Assessing the Risk of Recession Posted by AVCU on 3:31 PM

CUNA Mutual Members Capital Advisors consulting economist Robert F. DeLucia writes his observations about chances of a pending recession in his latest economic commentary.
Summary and Major Conclusions: The probability of recession has risen in recent weeks, but remains well below 50%. However, recessionary risks will continue to escalate in tandem with further weakness in equity markets and turmoil in credit markets. The next six months appear to be the period of maximum economic risk. Financial market forces are transmitted to the real economy through three channels: (1) Confidence in the private sector; (2) The wealth effect associated with plunging equity markets; and (3) Reduced availability of credit to households and business firms resulting from widening risk spreads in credit markets and the banking system. Financial markets are already priced for at least a mild recession. The major catalyst for recession would be a self-fulfilling prophecy, whereby investor fears of recession create the very financial conditions that could trigger an economic downturn. In sharp contrast to financial markets, underlying business conditions in the real economy - although depressed - do not signal a new recession. Most encouraging is the extraordinary financial health of the nonfinancial business sector. Key leading indicators are also consistent with continued sluggish growth in future quarters. The most significant economic risk is the worsening European debt crisis. The basic problem involves conflicting political pressures among the various euro members and institutions, which has resulted in policy gridlock. The practical consequence has been reliance on short-term piecemeal solutions and blockage of a consensus in adopting permanent long-term policy initiatives. Ultimate resolution of the euro crisis will be based upon major concessions by Germany, including additional funding for the EFSF; more aggressive monetary stimulus by the ECB; and creation of Eurobonds. Concrete steps toward a cohesive political and fiscal integration would greatly enhance the current monetary union. There is also growing pressure on the Federal Reserve to provide additional stimulus. While the precise nature of new unconventional monetary stimulus is uncertain, there is little doubt regarding the Fed's motivation to utilize all available tools in order to avert a recession. The crucial question is the viability of untested policies. The most probable outcome is sustained economic growth, but at an anemic pace of 1-2% during the next several quarters, improving to 2-3% during 2012. The catalyst for slightly improved growth prospects would be bold pro-growth policy actions in Europe and the U.S. Based upon current extremes in market valuations, the long-term investment merits of equities appear far superior to that of government bonds. Read Robert's entire economic commentary here.