Introduction
There has been a frenzy on Wall Street and in Washington to embrace a "recession is coming" position. Wall Street economists are shifting their forecast to one of recession, the federal government has streamlined efforts to cobble an anti-recession stimulus package, and various Federal Reserve "hawks" have shifted their position, finally acknowledging downside risks to the economy.

The question remains as to whether and how a recession would be relevant for investors. Financial commentators routinely assume that a recession would mean further losses for stocks, corporate bonds and other spread product. However, history indicates otherwise. Financial markets are discounting mechanisms. Whether the event of a recession means gains or losses for financial assets should depend on whether a slump is already discounted into market pricing, as in "Buy the rumour, sell the fact".

We argue here that financial markets are already priced for recession and that the historical incidence of recession in the past has had varied effects on asset prices. In fact, recession in the U.S. has often been associated with outperformance of spread product relative to Treasuries. Furthermore, there is no cogent evidence that a recession is presently under way, and the odds are still against a recession occurring.

Lest the second question in our title sound callous, we acknowledge that the issue of recession is clearly relevant for workers. Our focus is on the relevance for fixed-income investors.

Is a Recession Coming?
Each recession is different. Those of the 1970s and 1981-82 were predominantly driven by Federal Reserve efforts to restrain inflation, abetted by the effects of dismantled price controls, oil shocks etc. The 1990-91 recession occurred during the S&L crisis, exacerbated by the financial fallout from Iraq's invasion of Kuwait. The 2001 recession followed Y2K, the bursting of the Internet bubble, a consequent crash in the stock market, and three years of declining corporate earnings.

These differences effected different intensities of decline across economic sectors. While each recession exhibits the same, requisite declines in real GDP, the drivers of the declines vary substantially. By comparing contextual differences across sectors, we can obtain a better insight as to whether a slump is coming presently, which insights might also be of use in assessing investment prospects.

Any U.S. recession in 2008 will have to be triggered by a sharp drop in consumer spending. Yes, housing's plunge will be the true "driver" of any coming slump. However, the -1% drag homebuilding is exerting on GDP growth is too small to drive a slump all by itself. Housing must incite secondary declines somewhere else to spawn a recession, and the consumer is the only likely spot for such housing-related declines to occur. Exhibit 1 shows the contributions to GDP growth over various cycles provided by the three "super-sectors" currently of interest: residential construction, consumer spending and everything else (including business capital spending, government purchases and foreign trade).

Exhibit 1A shows current experience: declines in housing but nowhere else as yet. In contrast, in the 2001 recession, seen in Exhibit 1B, housing was a slight positive, and consumer spending growth slowed, but never went even NEAR negative territory. The 2001 recession was solely the result of declines in the rest of the economy, plunging equipment investment, in the wake of the Internet bubble and declining exports, reflecting similar experience abroad. Now consider the 1990-91 recession, shown in Exhibit 1C. While all three elements of the economy turned negative together, the bulk of the declines were in housing and consumption. The collapse of the S&L industry hit consumers hard, and the Fed provided little or no offset to this until quite late in the slump.

Exhibit 1a

Exhibit 1b

Exhibit 1c

For the recessions of the 1970s and 1980s, there was much more coherence among sectors. Those previous recessions were driven by harsh Fed tightening in the face of recession, and that restrained all economic sectors together. Since the 1980s, the Fed has had at least the ability to pursue countercyclical policies. It has not been so dominant a driver of recent recessions, and sector differences have been more prevalent.

This remains the case presently, and so the patterns of the 1990-91 and 2000-01 recessions are more relevant prototypes for any coming 2008 slump. Furthermore, with corporate profitability and financial conditions much more favourable than they were over 1998-00, with CAPEX not having shown the strong boom in recent years that it experienced over 1996-00, and with foreign growth conditions also much better now than in 2000 (when developing economies were still mired in the aftermath of the 1997-98 Asian Crisis), it is evident that U.S. CAPEX and exports are not going to show the sharp declines that drove the 2000-01 recession. Thus, compare the 1999-00 pre-recession behaviour of "the rest of the economy" in Exhibit 1B with that of recent years in Exhibit 1A.

If a 2008 recession is coming, it will likely be even more dominated by housing and consumption declines than was the recession of 1990-91. To tip the economy into recession, a sharp drop in consumer spending is necessary. While current economic data are subject to future revision, currently reported rates of growth in consumer spending are nowhere near zero, let alone the substantially negative rates a recession would require. It is clear that a recession is not presently in place.

Consumer spending growth could plunge in coming months, but is this likely? While falling home prices raise the threat of consumer collapse, the most reliable consumption indicator is household income, and real incomes still appear to be growing at positive rates. Job growth is nowhere near the kind of declines that would be necessary to drive negative income growth, and the most likely factor to drive such job declines would be a drop in consumer spending...which gets us back to square one.

The second most reliable indicator of consumer spending trends is interest rates. While the Fed's initial attempts at easing last fall drove only a slight decline in mortgage interest rates, recent efforts have been associated with a more precipitous decline. Lending standards are tighter as well, but it is hard to believe that the cumulative drop in mortgage rates to date won't provide at least some boost to consumers in months to come.

Finally, the fact remains that despite two years of declining home prices and other ills, consumption growth remains firmly positive. Notice in Exhibit 1 the much sharper pace of slowing in consumption prior to recession in 1990-91 and even prior to 2001. A move to significantly negative consumption growth is not impossible but would be a stark departure from current trends.

Exhibit 2

Exhibit 3

How Would a Recession Matter for Investors?
Once again, the impact of historical recessions on financial asset prices has been varied. Yes, the early months of recessions have typically been bad news for equities. However, for spread product, the onset of recession has often been associated with improvements in performance. Recession should be least likely to impart spread product losses when markets have underperformed before (in anticipation of) the slump, and history confirms this.

Since the onset of the credit crisis last August, investors' flight to quality and away from risk has pushed Treasury yields down dramatically and sharply elevated spreads on all credit instruments, to the point that recession is clearly priced into financial markets. As seen in Exhibit 4, as of late January, 2008-delivery Eurodollar futures yields were consistent with an overnight Fed funds rate of 2%, compared to 5.25% as of August. The Fed would not ease so aggressively in the absence of recession. As also seen in Exhibit 4, the expected rate decline presently is much sharper than was anticipated as of January 2001, on the eve of recession then.

Similarly, default rates on high-yield bonds would have to pass 13% over the next year to justify the levels of spreads seen in late January.¹ Yet, as seen in Exhibit 5, actual default rates totalled just 0.85% in 2007 and surpassed 13% levels historically only during the Great Depression. In other words, high-yield markets are priced to handle Depression-level default rates. Similar conclusions attain when comparing pricing for various segments of investment-grade credits with their historical default rates.²

Exhibit 4

Exhibit 5

MBS, ABS and emerging market debt pricing leads one to the same conclusion. So would the event of recession induce further declines? Although we can't answer this question definitively, the available evidence indicates that further losses are highly unlikely. The charts in Exhibit 6 show the relative behaviour of credit and MBS instruments presently and during the last four recessions. In each chart, movements in the overnight Fed funds rates are shown to track the timing and magnitude of Fed easing moves, whereas credit and MBS performances are the cumulative total returns for Lehman Credit and U.S. MBS indices relative to that for the Lehman Government Index.³

Exhibit 6A shows the recent underperformance in both credit and MBS from May 2007 to the present, despite declines in the Fed funds rate since September. As seen in Exhibit 6B, after underperforming in 1999 and 2000, credit instruments outperformed Treasuries in the last months before the 2001 recession and through the first six months of the slump. It was the 9/11 attacks — not the 2001 recession per se — that finally triggered underperformance of credit. The Enron/corporate governance crisis then triggered sharp further losses, but this was not directly related to the recession. MBS instruments exhibited less of an early recession rally than credit in 2001 but also NO preceding underperformance. Even so, the actual onset of recession did NOT adversely affect MBS performance, which held up well until 9/11. Keep in mind, too, that credit product performed well during the 2001 recession despite the fact that it was a business-driven slump, that profits had been declining for three years prior to recession, and that corporate defaults had picked up sharply prior to the slump and continued high during recession (as seen in Exhibit 5).

Exhibit 6a

Exhibit 6b

Within the consumer/housing-driven slump of 1990-91, the onset of recession triggered an immediate decline in credit product performance, with MBS performance declining a month later. Notice, though, that there had been no sell-off in spread product prior to (anticipating) that recession. Furthermore, the spread product losses coincided with Iraq's invasion of Kuwait. This event could be as much to blame for spread widening as the recession. Notice finally that the Fed kept policy rates steady early in the recession and that spread product performance improved shortly after the Fed began to ease aggressively in late-1990.

Finally, Exhibit 6D shows spread product performance during the recessions of 1980 and 1981-82. With respect to the 1981-82 slump, spread product performance deteriorated throughout 1979 and 1980 and then improved throughout that severe recession. Notice similar timing for the Fed funds rate. Early in the recession, the Fed eased only grudgingly. However, more intense easing efforts in July 1982 and after were accompanied by accelerated outperformance of spread product. As for the 1980 recession, spread product performance had also deteriorated prior to that slump, yet the first few months of that recession saw further losses. Then again, the funds rate continued to rise through the first few months of that slump, and it was also the case that the Volcker Fed instituted a number of special restrictions on bank operations, alongside President Carter's famous entreaty for consumers to cut up their credit cards. Both restraints were abruptly removed upon news of the 1980 slump, at which time spreads narrowed.

Exhibit 6c

Exhibit 6d

One would expect that corporate financial conditions going into a recession would be relevant for the relative performance of credit instruments, and an analysis of these might strengthen our case. However, even without resort to those considerations, the evidence presented here already indicates that the mere occurrence of recession need not be a negative event for fixed-income spread product. In two of the four slumps examined here, spread product outperformed Treasuries from the very onset of recession. In the two slumps where the onset of recession did coincide with underperformance of spread product (1980 and 1990), it was also the case that political/policy events accompanied the onset of the slump, Fed policy failed to respond immediately or even quickly to the economy's decline and, perhaps more tellingly, in 1990 at least, there was no preceding spread product sell-off to indicate recession had already been priced in.

Historical evidence is less compelling for equity prices. These have declined through at least the early months of every postwar recession, and in some cases throughout the recession, as seen in Exhibit 7. In the recessions of 1981-82 and 2001, equity prices declined throughout the slumps, even though they had also been declining well prior to the onset of recession. It may be that better corporate finances, a more sober stock price performance in recent years and aggressive Fed easing will forestall further equity declines in the event of a 2008 recession, but, unlike the case for spread product, there is no historical precedent to support that assertion.

Exhibit 7

Conclusion
One thing history teaches is that, other than declines in GDP and employment, nothing else is certain about the incidence of a recession. Still, the evidence does clearly indicate that a recession is not yet in place, and we believe that the indications are that a slump is still unlikely. Furthermore, the historical evidence also clearly indicates that a recession need not mean further underperformance for spread product, especially when markets have already fully discounted a recession into market pricing, as is the case presently.

The evidence does not conclusively indicate that U.S. financial markets would breeze through a 2008 recession, but it certainly portrays a spread product market well positioned for a slump. Not only is recession already discounted into fixed-income prices but the Fed is also easing aggressively, and policy/external events are presently disposed to mitigate rather than exacerbate downward pressures on the economy. When these factors were present in the past, the onset and course of recession failed to impose further losses on spread product instruments.

References
Western Asset (2007) "Working Out the Credit Crisis of 2007," December 2007, available on our website.

Footnotes

1. The implied default rates shown in Exhibit 5 and referred to elsewhere in this paragraph were calculated using Credit Default Swap pricing models, as provided on page "CDSW" of the Bloomberg system, along with the 1982-2005 average recovery rate upon defaults of 38.39% as per Moody's, and spreads on corporate market debt as reported by Lehman Brothers. Whereas Exhibit 5 in the text focuses on 1-year default rates, high-yield spread pricing on 23/1/08 indicated an implied 5-year default rate of 47.4% which has never been achieved in the 85-year history of Moody's default data. For AA debt, market spreads on 23/1/08 implied one-year default rates of 3.54%, far ABOVE the historical peak of 0.83% achieved in 1938.
2. Cf. the details in Footnote 1.
3. Since the durations of these indices are different, the most accurate measure would be to use duration-adjusted (excess) returns for Lehman Credit and Lehman U.S. MBS. However, while total return data for these indices are available back to 1973, duration and excess return data are available only back to 1988. So, in order to track a consistent set of indicators across historical episodes, we depict the ratios of cumulative total returns, as depicted in Exhibit 6. For the record, for those cycles for which both sets of data exist, the data patterns and resulting story for duration-adjusted returns are the same as for the cumulative returns shown. Adjusting for durations affects the magnitude of ups and downs in relative performance but not the direction, at least not for the post-1989 experience.