The recession question we should be asking isn’t ‘when’ but ‘how bad?’

It’s taken a while, but equity investors finally seem to get what bond investors have been signalling for months. Back in March, the yield curve for three-month and 10-year U.S. Treasuries inverted, meaning the three-month bills were yielding more than the 10-year notes, which isn’t the right way around if everything is hunky-dory in economics-land. But stock markets went on to have a pretty good April, a so-so May and then an even better June, as investors paid more attention to the Federal Reserve’s flip-flop than to the yellow light the three-month/10-year curve was flashing.

But on Wednesday, a more traditionally watched yield curve — the one between the two-year and 10-year Treasuries — also inverted. And so did the corresponding curve in the U.K. Add to that some dismal data from Germany and China and — well, oh yeah, the yield curve inversion mattered again.

Even Donald Trump’s promise to dial back his threatened tariffs on China — at least till Americans get their Christmas shopping out of the way — couldn’t stop the damage in stock markets. The S&P 500 and the Dow both dropped by about 2.7 per cent Wednesday. The S&P/TSX composite fell by about 1.7 per cent, propped up in part by investors plowing their cash into gold stocks, which is another indication of growing fears of a global downturn.

So the R-word is front and centre for equity investors. Are the worries warranted?

Well, on one level, of course they are. As the textbooks tell us, the two-year/10-year curve has inverted before every U.S. recession over the past 50 years. But the curve doesn’t tell us exactly when. Historically, recessions have occurred between 12 and 24 months after inversion. It might be the same this time, or it might not. The post-crisis yield curve has been generally flatter than in other recent periods, which means that a less dramatic shift in spreads can create an inversion. Perhaps those less dramatic shifts also undermine the curve’s storied accuracy.

Of course, unless the business cycle just doesn’t happen anymore (and maybe it doesn’t), we are always headed towards a recession, sometime. A more interesting question than when it will occur might be how it will play out.

It’s been more than a decade since the last big downturn, so maybe we don’t remember much what recessions look like. (Let’s leave aside Canada’s recession-that-wasn’t-a-recession in 2015.) It might well be different this time.

For one thing, a good part of today’s recession worries are driven by political uncertainty. We don’t know how much Trump’s trade war is already undermining business confidence or consumer spending, but if it gets worse, both will suffer. A hard Brexit — which is to say, a messy and painful Brexit — looks like it is just around the corner in the U.K., and it would send ripples throughout Europe. Germany’s second-quarter contraction was mild (-0.1 per cent), yet it could still easily tip into recession amid the slowdown in global trade and unknowable impact of the British malady.

Where’s the bubble that’s going to burst?

But politics is fickle. So is Donald Trump. The worst in the U.S.-China trade war might not come to pass; if Tariff Man’s levies start to pinch consumers in a directly noticeably way, he will be under pressure to reach a resolution. And there’s an election next year in the U.S. On Brexit, the next plebiscite is scheduled for 2022, but anything could happen after Boris Johnson pulls the plug. Populism might be in its heyday, but history suggests that a recession can sour voters pretty quickly.

Another point of differentiation, by way of a question: Where’s the bubble that’s going to burst? Last time around, it was in U.S. housing; the recession before that, the dot-com-crazy stock market; in the early ’90s, the Fed was raising rates into the teeth of an oil price shock. None of those seem to apply now, at least if you apply traditional counter-metrics to housing affordability and stock valuations, in large part because interest rates are so low.

Which does point to the one real bubble we have today: debt. According to the International Monetary Fund, worldwide outstanding debt reached US$184 trillion in 2017 (the latest year for which figures are available). That’s equivalent to 225 per cent of GDP in 2017, and 11 percentage points higher than in 2009. The private sector’s share of that amount owing has more than tripled since 1950 — making it “the driving force behind global debt,” according to the IMF.

Debt might not be the immediate cause of the downturn, but it might add fuel to the fire and make a recession worse.

So what happens if there’s a recession? Debt might not be the immediate cause of the downturn, but it might add fuel to the fire and make a recession worse. Say, for instance, that protectionism shaves enough points off global or U.S. GDP to create a sharp recession. Corporate and some government default risk could spike. A run on credit could follow, which could spark a liquidity crisis where nobody wants to buy anything. And the credit house of cards that low rates built would come tumbling down.

Yet it seems unlikely that policymakers would just stand by and watch. While central banks have been unable to kickstart their respective economies with accommodative monetary policies, they have shown a willingness to do something — anything — to prevent another Great Recession. And they still have tools at their disposal. If they see the prospect of a liquidity crunch, don’t be surprised if the Federal Reserve and the European Central Bank start acting an awful lot like the Bank of Japan.

And that might point to the most likely dénouement to the next recession: a period of mild expansion, or even stagnation, punctuated by intermittent downturns into the red, which central banks will counter ever more creative support. It can’t work forever, but as Japan proves, it can work for a very long time.

There’s no doubt that storm clouds are gathering over the global economy. But will they be followed by light — or by just more grey skies?

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