Worldwide Recession Risk Ticks Higher

If our global recession risk were a giant clock, the hands would be moving another tick closer to midnight. That’s the opinion of State Street MD, the world’s second largest asset manager, with $2.24 trillion under management. They suggest the odds of a shallow recession, or a “neo-recession” in its terminology, have risen to more than one in three.

There are the usual suspects of China and oil prices in State Street’s recession roundup but its calculation adds Japan to the mix of risk factors. That nation’s recent move to negative interest rates should definitely be filed under the heading “Things That Didn’t Work” when it comes up for review by the Bank of Japan.

Two Steps Back

The Japanese economy is going backwards and many analysts are pointing to slack consumer spending as a major reason. Japan saw its economy shrink by nearly one and a half percentage points in Q4 of 2015 as the government tried everything it could to spur growth and inflation. But the Japanese economy, one of the world’s five largest, continues to defy government efforts to spur growth.

In January the Bank of Japan moved interest rates into negative territory to try and weaken the yen, which stayed stubbornly strong against the yuan, the currency of China, Japan’s chief rival in the region. But in its efforts to unlock consumers’ wallets some of the ideas coming out of Japan’s central bank border on the hilarious.  After a consumption tax (their term for a national sales tax) hike in 2014, they’re purportedly, and counter-intuitively, sticking to plans for another hike next year.  The strategy is to spur consumption ahead of the price increase; in effect a countdown sale. But, as Marcel Thieliant, senior Japan economist at Capital Economics, points out, “[A]ctivity will almost certainly slump once the tax has been raised.”

The Yuan’s Goin’ Down

Last weekend China once again insisted it’s not going to devalue the yuan in response to investors pulling money out of the country, although it hasn’t ruled out capital controls that limit how much money investors can withdraw at any given time. Most analysts agree China might not have an option to devaluing its currency; something the IMF expressly told them was a no-no when they allowed the yuan to become one of the world’s reserve currencies. Even announcing it was going to move off current currency exchange rates, called pegs, would be economic suicide. All the same, announced or not, the yuan will devalue, just like it did last August. China is burning through its reserves of foreign currencies at an alarming rate, hoping the markets will stabilize before they hit bottom. Just like last time, the next devaluation will be poorly timed and badly handled because it’s better to look incompetent than evil when the IMF is looking over your shoulder.

All It Takes is One Spark

The pending devaluation of the yuan will trigger another cascade of bad news and impact everything in the financial pipeline. Devaluing the yuan will put more pressure on Japan; it will push the dollar to even stronger highs which, in turn, will push oil and commodity prices even lower. Keep in mind that the radical instability we’ve seen so far is the global economy working these issues out in an orderly fashion. If what we’re seeing is the orderly adjustment, imagine what the catastrophic change is going to look like!

Right now the global economy is a powder keg just waiting on a spark—and it won’t take much. Even something as simple as a slight change in bank lending standards, like the freeze that occurred in 2008, could tip the world over into a massive recession. What we’re dealing with today is bad but, under the right circumstances, it could get a lot worse.

Even though we’re going to see up days in the market, like today, it’s just too risky to change a defensive investment strategy right now.