With the warning lights flashing, how likely is a global recession?

The IMF thinks growth will pick up in the new year and Oxford Economics says only two of its seven warning signs are flashing red. But that could be enough to cause real trouble, says James Moore

Donald Trump’s trade war with China has hit the global economy (Reuters)

Just how likely is a global recession?

You’ll have seen the reports in recent months about warning lights flashing bright red. Economic sages have been trotted out to shake their heads and look grim. The fears they’ve been expressing would appear well founded.

The International Monetary Fund (IMF) has been steadily revising down its forecasts for this year and now expects growth to come in at 3 per cent. That looks just dandy from a country like Britain, which is confined to the slow lane. But context is everything. The aforementioned 3 per cent represents a marked slowdown from last year’s 3.6 per cent. Compared with the 2018 peak, Planet Earth plc is off by a full percentage point.

Manufacturing is in decline, while trade has been hit by the bellicosity of Donald Trump and his ongoing battle with China. Services has been left to do the heavy lifting but the survey data would indicate that they could find themselves under pressure before too long.

So to those warning lights, which we’ve been hearing a lot about. And here’s where it gets interesting.

Oxford Economics recently identified seven of them: world industrial output, global stocks, commodity prices, corporate bond spreads, US credit standards, a US earnings recession and the US bond yield curve.

Their predictive power ranges from 40 per cent to 85 per cent. But currently only two of them are flashing red.

The first one is world industrial output. It’s in decline so that’s your first ding ding ding. It also has a 64 per cent success rate. Oh dear.

The second is the US yield curve. For the uninitiated, this is a graph looking at the returns, or yields, available in the market for investing in US government bonds. In normal times they should be higher for longer-dated ones, to reflect the fact that you’re getting rewarded for putting your money at risk for longer.

When investors rush into long-dated bonds, pushing the yield down, its usually because they expect things to get nasty and interest rates to be cut as a result. The curve thus flips (economists say it becomes inverted) and the yield gets better on the short-dated bonds no one wants. This is what’s currently happening.

Be afraid, be very afraid. This has a success rate of 85 per cent when it comes to predicting global recessions.

But, but, but, I hear you say, none of the other warning lights have come on. And apart from commodity prices, they all have a hit rate of better than 50 per cent. Some of them do better than 60 per cent.

So we can breathe a little easier, right? Well, not quite. Adam Slater, lead economist at Oxford Economics, makes the point that the yield curve indicator has historically tended to start flashing a long time before the emergence of a recession. It’s one of the earliest signs that things are not going well.

When it comes to the others, the average lag between a recession signal emerging and one happening is much lower, ranging from eight months to almost nothing (in the case of a commodity price shock). Sometimes they don’t light until the contraction is properly underway.

So should we be buying our brollies? Perhaps not yet.

Despite the fear that’s been spread through the yield curve indicator firing, the IMF still thinks the world will rebound from its current woes and deliver growth of 3.6 per cent next year. Maybe the trade tensions ease. Maybe the bond markets’ fears are overdone. Maybe policymakers will act to stave off the worst.

Slater thinks that’s a little on the optimistic side but even he puts the chances of a recession, as opposed to just a downturn, at only 30 per cent. In betting terms, that would make it a 9-4 shot. Plenty of punters will have backed runners at that price and won, but it’s still odds against.

What about Britain? Well, unfortunately we have Boris Johnson and his economically illiterate Tories to contend with here. The world might avoid a recessionary hit but the chances of us experiencing one are, to my mind, considerably higher.