UBS: There's a 31% chance of a US recession in the next year

Major US stock market averages are rallying after Wednesday’s Fed decision
to keep policy on hold while indicating positive vibes for the US economy.

Metals, crude oil and real estate investment trusts are moving higher, but a research note by UBS Global Macro strategy out on Thursday suggests to keep the champagne on ice.

UBS’ credit model, designed to find the likelihood of a recession over the next few quarters, considers four corporate credit measures: interest coverage, leverage, loan performance, and bank lending standards with recessions. Based on the historical relationship between those measures and ensuing recessions, the bank’s model estimates the risk of a recession at 31% over the next year, from Q2’16 to Q2’17.

While this hasn’t changed from previous estimates of 28-32% over the past few quarters, “US recession risks remain elevated when compared to much of the post-crisis period.”

Elevating this recession risk, according to the UBS report, are debt growth, up 5.5% year over year, struggling domestic profits, which fell 5.4% quarter over quarter in Q2 in a sup rise to analysts, and tighter lending standards.

Mitigating recession risks are a strong dollar, continued low interest rates, and a decline in bank non performing loans from 1.57% in Q1 to 1.49% in Q2.

This chart, which breaks out the four credit measures the bank’s model uses to estimate recession risk, shows that high leverage (in blue) is the biggest problem in the model’s assessment right now:

Q2 foreign profits of US subsidiaries rose 3.1%, the largest increase quarter over quarter in six years. The UBS global macro strategy team, led by Stephen Caprio, “expect this trend to continue. In coming quarters, dollar base effects are set to provide the largest earnings tailwind since Q3 2011.”

This is boosting higher quality asset classes, like the S&P 500. The team expect that high dividend yielding, “bond-like” equities will continue to perform and can still rally further as low interest rates boost valuations and increase the demand for quality.

The high yield rally however isn’t as clear.

“This year’s epic rally contrasts with an historical precedent of negative high-yield excess returns amidst similar recession odds,” the note states. “We think much of high-yield’s future performance will depend on whether this year’s rally leads to improved fundamentals, or if fundamentals continue to remain weak.”

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