Sent: 03-07-2013 14:17:02
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The Chance of Recession
Attributing probabilities to Australian economic outcomes feigns science but is often an economists' ploy to avoid accountability. Investors need to recognise this as a possible motivation in assessing the decision making value of any economic forecast.
Before the topic was overwhelmed by the Labor Party leadership ructions last week, Julia Gillard had shown considerable tetchiness after one of the local economics commentators said Australia faced a 25% chance of plunging into recession.
Attaching probabilities to economic outcomes recognises that, even among the most skilled forecasters, getting the direction right is hard enough. A precise number is sometimes foolhardy.
Having a strong conviction that a falling Australian dollar, for example, might settle at 85 cents at the end of 2013 rather than 82 cents or 87 cents might be too much to ask. Saying the currency is going to move lower, with a range of likelihoods attached to numbers between 82 cents and 87 cents, might be a more realistic view of the risks and helpful in framing commercial or investment strategies.
Less helpful, however, is a directionless forecast. For example, a forecaster who says there is a 50% chance of the currency being higher at the end of 2013 and a 50% chance of it being lower might simply be flagging his own muddled thinking or an absence of a useful analytical framework within which to consider currency variations.
Everyone needing a forecast as an input into their investment decision making will know that accuracy is unusual. The chance of being wrong is high. The forecasting sceptic might still find it helpful to know how views are evolving. Is the chance of a recession rising of falling? An economics commentator could add some value by framing his forecasts in this way.
The contrary view about the usefulness of attaching a probability to future events is that it is simply a ploy to always be right. If an economist suggests a 25% chance of a future recession, he is covering all the bases. If there is no recession, he will claim to have been right. If there is a recession, he will seek kudos for having alerted his clients to the possibility ahead of it happening. In many instances, attaching a probability to a forecast is designed to create wriggle room for a forecaster conscious of his own fallibility.
It is hard to know what a 25% chance of recession means without an understanding of the historical frequency of recession. More subtle views would include periods of slow growth coupled with a rise in unemployment as candidates for recession but recessions are commonly defined as two successive quarters of shrinking GDP.
The Australian Bureau of Statistics (ABS) has published GDP estimates for the Australian economy for each quarter since September 1959, giving us a total of 214 data points. Over that period, the ABS has recorded a quarterly reduction in GDP on 37 occasions. The median quarterly GDP contraction has been 0.6%. The largest quarterly fall of 2.0% occurred in June 1974.
According to the ABS data, there have been just six occurrences of back to back quarterly contractions in economic output. That puts the chance of a recession - defined as two or more successive quarters of contracting GDP - at 2.8%, at least as far as history offers a guide as to its likelihood.
If the chance of a recession is less than three percent based on the history of Australia's economic performance over the past fifty years, a 25% chance of a recession implies an eight times greater chance than over the history of the modern Australian economy.
Everyone with an interest in financial markets has a heightened awareness of risk since the financial crisis in 2008 and its debt burdened aftermath in Europe. Risk awareness is affecting market valuations and the deliberations of economists thinking about future outcomes.
By putting a high probability on the occurrence of a recession, where forecasts in other times gave it little weight, economists are at risk themselves of trying to compensate for past failures. Including a substantial chance of a recession in any forecast plays to the fears of investors (and perhaps makes the economists' advice more acceptable) but threatens to bias forecasts (and reinforce risk aversion) by implying important structural changes where none might have occurred.
Of the six occasions since 1960 during which the nation's GDP has shrunk for two successive quarters, the first, in 1960-61, came with a government induced credit squeeze. A sequence of three rolling recessions in the 1970s came in the aftermath of the first oil price shock, rising domestic inflation, political upheaval and relatively high interest rates. Another recession in 1982-3 also came with a surge in oil prices but was accompanied by US policymakers determined to bring inflation under control by boosting interest rates. The last recession - the one forever linked to Australian Treasurer Paul Keating - came in 1991.
Two things stand out in this history. Firstly, recessions have usually been associated with high or rising domestic interest rates. In that sense, policy makers chose recession. It was not an exogenous shot out of nowhere. Secondly, each of Australia's recessions came with a recession in the USA in nearby months. International conditions have played an important role in Australia's growth outcomes.
The prospects for the world economy are becoming less tied to the state of the US economy as emerging economies now account for as much output as the advanced economies. Nonetheless, the chance of an Australian recession appears likely to be highest when international growth is slowing and interest rates are rising or are historically high due to a fear of escaping inflation.
International growth has slowed but appears to be stabilising with some prospect of higher growth rates in late 2013 and through 2014. Interest rates appear set to be low around the world for a lengthy period. Central banks are more fearful of low inflation than an inflationary surge of the sort accompanying excess demand.
There will always be some chance that sudden changes in conditions precipitate a recession but a recession is an inherently low probability event usually created by very specific circumstances most frequently associated with direct policy intervention.
An adviser or independent investor needing to assimilate economic forecasts into their investment decision making should consider whether statements about an unusually high probability of recession represent a material change in likely economic outcomes or whether it is simply an artifice of economists fearful of getting their forecasts wrong and wanting to ensure they have as much wriggle room as they need to rationalise their forecasting track records after the event.
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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