07 March 2011

Press Viewpoint

Current oil prices push indicators to estimate almost 1 in 6 probability of a recession next year

John Stopford, co-head of Fixed Income, Investec Asset Management, explains that the team’s analysis suggests that the potential for a sharp slowdown in global growth is increasing and such an outcome would be very likely if oil continues to rise, but that offsetting factors should prevent this from becoming a full-blown recession.

Turmoil in the Middle East has helped to push the price of oil above $100 per barrel for the first time since the credit crisis. This clearly has implications for global inflation, but the observation that each of the recessions in the last 40 years has been preceded by an oil price spike should make investors even more concerned. Indeed, the 2008 recession looks to have been precipitated in part by the squeeze on real incomes induced by a rapid increase in oil and food prices, combined with policy tightening designed to fight the resulting acceleration in inflation.

To help us understand how damaging the current rise in the oil price might be we can feed it into our own leading economic indicator of global growth and stress-test the results. This indicator takes information, such as commodity prices, monetary policy settings, measures of economic slack and credit availability, which are available now, but which impact the economy with a lag. Together, these measures can give us some indication of the likely direction of growth over the next year or so, and estimate the probability of a recession. This is not an attempt to forecast the future, but rather to see the potential consequences of the changing economic environment.

• So far the rise in oil prices has been more muted than in 2008. It is, however, up by over 50% in the past year, and food inflation is even worse than back then. Both elements are beginning to push headline inflation higher and will undermine consumer purchasing power this year, especially in developing economies. Our leading indicator suggests that this effect should be enough to push global growth back below trend in 2012. Other components of the model remain more positive, and certainly global monetary policy remains very loose, especially in the developed world, which should continue to support economic activity. That said, policy is slowly being tightened and is also somewhat counterproductive, being one of the factors driving commodity prices higher through stronger growth and asset price inflation.
• Using the current oil price, our indicator estimates an almost 1 in 6 probability of a recession next year, up from very little chance a few months ago. To put this into perspective, the estimated recession probabilities were around 30% to 40% about 12 months ahead of the 1990 and 2001 recessions and over 70% before the 1975, 1980 and 2008 recessions.  Unfortunately, our commodity analysts see a real possibility that oil prices could rise further, perhaps to $150 per barrel. Putting this number into our indicator raises the probability of a recession in 2012 to about 25%, still below the levels that have generally been followed by an economic contraction. Looked at another way, our analysis suggests that the potential for a sharp slowdown in global growth is increasing and such an outcome would be very likely if oil continues to rise, but offsetting factors should prevent this from becoming a full-blown recession.
• There is a clear risk, however, that this conclusion turns out to be too optimistic. In particular, excessive levels of leverage may mean that the global economy is now more vulnerable to a sharper downturn than in prior cycles, not least because there is less scope for developed governments and central banks to provide additional policy support. As a consequence, the likelihood of more aggressive quantitative easing next year and more inflation in the medium-term appears to be high.

Unfortunately, courtesy of the law of unintended consequences, the Fed and other central banks, by once again keeping monetary policy too easy for too long, are probably only making a commodity induced down-turn in 2012 more likely and limiting their options for responding to it, if it comes. For the global economy a mix of moderate growth and somewhat tighter policy seems more likely to foster a durable expansion than an aggressive effort to stimulate growth at any cost. The Chinese appear to have understood this, but Mr. Bernanke and others have not, and that worries us.

ENDS -

For further information, please contact:
Vian Sharif   + 44 (0) 20 7597 1834 or +44 (0) 7826 911669
Investec Asset Management                                 

The information contained in this press release should not be relied upon by private investors or any other persons to make financial decisions. All of the views expressed about the markets, securities or companies in this press comment accurately reflect the personal views of the individual fund manager (or team) named. While opinions stated are honestly held, they are not guarantees and should not be relied on. Investec Asset Management in the normal course of its activities as an international investment manager may already hold or intend to purchase or sell the stocks mentioned on behalf of its clients.The information or opinions provided should not be taken as specific advice on the merits of any investment decision. Telephone calls may be recorded for training and quality assurance purposes.