UBS model predicts 1-5 chance of recession
August 23, 2007
UBS - Global Economics Comment
UBS update their (probit) regression framework of the economy to assess the probability of a recession. The model looks at asset prices that have a good correlation with the economic cycle and is built on the idea that ‘the collective judgment of investors represents the best ‘real-time’ read on likely future cyclical outcomes’. Key inputs include the shape of the yield curve, the performance of cyclical stocks relative to defensive stocks, metals prices, AUD/CHF, and corporate bond spreads. Each of these provides a recession probability, which can be combined to give an overall probability of recession. ABN reports:
The yield curve is clearly ‘flashing’ the greatest cautionary signal, with a global recession probability in excess of 30%. The recession probabilities of the remaining indicators are somewhat lower, though all of them have risen in recent weeks.
Charting the combined recession probability yields the following chart:
The message is pretty straightforward: the markets’ estimation of global recession likelihood has risen and at present lies at about 20%.
However, UBS also observes:
… even with the current recession probability estimate hovering around 20%, it is well below the levels attained ahead of prior recessions (i.e., in those cases where the ‘actual’ line reached a value of ‘1’). Moreover, in the mid-1980s and again in 1998, the estimated probabilities rose to levels above current reads, but without correctly predicting a recession outcome. Also, as we noted earlier this year, the yield curve appears to have lost some of its predictive power—curves today are more prone to be flat or inverted than in past cycles.
Yet it is also correct that, unlike earlier this year when asset prices were flashing elevated recession probabilities, financial and economic fundamentals have deteriorated. The sharp curtailment of credit in capital markets and selected areas of the ‘real’ economy are more worrisome than was the case during the market setback of February-March. US house prices and activity show no signs of stabilizing. And credit markets are exhibiting clear signs of stress, as financial institutions reduce risk and counterparty exposure.
Concluding:
… we believe outright recession ought to be avoided provided that policy responses are appropriate and that markets settle down. Nevertheless, as we noted in our published work this week, the case for a period of below-consensus and below-trend US GDP growth has been reinforced, as has the fundamental justification for Fed easing in H2 2007.
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