Recession Risk not Priced in CRB Index, High-Yield Spreads

Wall Street economists have lowered their growth forecasts for the second half of 2007 amid the ongoing credit turmoil, raising the odds of an economic recession. The United States last suffered a recession -- defined as two consecutive quarters of negative growth, in 2001. The last serious recession was in 1990-1991 when the Savings & Loans debacle and the unwinding of junk bond speculation drove the country into a painful economic slump.

But if the United States is truly entering recession territory, why have benchmark commodity indices rallied over the last few weeks? The Goldman Sachs Commodity Index, soaring mainly due to surging oil prices, is now in record territory while the CRB Index is just four points away from a 52-week high on the heels of high oil prices, gold’s newfound strength and a wicked bull market for the grains. Normally, an economic slowdown threatens consumption, driving commodities sharply lower as demand cools. Yet, this is not happening in September – despite the credit-crunch and bear market in housing.

One explanation is that although the United States might already be in an economic recession this quarter, the rest of the world is still growing at a far healthier clip. Unlike ten years ago when the U.S. drove global consumption, most international economies now rely less on the American consumer. Plus, China remains a major demand equation for global growth.

China, where inflation hit a ten-year high through August, continues to devour almost every conceivable commodity to bolster her booming economy. Twenty or thirty years ago, China was barely a dent in commodity consumption; today it is a massive importer of raw materials and increasingly, a significant regional consumer of manufactured goods.

In addition to commodities remaining at elevated levels, high-yield bond yields have not risen sufficiently to warrant recession risk.

Historically, risk premiums for high-yield bonds and emerging market debt have soared on the heels of a U.S. recession. Fears of a slowdown result in a scramble for safe-haven securities, which has indeed occurred over the last six weeks. But this scramble to find liquidity has more to do with a clog in mortgage-backed funding than problems relating to rising defaults or deteriorating business conditions. If we were truly in a recession or heading into a period of economic contraction, high-yield bond spreads would be much higher right now. Instead, buyers are returning to these markets and driving yields down.

I’m not entirely convinced the United States will avoid a recession because of deepening housing-related woes and over $500 billion dollars’ worth of mortgage resets occurring next April. That’s going to put more pressure on the economy. Plus, the Fed has been too slow to act, delaying much-needed interest rate cuts. But the good news is that the world’s largest economies outside of the United States are still growing, mainly the emerging markets where balance-sheets and trade-flows are booming. Hopefully, China and the rest of the world can help spare a severe U.S. recession in 2008 by accumulating cheap U.S. assets and keeping interest rates low to resuscitate growth.

Have a good weekend.