The global uncertainty we’ve been tracking all year hasn’t faded. We’re still grappling with war in Ukraine, surging inflation and rising interest rates. While risks around our base case remain in place, we don’t think that their relative probability has shifted since we released our Global Economic Outlook in March.

Take the question of a US recession. We maintain that the risk of this happening over the next 12-18 months is about 25%, just as we’d predicted in February. But if the US does go into recession, we don’t think that the downturn will be very deep or protracted.

The risk of a Eurozone recession looks similar. That said, this region is under greater threat from surging energy prices. One trigger would be disruptions to Russian energy exports — we’re going to be watching this closely for signs of escalation.

While the risks and uncertainty continue to progress and shift; ultimately, our baseline forecasts remain the same for the time being.

US recession risks remain, but they’re stable for now

In our view, there is about a 25% risk of US recession within the next 12-18 months, and roughly 35% in the next 24 months (Chart 1). We’ve come to this conclusion based on a combination of quantitative modeling (Chart 1) and qualitative judgment. 

Source: Haver, FRED, abrdn, as of March 2022. Note that the real yield curve uses the 5s-10s spread instead of 1s-10s because of the volatility in short-term inflation expectations.

According to this chart, the nominal yield curve suggests the highest probability of recession in the next 12 months — roughly 26%. The real yield curve also signals recession risks in the coming year rising, albeit to a lesser extent — about 17%.

Meanwhile, the term-premia adjusted yield curve, which strips out the effect of lower-term premia, continues to signal a relatively low risk of recession within the next year, at less than 10%. All of this to say that it’s important to take the most recent yield-curve inversion with a grain of salt. Just because yield-curve inversions have been a historical harbinger of recession doesn’t mean that the latest one is.

A downturn would likely be a run-of-the-mill US recession

US recessions’ depth, duration and impact on corporate profits have varied significantly over the past 70 years (Table 1).

Source: Haver, FRED, abrdn, as of March 2022. Note that the real yield curve uses the 5s-10s spread instead of 1s-10s because of the volatility in short-term inflation expectations.

According to this chart, the nominal yield curve suggests the highest probability of recession in the next 12 months — roughly 26%. The real yield curve also signals recession risks in the coming year rising, albeit to a lesser extent — about 17%.

Meanwhile, the term-premia adjusted yield curve, which strips out the effect of lower-term premia, continues to signal a relatively low risk of recession within the next year, at less than 10%. All of this to say that it’s important to take the most recent yield-curve inversion with a grain of salt. Just because yield-curve inversions have been a historical harbinger of recession doesn’t mean that the latest one is.

A downturn would likely be a run-of-the-mill US recession

US recessions’ depth, duration and impact on corporate profits have varied significantly over the past 70 years (Table 1).

*Represented in quarters
Volcker refers to two recessions of the early 1980s.
Source: Haver, abrdn Research Institute (as of April 2022)

As Table 1 illustrates, on average, a downturn delivers a 2.8% peak-to-trough decline in GDP and a 17.5% decline in nominal corporate profits. Excluding the Covid-19 recession and the once-in-a-generation 2008 Global Financial Crisis (GFC), GDP decline stands at 1.8% with profits down 15%. Contractions normally last for about three quarters, and it usually takes the economy about 18 months to recoup lost ground.

The good news is that right now, the economy isn’t displaying widespread, deep financial imbalances that would lead us to expect a downturn to trigger a financial crisis (or a subsequent period of protracted, painful debt de-leveraging).

So, what will the next market downturn look like? Could we see shallow contraction in activity and profits, like we saw in 1960, 1970, 1990 and 2001? On average, across these recessions, activity contracted by a relatively benign 0.5% from peak to trough and during those periods, nominal profits were down 11% at their worst.

But this view could be too optimistic. In each of these smaller downturns,¹ the US Federal Reserve (Fed) was able to ease policy pretty quickly and aggressively. On average, during these smaller recessions, the Fed Funds rate dropped by 3% over the course of the 12 months following the beginning of these shocks.

Our “Fed kills the cycle” scenario embeds the view that such a rapid reversal wouldn’t be possible, since the Fed is going to be forced to keep interest rates high in order to bring inflation back under control. This would leave the economy exposed to tighter monetary conditions for longer and make it harder to imagine a very mild recession.

Before the GFC, the recessions of the 1980s, also known as the Volcker recessions, were some of the worst in US post-Great Depression history. These recessions weren’t especially deep, but lasted for several years. It took three years for corporate profits to regain the losses they’d experienced since the start of the correction. This is because the Fed held real rates high for years to bring down mounting inflation expectations in an effort to avoid them becoming unanchored, as they had in the 1970s.

We don’t foresee a reset of this magnitude as the most likely outcome. The GFC and the Volcker shock represent extremes and we think a more typical recession is more likely if the economy does take a turn for the worse.

Such a downturn, which would see the economy suffer roughly a 2% peak-to-trough decline in GDP, would imply a drop in corporate profits between 15% and 20%, based on previous experience. This type of downturn would likely last for three-four quarters and precede a relatively rapid recovery period, where the economy bounces back within 18-24 months.

While history, data and judgment inform our forecasts, the nature of any downturn is highly uncertain. Should inflation cool more rapidly as the economy moderates, then more rapid policy loosening would help cushion the shock. On the flip side of this, stubborn inflation would push us closer to the Volcker-style scenario, which could elongate the economic pain.

Europe would catch a cold from the US

The probability of recession in the Eurozone within the next 12-24 months is about the same as in the US. But it’s important to note that while recession isn’t our baes case, a downturn in the US would likely prove fatal for the European cycle.

On a more positive note, more moderate monetary policy tightening compared to the US and more protracted support from the EU Recovery plan could help mitigate the severity of any possible downturn in terms of scale and duration.

US influence aside, the main risk for recession in Europe doesn’t come from the central bank slamming on the brakes. The European Central Bank (ECB) maintains a more cautious stance than the Fed in the face of downside risks to growth. Instead, there’s a greater concern in Europe that higher energy prices could trigger a sharp enough squeeze on households and consumers to kill the cycle.

We’ve revised our European growth outlook lower in the face of this shock, to about 2.6% (compared to our February outlook of 3.2%). We’ve also revised our inflation expectations in Europe upward. We expect price increases to peak around 9% in June, with core inflation around 4%, before decreasing in the second half of the year thanks to annual base effects.

But we must also flag further downside risks. In the event of a full EU embargo on Russian oil and gas, the Euro-area economy would likely contract this year in the face of higher energy prices and supply disruptions. If this scenario should come to pass, we’d expect a recovery in 2023.

Note that our latest scenario analysis of the war in Ukraine remains intact. The key assumption in these macro forecasts is that Western sanctions will remain in place for the foreseeable future. Though there are plausible scenarios in which sanctions are escalated further if the conflict drags on, or in which sanctions ease if Ukraine and Russia are able to reach a negotiated settlement.

Overall our scenario distribution hasn’t changed

We’re monitoring recession risks in the US and Europe, but overall, our scenario distribution hasn’t changed much since earlier in the year. However, it’s important to remember that there’s much uncertainty, especially as the fallout from the ongoing Ukraine continues to ripple through the global economy.

¹ The smaller downturns refer to those in so 1960, 1970, 1990 and 2021

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Past performance is no indication of future results.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.