The odds of a U.S. recession this year have risen to 40 percent, according to Deutsche Bank's chief U.S. economist, Joseph LaVorgna.
ISM nonmanufacturing data Wednesday was surprisingly weak, with the index at 53.5, down from 55.8 in December. Economists had expected 55.1, which would have showed just a slight slowing in the service side of the economy.
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Markets had been watching the number for any signs of cracks in the service sector, which had been going strong while manufacturing dipped into recession. The index shows contraction when it is under 50, but the January level was the lowest since December 2013.
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"The service side follows the manufacturing side. I don't just look at the fact that manufacturing is a small part of the economy. It doesn't matter. If there's anything we learned in the last business cycle, it's size doesn't matter," LaVorgna said.
LaVorgna's recession odds are higher than the Wall Street average. The CNBC Fed Survey last week showed an average expectation of 24 percent among the respondents.
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"Let me be clear — it is not my baseline. But if we have a recession, it would likely be a very shallow recession, more akin to what we saw back in 2001. However, risky assets under such an environment go lower in price if the downside risks were to materialize," he said.
LaVorgna said the odds of recession have been rising because of the worsening financial conditions and stock market sell-off.
"I would say we entered the year with a 33 percent chance of recession in my opinion, and for every 1 percentage point the stock market falls I would increase my recession risk," he said. "Now with the stock market down 7 percent, I put the recession risk at 40."
LaVorgna said there are other warnings. "You have to be worried about recession. Profit margins have peaked. The yield curves 2s/10s are the narrowest since 2010. Credit spreads have blown out to recession levels. The dollar has exploded to the upside. Materials prices have weakened. The markets are all telling you the same thing," he said.
Stocks immediately sold off when the ISM report was released at 10 a.m. ET on Wednesday, and bond yields fell as buyers rushed to Treasurys. The 10-year dropped to 1.82 percent, a one-year low. Stocks later came off their lows.
U.S. growth has been slowing, with fourth-quarter GDP up just 0.7 percent, but economists do expect the first quarter to have growth of more than 2 percent.
The market initially reacted to but later ignored a positive report on January jobs. ADP showed private payrolls increased by 205,000, a positive sign for Friday's government jobs report.
ISM showed a slowdown in most components, with one of the most worrying the decline in business activity, down 5.6 points to 53.9. That was the largest drop since the recession, according to JPMorgan economists.
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