecast to 1.2% from 1.6%. The Standard & Poor’s 500 Index, which dropped 5% in January, has been rising since the second week of February and is now about 1% higher for the year. Even so, many of the reasons to be cautious about the outlook for growth have not changed in the past month or so of optimism. First, commodity prices will likely continue to fall as slow global demand growth meets the huge supply resulting from past over-investment and the tendency among many commodity producers to further increase output in the face of falling prices. This is especially true for oil as OPEC (led by Saudi Arabia) is in a deadly game of chicken to see which major producers will slash prices to eliminate excess supply.

Second, the world is still working off the heavy debts and other imbalances accumulated during the 1980s and 1990s. As one example, total U.S. household debt as a percentage of disposable (after-tax) income has declined to 104% from its 130% peak, but remains far above the earlier norm of 65%. The household saving rate has rebounded from a 2% low in 2005 to 5.4% in February, but is still well below the 12% level of the early 1980s to which I expect it to return.

Furthermore, the three-decade-long era of globalization is over. It transferred manufacturing and other production from North America and Europe to China and other developing countries and drove economic activity there. But just about everything that can move already has; there’s little manufacturing capacity left to export.

So, from the depths of despair and fears of global recession in January, hope and investor confidence returned in February and March. But has anything fundamentally changed, on balance?


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