“When it rains, it pours.”
That is most assuredly one of the most heavily used cliches in the history of the English language but a failure to understand it apparently causes Citi’s economics team to get it wrong when it comes to forecasting the depth and trajectory of recessions.
In a new note, the bank looks at what happens when mean reversion fails, pushing a struggling economy even further into the abyss. Here’s a list of some of the mean reverting forces that help economies to correct and pull themselves out of trouble:
“Both economic theory and practice establish that business cycles are self correcting. Of course, policies can help engineer a quicker recovery (and even altogether prevent a recession) but most economies and markets, under normal circumstances, eventually return toward mean growth. High unemployment puts pressure on wages which, in turn, reduce labor costs and eventually increase the demand for workers. Sustained low investment ultimately results in a low capital stock, which increases the return to capital, eventually driving up investment. Weak growth typically results in real exchange rate depreciations, which eventually increase net exports and aggregate demand. These are some of the mean-reverting forces that ensure that a market economy will normally go through a business cycle, but that it will seldom face an economic depression.”
But an overreliance on the assumption that these forces will everywhere and always lead economies out of the recessionary doldrums has apparently caused Citi to be “too optimistic” in their forecasts on EM growth – and that’s putting it nicely:
In an effort to figure out why their forecasts have consistently missed the mark as multiple EMs head toward severe corrections, Citi took a look at 55 recession episodes in emerging markets during the last few decades and discovered a funny thing: when things are going bad they tend to get worse, not better:
A first test of the nonlinearity hypothesis for recessions consists of estimating the probability of an additional decrease in output of, say, 2% or 4%, given the accumulated fall in output since the previous peak. Under the mean-reversion framework, this probability should decrease the bigger the cumulative fall is. Our estimates show that this is not the case. Once the cumulative decrease in output surpasses certain thresholds, the slope of the curves becomes positive. The Ushaped curve illustrates that the probability that output falls further bottoms out and eventually increases. As the output fall grows large, nonlinearities emerge, increasing the probability of another negative growth year.
As shown below in Figure 2, the probability activity falls an additional 2pp is decreasing for moderate declines in output, reaching a (local) low after an accumulated drop of around 4.5%. For instance, after activity has fallen 6%, the Ushaped probability curve suggests that an additional 2pp contraction has a 67% probability. In the case of the probability of an additional 4pp drop, the curve reaches a low at around 6%, increasing after that. In the case of “very deep” recessions (accumulated falls in output between 9 and 10%), both curves are upward sloping. This suggests that, eventually, after a certain threshold is exceeded, activity is likely to further contract quite meaningfully, i.e., the probability activity falls by an additional 4pp after a 10% depression-like contraction is no smaller than in the initial phase of a recession.
Now to someone without a PhD in economics this would have been obvious, but as anyone who’s ever done any academic research knows, the “very serious” people spend quite a bit of their time discovering things that largely belong in the realm of common sense.
A slavish adherence to the notion of predictable business cycles has led professional economists astray on any number of occasions and indeed, the entire thesis behind the machinations central banks are currently going through rests on the notion that these cycles can be smoothed and manipulated. Far from being able to successfully tinker with then, it would appear economists don’t understand them at all.
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Below, find Citi’s take on what the above means for Brazil, the poster child for EM malaise.
Take for instance the case of Brazil. When we use quarterly GDP data (available up to 3Q15), activity has shrank 5.8% from the peak. Thus, the country currently sits in the area where the blue line in Figure 2 has a positive slope. This means that the more output falls from this point (at the margin), the more likely it will contract by (at least) an additional 2pp. In other words, Brazil seems to have entered a stage where negative spillovers could offset mean-reverting forces. Given the preliminary Q4 data available, it seems that growth has remained negative. This could conceivably place Brazil beyond the trough of the light blue curve, indicating that even a 4% further contraction may be increasingly likely. In sum, this first exercise suggests that in Brazil, the accumulated fall in output may already be enough to trigger negative spillovers and nonlinearities.
via Zero Hedge http://ift.tt/1TAprFE Tyler Durden