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What is a recession? A broad and deep downturn in economic activity that is closer to a growth slowdown than a recession.

Common indicators for predicting recession: Some models have been triggered, but the "special characteristics" of this economic cycle have made many indicators invalid

The main factors leading to recession: monetary tightening, fiscal cuts, high leverage, stock market crash, external shocks; most of the pressures are currently controllable

Historical experience of recession: investment declines significantly. If the recession is deep, risk assets will continue to be under pressure, and gradually recover in the later stages of the recession.

The revelation for the present: Under the pressure of economic slowdown rather than systemic recession, the safe-haven asset rate cuts have basically ended, and there is a better opportunity to intervene after the correction of risky assets

The US economic data has been lower than expected, coupled with the reversal of carry trades and the sharp fluctuations in the global equity market, which has significantly increased the market's concerns about the US economy heading towards recession and a "hard landing". In this article, we will clarify the concept, characteristics and triggering factors of recession, judge the potential recession risk of this round, and answer the core questions of investors: how to trade next, should we focus on the opportunity to buy when the market falls, or the risk of further sharp falls?

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July non-farm payrolls and ISM manufacturing PMI data were significantly lower than expected, significantly increasing market concerns about the US economy heading for recession and a "hard landing".US Treasury BondsInterest rates quickly fell below 3.8%, U.S. stocks fell sharply, the S&P market recorded its largest one-day drop in two years, and the U.S. dollar index fell to 103, all of which met the characteristics of "recession trading". However, there are also interesting "exceptions". As the recession narrative heats up, copper closed up slightly by 0.4%, and gold fell as real interest rates and the U.S. dollar index fell. This is not only basically close to the range given in our gold "pivotal point" forecast model based on real interest rates and the U.S. dollar ("2024 Second Half Outlook: Looseness is Halfway Through"), but also reflects the differences and entanglements of different assets when trading "recession".

Obviously, the current judgment on the degree of growth slowdown is critical and directly determines the asset selection and operation strategy. In other words, is it a normal slowdown or a deep recession? Is it a "soft landing" or a "hard landing"? The growth slowdown is an indisputable fact and is the result of the current US economic cycle and tightening financial conditions. Otherwise, there would be no need for the Fed to cut interest rates. But if it is just a normal economic slowdown, that is, the degree is not deep, and the Fed can make a small interest rate cut to make the economy more stable, it is not necessary to cut interest rates.Monetary PolicyIf the market returns to neutrality and loosens to boost demand again (such as in 1995 and 2019), risk assets will not be subject to systemic pressure. They will be under pressure in the short term but gradually turn to the logic of improving the denominator, that is, the correction provides better opportunities for intervention ("Is the US stock market currently trading a recession?"); if there is a recession risk, it means that the decline in demand is very deep, and the Federal Reserve also needs to cut interest rates significantly to hedge economic pressure. Even cutting interest rates alone is not enough to boost demand. At this time, there will be more trading logic of downward movement of the numerator, rather than improvement of the denominator, that is, risk assets "cannot be touched in the short term." For example, the maximum retracement of US stocks in a deep recession is 44%, which is significantly greater than the 19% of a mild slowdown.

Chart: The maximum retracement of US stocks in a deep recession is 44%, which is significantly greater than the 19% in a mild slowdown.

Source: Bloomberg, CICC Research

Of course, the "recession narrative" will also achieve a de facto "recession deal" when there is no great pressure on growth, which is reflected in the blessing and amplification of emotions. Previously, economic data exceeded expectations and people were worried that inflation would remain high. Now it is too weak and people are worried about economic recession. Behind this is the amount of accumulated gains and the amplification of emotions. If we only emphasize the recession narrative, we may be too pessimistic about risky assets and too optimistic about safe-haven assets.

In this article, we clarify the concept, characteristics and triggering factors of recession, judge the potential recession risk of this round, and answer the core questions of investors: How to trade next? Should we focus on the opportunity to buy when the market falls, or the risk of further sharp decline?

What is a recession? A broad and deep downturn in economic activity that is closer to a growth slowdown than a recession.

An economic recession is a severe, widespread, and prolonged downturn in economic activity. The National Bureau of Economic Research (NBER) has long been responsible for determining the stages of recession in the United States. The main indicators examined include personal real income after deducting transfer payments, non-farm employment, household survey employment, real personal consumption expenditures, real manufacturing and trade sales, and industrial output. When determining a recession, the NBER takes into account depth, diffusion, and duration. All three dimensions must be met, but extreme values ​​of a certain standard can make up for the insufficiency of other standards. Since the NBER does not disclose specific quantitative standards and the announcement time is often delayed, it is difficult to use the judgment of the above dimensions as a specific reference for recession trading in actual operations.

Chart: The NBER defines recession based on six indicators, including personal real income after deducting transfer payments, non-agricultural employment, etc.

Source: Haver, CICC Research Department

Judging from the current major indicators, the fundamentals of the US economy can only be regarded as a slowdown in growth, which is still far from the recession defined by NBER. From the perspective of the dimensions of the indicators used by NBER, 1) income and consumption, personal disposable income slowed slightly from 4.0% at the beginning of this year to 3.6% in June, and personal consumption expenditures increased from 1.9% at the beginning of the year to 2.6% in June, both of which have maintained a relatively stable growth rate since 2023.

Chart: Personal consumption expenditure increased from 1.9% at the beginning of the year to 2.6% in June, maintaining a relatively stable growth rate since 2023

Source: Haver, CICC Research Department

2) Employment: The overall job market is indeed cooling down, especially the 114,000 new non-farm payrolls in July, which was significantly lower than expected. However, it cannot be ruled out that it was affected by "accidental" and "temporary" factors. According to the report of the Ministry of Labor, it may have contributed two-thirds of the 0.2 percentage point increase in the unemployment rate.

Chart: The overall job market is indeed cooling down, especially the 114,000 new non-agricultural jobs in July, which was significantly lower than expected

Source: Bloomberg, CICC Research

3) Production: Industrial output improved both month-on-month and year-on-year, with the year-on-year growth rate reaching 1.6% in June this year.

Chart: Industrial output improved both month-on-month and year-on-year, with a year-on-year growth rate of 1.6% in June this year

Source: Haver, CICC Research Department

Chart: July ISM manufacturing PMI fell sharply and was lower than expected

Source: Haver, CICC Research Department

Comparing the indicators of various dimensions during the NBER recession since 1970: 1) Income and consumption, personal consumption expenditure slowed down significantly year-on-year before the recession, and personal consumption expenditure turned negative year-on-year in 6 of the 7 recessions; 2) Employment, the unemployment rate rose to an average of more than 5% in the early stages of the recession, and the number of new non-agricultural jobs turned negative; 3) Production and investment, industrial output fell rapidly year-on-year and turned negative, and the actual scale of non-residential fixed investment fell by an average of about 8%.

Chart: Overview of the Coincident Indicator of the US Economy in Five Dimensions

Source: Haver, CICC Research Department

Chart: Overview of the five major dimensions of the US economic leading indicators (Leading Indicator)

Source: Haver, CICC Research Department

Common indicators for predicting recession: Some models have been triggered, but the "special characteristics" of this economic cycle have made many indicators invalid

To predict recessions and guide trading, the market often usesGDPGrowth, U.S. Treasury term spreads, the Sahm Rule, and the Bank of JapanRate hikesAs forward-looking indicators of economic recession, some indicators have been triggered, but these indicators also have certain limitations and cannot be simply applied. The particularity of this round of US economic cycle (the "rolling" of various links is obviously misaligned to form a hedge) has made some indicators obviously invalid. For example, negative GDP growth and curve inversion have already appeared, but recession has not yet arrived, which fully demonstrates the "specialness" of this round of cycle.

1) Two consecutive quarters of negative GDP growth is an empirical model of a "technical recession". In the first and second quarters of 2024, real GDP growth is still relatively strong, which does not meet this definition. From historical experience, "technical recession" usually means that a real recession defined by NBER will also occur, but the opposite is not true. Since 1948, there have been a total of 12 recessions defined by NBER and 10 technical recessions with two consecutive quarters of negative real GDP growth. It can be seen that each technical recession corresponds to an NBER recession, but the opposite is not necessarily true. The initial value of the US real GDP in the second quarter of 2024 recorded an annualized rate of 2.8%, an increase from 1.4% in the first quarter, and higher than the market expectation of 2%, which does not meet the definition of a "technical recession". Previously, there were two consecutive quarters of negative growth in the first and second quarters of 2023, which triggered concerns about recession, but it was later proved that this experience was not applicable.

Chart: Real GDP growth in the first and second quarters of 2024 is still relatively strong, not meeting the definition of a technical recession

Source: Haver, CICC Research Department

2) The inverted yield curve is not necessarily related to weak demand and recession. The current inversion has lasted for nearly two years (the 2s10s spread turned negative on July 5, 2022, and the 3m10s spread turned negative on October 27, 2022), and private sector credit has not collapsed significantly. In judging recessionary pressure, the 3m10s spread is the main reference for the New York Fed's recession prediction model, which essentially measures the relationship between short-term financing costs and long-term returns. However, since the Fed's sharp interest rate hike of 525bp, the inversion of the U.S. Treasury yield curve has lasted for nearly two years, and is currently still in the deepest inversion since the 1980s, but private sector investment remains relatively resilient, and even started a small credit expansion when financial conditions loosened at the beginning of the year ("The Pendulum and the "End Game" of the Rate Cut Transaction").

Chart: The U.S. Treasury yield curve has been inverted for two years

Source: Bloomberg, CICC Research

3) The Sahm Rule shows that the current rise in unemployment has triggered recession conditions, but the rule may fail under the combination of high growth and low inflation. When the three-month moving average of the unemployment rate rises by 0.50 percentage points or more from the low point of the previous 12 months, it indicates that a recession is about to begin. However, this indicator is not forward-looking, and it is often only when the recession begins that this data exceeds 0.5. Since 1960, the average value of the month when a recession began was 0.26, but when this indicator reaches 0.5, it must be in a recession. After the July unemployment rate data was released last Friday night, the value of the Sahm Rule has exceeded 0.5. Sahm also has his own evaluation of the Sahm Rule. When economic growth is good and inflation drops to 2%, it does not necessarily constitute a recession. In addition, in his latest interview, Sahm also said that he was not facing an immediate recession risk. This time may be different, such as the impact of immigration. Whether it is necessary to consider the starting point of the unemployment rate increase, rather than just the magnitude [1].

Chart: Sam's rule shows that the current rise in unemployment has triggered recession conditions

Source: Haver, CICC Research Department

4) The Bank of Japan raised interest rates again last week. According to market experience, this is a sign of recession. However, this is an a posteriori rule and lacks a necessary connection. The Bank of Japan’s four interest rate hikes, including this one, were all inFed rate hikesThe recession is nearing its end, so using the Bank of Japan's interest rate hike to judge the US economic recession is actually judging that "Federal Reserve interest rate hikes often lead to recessions", but not every round of Fed interest rate hike cycles will necessarily lead to a recession.

Chart: The Bank of Japan raised interest rates again last week, which is a sign of recession according to market experience

Source: Bloomberg, CICC Research

It is not difficult to see that each indicator has its own limitations, and even fails. This shows that instead of mechanically entangled in the law itself based on the summary of historical laws, it is better to understand the mechanism behind it and whether it is applicable to the particularity of this time. The current baseline scenario is a mild weakening of the economy, which is also the result of tightening financial conditions and before interest rate cuts. Since the interest rate hike cycle, financial conditions have remained tight, which in itself will suppress growth and demand, but the restrictions of monetary policy and financial conditions on demand are marginal, so the degree of weakening of fundamentals should not be excessively linearly extrapolated.

The main factors leading to recession: monetary tightening, fiscal cuts, high leverage, stock market crash, external shocks; most of the pressures are currently controllable

Since the 1920s, the United States has experienced 18 recessions. Recessions are triggered by multiple factors, and often not by a single factor. After analyzing and summarizing them one by one, we found that the triggering factors can be roughly attributed to one or more of the following five situations: monetary tightening, fiscal spending cuts, high leverage, stock market crashes, and external shocks.

Chart: According to NBER definition, the United States has experienced 18 recessions since the 1920s

Source: Haver, CICC Research Department

Chart: Recessions have been triggered by monetary tightening, fiscal cuts, high leverage, stock market crashes, and external shocks

Source: Haver, CICC Research Department

For example, the 1970s and 1980s were more due to the rapid rate hikes by the Federal Reserve in response to high inflation under supply shocks; the Great Depression of 1929 and the bursting of the technology bubble in 2000 were more due to large-scale speculation and overvaluation pushing up US stocks and triggering financial systemic risks; 1920, 1945, 1953, and 1969 were more due to the sharp cuts in government fiscal spending after the war. In summary, the factors that led to the 18 recessions were: 14 monetary tightenings, 5 fiscal cuts, 2 high leverages, 2 stock market crashes, and 7 external shocks.

Chart: Overview of inflation and unemployment rates before and after recessions since the 1920s

Source: Haver, CICC Research Department

Chart: Overview of monetary policy, fiscal policy and triggering factors before and after recessions since the 1920s

Source: Haver, CICC Research Department

Combined with the current environment, most of the pressures in the above recession triggers are controllable: 1) Monetary tightening is the main contradiction, but it is also expected to ease quickly. On the one hand, the "dovish" meeting statement and post-meeting interview of the Federal Reserve in July have pushed the September rate cut to become the market's consensus expectation, and the expectation of a 50bp rate cut is also brewing. On the other hand, the market has traded a lot of easing, the US Treasury bond interest rate has fallen below 3.8%, and the weakening of the US dollar index has helped to hedge the tightening of financial conditions caused by the decline of US stocks;

Chart: Stock declines drive tighter financial conditions

Source: Bloomberg, CICC Research

2) The extent of fiscal spending cuts is limited. Although the pace of fiscal expansion this year is slower than that in 2023, overall, fiscal policy remains relatively positive. According to the IMF’s forecast, the US structural deficit ratio in 2024[2] will still be close to 6.7%, higher than the highest level before the pandemic in 2015-2019;

Chart: The U.S. structural deficit ratio in 2024 will still be close to 6.7%, higher than the highest level before the epidemic in 2015-2019

Source: IMF, CICC Research Department

3) The private sector leverage ratio is low, and the household, financial and non-financial corporate sectors have continued to deleverage since the financial crisis and are now relatively healthy;

Chart: Household, financial and non-financial corporate sectors have continued to deleverage since the financial crisis and are now relatively healthy

Source: Haver, CICC Research Department

4) There may be risks in the stock market crash and external shocks. The recession narrative after the weakening of fundamental data may also be amplified under the stock market crash and external shocks. For example, from 1929 to 1933, the excessive speculation in the stock market led to the Great Depression, and the bursting of the technology bubble in 2001 and the outbreak of the "911" incident interrupted the 10-year expansion cycle of the US economy after World War II. The two rounds of economic recessions mainly caused by the stock market decline made the expected recession a reality under the macro narrative addition and emotional overreaction. But taking a step back, as long as it is not a debt problem on the balance sheet, a larger interest rate cut and a faster rate cut can help solve the problem.

Historical experience of recession: investment declines significantly. If the recession is deep, risk assets will continue to be under pressure, and gradually recover in the later stages of the recession.

What are the fundamentals during a recession? By calculating the quarterly contributions of real GDP during a recession, we found that the average contributions of consumption, investment, and government spending were -0.6%, -2.7%, and 0.6%, respectively. This shows that recessions have a dampening effect on consumption, but non-durable consumer goods remain resilient. Government spending was negative only once in the past 12 recessions, indicating that governments tend to increase fiscal spending to cope with economic downturns. In contrast, private sector investment has significantly dragged down the economy in the past 12 recessions and has been significantly higher than consumption and government spending.

Chart: Private sector investment is a much bigger drag on the economy than consumption and government spending

Source: Haver, CICC Research Department

How do assets perform during a recession? If the recession is deep, risk assets will continue to be under pressure. We define the extent of a recession by the decline in real GDP from its peak. According to experience, a decline of more than 3% is considered a deep recession, and less than 3% is considered a mild recession. Since the 1920s, there have been 10 deep recessions and 8 mild recessions.

1) Overall performance: Before and after the onset of a deep recession, the median maximum drawdown of the S&P 500 was 44%, much larger than the maximum drawdown of 19% during a mild recession.

Chart: Deep recessions tend to have deeper declines and start closer to the recession than mild recessions, but end at the opposite time.

Source: Bloomberg, CICC Research

2) Industry performance: Daily consumption and defensive sectors generally experienced smaller declines during the pullback, which is consistent with the characteristics of defensive sectors; however, sectors such as real estate, financial services, media, utilities, and insurance experienced more dramatic declines during deep recessions, which means that these sectors are more sensitive to the degree of recession. In comparison, the growth-style technology sector is relatively less sensitive.

Chart: Daily consumption and defensive sectors generally fell less during the US stock market pullback, which is consistent with the characteristics of defensive sectors; however, sectors such as real estate, financial services, media, utilities, and insurance fell more sharply during the deep recession

Source: Datastream, CICC Research

In addition, asset performance varies in different stages of recession: 1) In the early stage, crude oil is the best, followed by gold and government bonds, the US dollar and industrial metals are average, and emerging and growth stocks and credit bonds lag behind; the upper and midstream cycles are leading, and defense/daily consumption, among which financial real estate, technology and discretionary consumption are not good; 2) In the medium term, crude oil and industrial metals fall back, bonds are the best, and US stocks recover; defensive/daily consumption is the best, the upper and midstream cycles fall back, and financial real estate and technology recover; 3) In the late stage, US stocks, emerging and industrial metals recover, bonds are average, crude oil lags behind, and gold is the worst; financial real estate and discretionary consumption are the best, the upper and midstream cycles and technology media recover, and defensive/daily consumption is the worst.

Chart: Overview of asset performance before, during and after a recession

Source: Bloomberg, CICC Research

Chart: Overview of U.S. stock industry performance in the early, middle and late stages of a recession

Source: Datastream, CICC Research

Revelation for the present: Under the pressure of economic slowdown rather than systemic recession, the safe-haven asset rate cuts have basically ended, and the correction of risky assets provides a better opportunity to intervene

We have been suggesting that the Fed can cut interest rates because we agree and see that monetary policy is in a restrictive range and tightening financial conditions will cause growth to decline and inflation to slow, but we do not agree that market sentiment has reached the other extreme of "recession concerns", just as we did not agree with the market's excited expectation of the start of the global investment cycle when the copper price rose to $11,000/ton in May. Therefore, there is no need to resist the market in the short term and wait for expectations to be digested, but there is no need to exaggerate panic too much. Even in the "normal" small cycle of three interest rate cuts in 2019, the stock market and copper fell before the interest rate cut.

Chart: The US stock market did not fall before and after the interest rate cut in 1995. In 2019, the US stock market had a phased correction but quickly regained its upward momentum.

Source: Bloomberg, CICC Research

From the perspective of assets, under the basic assumptions of a "soft landing" of the economy and a small interest rate cut by the Federal Reserve, before the interest rate cut is realized, assets on the denominator side (such as US bonds and gold) can still be traded and are more flexible, while risky assets on the numerator side (such as US stocks and copper, etc.) will be under pressure. This is also the typical "routine" of every interest rate cut transaction ("Interest Rate Cut Trading Manual"). However, the "specialness" this time lies in the rhythm. If it is based on the assumption of a slowdown but not a recession, similar to 2019, the interest rate cut will gradually end after it is realized, and assets will also rush to run, so it is necessary to take a half step ahead, which also explains the performance of gold falling on Friday.

Chart: The pullback provides an opportunity to intervene in the interest rate cut trade. The current easing trade is more than halfway through, and the reflation trade has not yet been completed.

Source: Bloomberg, FactSet, CICC Research

► Before the interest rate cut begins, you can still participate in interest rate cut transactions that benefit from loose monetary policy.Assets that benefit from the improved liquidity on the denominator side of the interest rate cut have certain room and greater flexibility, but since there is no other benefit logic, they need to grasp the rhythm of "fighting and retreating", such as U.S. Treasuries, gold, and small-cap stocks that lack earnings support; risk assets on the numerator side are facing correction pressure, but since it is not a recession, risk assets will not continue to be under pressure, and the correction also provides an opportunity for subsequent intervention.

After the interest rate cut is implemented, assets that solve both the numerator and denominator problems will be better.After the rate cut, the relative allocation value of assets that benefit from the increase in demand brought about by the downward trend in financing costs and thus improve the profitability of the numerator will increase. When the rate cut is realized, it may also be the end of the rate cut transaction, and gradually turn to assets that benefit from re-inflation, such as US stocks and bulk resources such as copper and oil.

[1] https://www.barrons.com/articles/sahm-rule-recession-4b114b90

[2] Structural deficit refers to the fiscal deficit after cyclical adjustment, that is, it does not take into account the economic cycle.

Source

Source: China International Capital Corporation

This article is excerpted from: "The Basis for Judging Recession and Historical Experience"

Gang Liu, CFA Analyst SAC Certificate No.: S0080512030003 SFC CE Ref: AVH867

Wang Zilin, contact person SAC license number: S0080123090053