Defining a Black Swan Event
A Black Swan event, as defined by Nassim Nicholas Taleb, is a rare and unpredictable event with severe consequences. These events are often characterized by their extreme rarity, profound impact, and widespread insistence that they were obvious in hindsight. The possibility of a US recession fits this description well; while the consensus is optimistic about a soft landing, a recession could be a severe and unforeseen development. Why raise this point now? Because there are a number of hedges that are currently cheap as nobody is interested.
Consensus Expectations vs. Emerging Risks
The prevailing expectation is for the US economy to experience a “no-landing” scenario, reaching the target 2% inflation without a major slowdown, where growth continues unabated, buoying risk assets. This optimistic outlook has been bolstered by recent economic resilience despite aggressive monetary tightening. However, this consensus view might be overlooking several emerging indicators of economic weakness.
2023: The Most Anticipated Recession That Never Was
Last year, there was widespread anticipation of a recession due to the Federal Reserve’s rapid rate hikes. Predictions varied, with models forecasting recession probabilities as high as 100%. However, contrary to these expectations, the economy continued to grow, defying traditional recession indicators such as the inverted yield curve and elevated inflation.
NY Fed Prob of Recession in US Twelve Months Ahead Predicted by Treasury Spread
Current Signs of Weakness
Despite the optimistic consensus, recent data suggest that the economy may not be as robust as it appears. The New York Fed’s yield curve recession predictor has issued some of the loudest warnings since the early 1980s, and the average unemployment rate has risen by 0.34% over the past year, marking the most significant increase outside of the pandemic since 2010.
Market Complacency: A Dangerous Underestimation?
The VIX index, a measure of market volatility, has recently closed below 12, its lowest level since 2019, while the S&P 500 has reached new all-time highs. This juxtaposition of low volatility and high equity valuations suggests a high level of investor complacency.
VIX at pre-covid levels
Corporate Earnings and Consumer Behaviour
Recent earnings reports from high-end retailers like Burberry indicate slowing demand in the US, suggesting that consumers are becoming more selective. Additionally, a rising proportion of BBB-rated bonds are now on watch for downgrades, indicating increased financial stress among higher-quality debt issuers.
Interest coverage and recession
The Case for a Recession as a Tail Risk
A recession, though not the consensus view and neither is Simplify Partners’ view, is a credible tail risk. Unlike inflation, which many consider a potential issue, a recession is not currently priced into market expectations. The low spread between investment-grade and high-yield bonds, coupled with historically low option-adjusted spreads, signals that markets may be underestimating credit risk.
OAS Spread
The Fed’s Dilemma and Potential Policy Errors
If the economy slows more than expected, the Federal Reserve’s commitment to a higher-for-longer interest rate policy might delay crucial rate cuts. This delay could exacerbate economic and financial damage, particularly affecting vulnerable segments of the population. As noted by Prof. Mohamed El-Erian, the Fed lacks a reliable strategic anchor, making timely and appropriate policy adjustments uncertain. We add that, as Powell said, they are data-dependent and assess certain variables no more frequently than quarterly.
Conclusion: Preparing for the Unexpected [is relatively cheap]
While the current market environment appears stable, the underlying risks of a recession not negligible and warrant careful consideration. Locking in hedges while the outlook is still positive could prove to be a prudent strategy as we approach the US election and, more importantly, as the US economy ends 2025 with a record deficit to GDP.
Warm regards,
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Federico Polese
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