'We are worried': Bank of America lays out the latest warning signs that a recession is approaching - and explains why the next crisis will be a lot harder to fight

traders black mondayA trader holds his head as he reads a note on the derivative market at the Paris stock exchange, October 28. The French blue-chip share index fell by more than 9 percent which is the second biggest one-day fall since 1987 Black Monday.Jean-Christophe Kahn/Reuters

  • US economists at Bank of America Merrill Lynch warn there is a "heightened risk of recession."
  • They updated their recession outlook after the recent escalation of the US-China trade war and the ensuing market volatility.
  • The bank's chief investment strategist also offered investing recommendations for this period of uncertainty.
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Investors have reckoned with the threat of a recession over the past two weeks.

Within a day of the Federal Reserve's July 31 rate cut, President Donald Trump announced that the US would slap new tariffs on nearly all Chinese imports.

This trade-war escalation and the ensuing market chaos prompted economists at Bank of America Merrill Lynch to update their recession outlook.

Their main conclusions were two-fold: the risk of a recession is now higher, and a key tool to combat the next one has lost some of its efficacy.

With these findings, they published their third primer on recessions since November 2018.

"And this time, we are worried," said Michelle Meyer, the bank's chief US economist, in the note.

She continued: "We now have a number of early indicators starting to signal heightened risk of recession. Our official model has the probability of a recession over the next 12 months only pegged at about 20%, but our subjective call based on the slew of data and events leads us to believe it is closer to a 1-in-3 chance."

Read more: Morgan Stanley scoured 100 sets of data and warns we're 'just outside the danger zone' of the next recession. Here's how it says to prepare.

Here are the highlights of what their recession model is showing:
  • The yield curve, which shows the relationships between long- and short-term Treasury yields, continues to send an ominous recession signal. This week, the spread between 3-month and 10-year treasuries fell to -32 basis points, its worst inversion since 2007.
  • Recent data on auto sales, industrial production, and aggregate hours worked have worsened.
  • And although their model is unable to fully capture the threat of the trade war, they view it as the biggest downside risk to the economy.

On the plus side, the level of initial jobless claims - among the earliest warning signs of trouble - is still very low and not sending a recessionary signal.

'Easy growth' is over

Meyer noted that the economy's next slowdown will be harder to deal with than the most recent scares in 2012 and 2015.

Neither of those episodes was severe enough to end the record-long expansion. However, the economy is now further into its expansion and more vulnerable to shocks, Meyer said. The era of "easy growth" has passed because the economy has returned to full capacity, she added.

In addition, the two scares occurred before the Fed started raising interest rates and shrinking its balance sheet. The central bank now has a more limited set of tools to fight the downturn.

Finally, the yearlong trade war has raised the overall threat level of a global recession.

What BAML's chief investment strategist recommends

Investors' concern about a recession reached a fever pitch on Monday, when the stock market suffered its biggest sell-off of 2019.

Michael Hartnett, the chief investment strategist at Bank of America Merrill Lynch, observed some notable flows that also occurred.

On Monday, investors pulled $12.4 billion from global equities in their 12th-largest daily drawdown on record, Hartnett said in a recent note. They yanked $6.2 billion from emerging-market stocks last week - the largest weekly depletion since China devalued its currency in August 2015. Meanwhile, gold recorded its fourth-largest weekly inflow on record.

The flows data, combined with the price action in bonds, suggest that traders were shedding riskier assets in favor of safer ones.

Read more: 'The greatest bubble ever': One market expert warns that a relentless bull market is on the brink of crashing and explains how to profit from its demise

But Hartnett recommends staying bullish through the end of the third quarter while keeping an eye on two developments: China's economy, and how the trade war is affective the job markets in key battleground states for the 2020 election.

In the interim, he offered a few "contrarian" trades for bullish investors.

They could "trim very overbought bonds" and buy stocks that are global, cyclical, and high-dividend payers.

He also recommends buying South Korean stocks and betting against Treasuries, as improvement in Korea's economy is often used as a bellwether for the global situation. The iShares Core KOSPI 200 Index exchange-traded fund captures Korea's benchmark equity index.

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