- Although current recession odds are low, it’s instructive to understand the signals we view as warning signs of a turn in the economy.
- Only two of the 11 recession indicators we follow are currently signaling recession risks.
- A healthy U.S. consumer gives us confidence that the current expansion has room to run.
The optimism surrounding President Donald Trump’s ambitious pro-growth policy proposals would appear to dismiss the near-term likelihood of a recession. Yet the administration’s success in pushing through an ambitious package of tax reforms and increased infrastructure spending is far from assured. Republicans in the House and Senate, for example, are divided on the need for border adjustments as part of a corporate tax overhaul. The market is also failing to discount the risks that the iconoclastic President poses that could negatively impact trade and the fortunes of many U.S. companies and consumers. Trump has already dismantled the Trans Pacific Partnership, which could raise the cost of imported goods from the countries in the pact more than $600 million per year, and suggested a 20% import tax on goods from Mexico.
While we believe the odds of a recession are low right now, it’s helpful to understand the signals that we view as warning signs of a turn in the economy. When determining the probability of a recession, we first need to figure out what type of inflationary environment we’re in. The length of the expansion is highly dependent on the level of inflation. Looking back at all the expansions since the 1960s, the average has been 27 quarters or roughly seven years long. However, excluding the two high-inflation expansions in the 1970s, the remaining low-inflation expansions have averaged 33 quarters (Exhibit 1). So the average expansion period with low inflation has been over eight years. To get to that average, the current expansion would need to continue until late this year. Given the wait and see stance of the Federal Reserve on removing accommodation from the economy, there’s a good chance we make it past that point.
Exhibit 1: Economic Expansions and Real GDP Growth
Predicting recessions is not that easy, but there are data points that can give us insight. The problem, however, is that most economic data points tend to be lagging or coincident indicators, meaning they don’t have much predictive ability. There are, however, data points that can project what will happen in the future. These are called leading indicators. But no single data point can tell you the whole story so it’s important not to look at any one statistic in isolation. Exhibit 2 lists a number of the risk indicators that can help us form an opinion on the economy. Currently, just two out of 11 are flashing a warning sign of danger ahead: CPI Energy, which reflects the roughly 100% increase in crude oil prices from their trough last February, and Corporate Profitability as a percentage of GDP, which remains well below its 2014 peak.
Exhibit 2: U.S. Recession Risk Indicators
|Average Hourly Earnings||No|
|Personal Consumption Expenditures Deflator||No|
|10-Year Treasury Note and 3-Month T-Bill Spread||No|
|Consumer Non-Mortgage Delinquency Rate||No|
|Corporate Profits Financial and Nonfinancial % GDP||Yes|
|High Yield Spread||No|
|Temporary Worker Trend||No|
|Four-Week Average of Initial Jobless Claims||No|
Leading Economic Indicators Signal All Clear
Let’s examine a few of the more important ones. The composite of leading economic indicators (LEI) is made up of 10 components whose changes tend to precede changes in the broader economy. The LEI suggest a good likelihood of a continuation of this economic cycle. On average, when the index eclipses the previous market’s peak, it takes six years on average before you see a recession. We have come close but have yet to pass the previous peak set in 2005. That is not to say the current cycle will last another six years, but there is a high probability that the expansion will last several more years. There are several indicators we view as most effective in forming a recession forecast.
Building permits are a helpful guidepost because they can tell us about growth years into the future. It takes years to get a building permit, build a house, sell the house and finally furnish it - all of which are additive to the economy. In fact, housing-related activities make up approximately 16% of U.S. GDP. The direction of permits serves as a good compass on where the economy is heading. Just prior to recessions, permits tend to drop aggressively. Today, permits are firmly in an uptrend and should go higher (Exhibit 3). Just to keep up with population growth and demolitions, the U.S. housing supply needs to increase at a pace of 1.4 million units per year. The current pace (as of December 2016) is 1.2 million. The bursting of the housing bubble led to nearly a decade of underbuilding, creating pent up housing demand. On top of that, banks are finally loosening up their lending standards. While mortgage rates have ticked up since the election, they remain near generational lows and are encouraging a long-sought-after increase in first-time home buyers that is critical to a sustainable housing recovery. On average, permits peak two years prior to a recession, so the trend in building permits projects continued expansion.
Exhibit 3: Building Permits for New Private Housing Units
The yield curve, which compares the level of Treasury yields across maturities, is another closely-watched gauge of economic health. Normally, short-term interest rates are lower than long-term rates. But when the costs of borrowing for shorter time periods are as much or more than the gains from lending for longer time periods, the yield curve is said to be flat or inverted. Such a shape for the yield curve is one of the most reliable indicators of imminent recession. A flat or inverted yield curve has successfully predicted the last seven recessions going back to the mid-1960s.
Why is the yield curve so effective a predictor? When short rates are higher than long rates, this reduces the net interest margin that enables banks to make a profit. With less incentive to lend, banks reduce loan volumes, leading to a contraction in the supply of credit that supports economic activity. Right now, the yield curve is steep; with the difference between the 10-year U.S. Treasury note and the three-month Treasury bill at approximately 190 basis points. However, yield curves can change quickly – witness the spike in long yields post-election. Once the curve inverts, a recession is likely sooner than later – the past three recessions have followed in a year or less.
The price of crude oil is also closely correlated to recessions as virtually all economic downturns are preceded by an oil-price spike. This makes sense because the consumer is highly affected by gasoline prices. In July 2007, oil was trading at $85 per barrel (bbl) in today’s dollars and in a steep uptrend, eventually hitting $145/bbl. Today, the price is above $50/bbl and oil has traded in a narrow range around these levels for more than nine months (Exhibit 4). Although oil prices are up considerably over the last year, consumers are in a much better place financially than they were when oil stood at $145/bbl and the increase has not impacted spending patterns. The average American family saved over $1,000 in gas prices in both 2015 and 2016 compared to the costs they faced in 2014. That’s been a huge boost to personal spending capability, which has also acted to lower the chances of recession. Corporate activity related to the energy sector fell precipitously with the drop in oil prices to 13-year lows last February and capital expenditures in the oil patch are just beginning to rebound. OPEC’s decision to cut production late last year, combined with improving economic activity outside the U.S., should bring global supply and demand back in balance, yet not at the risk of a price spike.
Exhibit 4: No Spike in Crude Oil Prices
There’s one other area that we like to look at when forecasting the economy: the consumer. Consumer spending makes up almost 70% of U.S. economic activity. In forecasting, if you get the consumer right, more often than not, you get the economy right. Consumers are in the best shape they’ve been in the post financial crisis period. Higher employment has helped consumers get their financial houses in order with household net worth up 33% from its last peak in 2007 and debt service payments close to record lows.
Employment trends remain healthy, with wage growth recently touching a post-recession high of 2.9%. Job openings peaked last April and are still trending above historical norms (Exhibit 5). A greater availability of jobs provides more incentive for employed workers to change jobs and for those who have left the workforce to come off the sidelines. With the official unemployment rate at 4.8%, there are also fewer workers competing for open positions: 1.4 people per open job as of December 2016 compared to 7 per open job in the beginning of the recovery in 2009.
Weekly unemployment claims, another indicator we track, also continue to trend downward and have been under the 300,000 threshold for 101 straight weeks, the longest stretch since 1970. Weekly claims are one of the best high frequency data points out there because of their recency and because they are unrevised. You can take that number at face value. We get concerned when claims start to creep up, which could foreshadow future weakness in the labor markets. But based on recent prints, the coast is clear on this front.
Exhibit 5: Labor Markets Keep Improving
Taken in aggregate, these indicators suggest the odds of a recession are low. We would project the current odds at about 20%. It’s important to analyze recession probabilities due to the damaging impact they have on equity markets. Over the last three recessions, the S&P 500 Index has declined 11.7% on average. The strength of the consumer and the positive economic indicators all point to a continued expansion into 2017. This positive backdrop should motivate long-term investors to stay the course.