The US economy is growing increasingly vulnerable under energy shocks, and any fracture in market sentiment could cause recession risks to surge abruptly, leading to a swift repricing of Federal Reserve interest rate cut expectations. On March 26, macro strategist Simon White noted that while the near-term probability of the US entering a recession remains low, pressure on hard data is mounting. A potential escalation of the Middle East situation provides a catalyst for the deterioration of soft data. He warned that recessions, when they arrive, often do so suddenly and can be unforgiving to unhedged investment portfolios. Regarding market impact, almost no assets are currently pricing in a recession scenario. Should recession risks intensify, US short-term interest rates would face the most dramatic repricing. Markets had already pared back approximately 60 basis points of rate cut expectations for the year following the outbreak of conflict. However, if clear recession signals emerge, these rate cut expectations would not only return swiftly but could potentially exceed pre-conflict levels.
Recession risks are accumulating. Simon White's recession warning model comprises 14 sub-models and requires at least 40% to be triggered to signal a recession. Currently, only about 20% of the sub-models are activated, including a recently triggered oil price spike indicator, suggesting near-term recession risk remains manageable. However, historical patterns of the model show that once the reading breaks upward from the 20%-30% range, it tends to climb rapidly, reflecting the abrupt nature of recessions in the real economy. After increasing the weight of the oil price sub-model to reflect crude oil's growing impact on GDP, the model's reading has risen from just over 20% to 30%, approaching the critical 40% threshold. Only two more sub-models need to trigger to issue a recession warning. Stocks and credit markets currently imply a recession probability of about 20%, while copper prices and the yield curve are more pessimistic, implying probabilities of 45%-55%. The S&P 500 has fallen only about 4% since the war began, and the S&P Global Composite PMI preliminary reading dipped slightly to 51.4, indicating overall market sentiment remains resilient. Whether this calm can persist will be key to the US avoiding a recession.
Hard data shows early pressure, policy space is limited. The danger of the current situation lies in hard data already showing signs of pressure. Since the beginning of the year, housing data, auto sales, and overall coincident indicators have weakened. Simon White points out this is a "worst-case combination." When soft data weakens first, the Fed still has an opportunity to interrupt the negative feedback loop through preemptive easing, stabilizing sentiment before hard data deteriorates. But when hard data comes under pressure first, damage is often already done, significantly reducing the effectiveness of policy intervention. Soft data has not yet shown significant deterioration, with indicators like the ISM, margin accounts, money supply growth, and the yield curve remaining relatively stable. However, once soft data begins to weaken and resonates with hard data, causing both to breach warning levels simultaneously, the probability of entering a recession within the next 2 to 3 months would increase substantially.
Energy shocks amplify downside risks. Oil prices are a core variable in the current risk landscape. Gerard Minack of Minack Advisors points out that while the US economy's energy efficiency has greatly improved—a barrel of oil now supports over three times more real GDP than in the 1970s—this very progress also means that if high oil prices cause demand destruction, the negative GDP impact from losing a barrel of oil could also be three times greater. Simon White compares the current situation to the 1990 recession. Back then, the savings and loan crisis had already led to credit tightening, and Iraq's invasion of Kuwait caused oil prices to double. The energy shock prolonged and deepened that recession, with stocks ultimately falling 20%. Currently, widening credit spreads and stress in private credit show early signs of credit deterioration, forming an uneasy parallel with the 1990 backdrop.
Market impact under a recession scenario. If a US recession materializes, all asset classes face significant repricing. For equities, the median stock market decline during recessions since 1960 is 12%, but after the 1973-1974 OPEC oil shock, the decline reached as high as 45%. While bonds would benefit from safe-haven buying, given the stagflationary nature of the current shock, bond gains might fall far short of their performance during recessions over the past three decades. Regarding commodities, in recessions triggered by commodity prices themselves, commodities often perform relatively robustly. The most substantial repricing could occur in the US short-term利率 market. Simon White states the timing for this trade is not yet ripe, but once market sentiment begins to crack and recession risks rise, the repricing of rate cut expectations will arrive "swiftly and mercilessly," with the expected magnitude of cuts potentially exceeding pre-conflict levels.
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