US will not fall into recession in 2016, but might come close in 2017, UBS says

The US economy was not on course to fall into recession in 2016, but under certain circumstances the risk of such an event in 2017 might rise significantly, UBS told clients.

More volatility was to be expected in equity markets, and the probability of the American economy falling by the wayside had indeed worsened, but current recession risks were still consistent with a positive return from stock over the course of 2016, the Swiss broker said.

"One should not adopt a bearish tactical stance on risky assets. Today’s increased level of recession risks is still in sync with positive US equity returns over the next year. This is another sign to us that markets had grown excessively pessimistic in recent weeks. We think investors should also expect more volatility," strategist Stephen Caprio said in a research note sent to clients.

According to UBS's credit model, the risk of a recession in the States through the fourth quarter of 2016 stood at 23%, in comparison to 16.5% through the third quarter, Caprio said, far from the 50% readings which had signaled such a risk in the past.

That was the result of falling corporate earnings and a tightening in bank and non-bank liquidity, Caprio explained.

Similarly, the broker's base case for 2017 was for that recession risk to remain around then current levels, "which would be a modest positive again for risky assets."

Recession risk for 2017 might jump to 49%

However, if some of the risks which materialised at the start of 2016 continued then the probability of a downturn might rise significantly, leading to "substantial" downside risks for risky assets and a spike in volatility, UBS said.

Under such circumstances, the best course of action for investors, in their opinion, was to position for specific trades that had either asymmetric risk-reward profiles or that specifically protected against the risk of a market downturn, Caprio said.

One such trade was to be 'long' EUR/USD versus the Japanese yen, or going short US small-capitalisation stocks versus large capitalisation ones.

"If the themes of rising Chinese devaluation risks, lower oil prices, and tighter Fed policy (through a stronger dollar) continue in 2016, 2017 recession probabilities could rise to 49%. This could lead to a substantial downside for risky assets and a significant spike in volatility."