by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co
Key Points
- There’s more than one yield curve; and the Fed believes the one with the best “tell” for the economy shows elevated recession risk.
- Leading indicators’ trends paint a worse picture than their levels.
- Most “soft” measures of economic data have been deteriorating since the trade war began; but recently some of the “hard” data has succumbed to trade/tariff uncertainty.
The National Weather Service offices issue storm Watches, Advisories, and Warnings. Normally, a storm Watch is issued well in advance of the storm; indicating the risk of a hazardous event has increased (at least a 50% chance of it occurring). As the event becomes imminent, a Watch will normally be upgraded to either an Advisory or a Warning (indicating an 80% or greater probability of occurrence). An Advisory indicates conditions pose a significant inconvenience; while a Warning indicates that conditions pose a severe threat.
[backc url='https://sendy.advisoranalyst.com/w/J8pxsj3OgR4yxKxsA1169Q']It’s been nearly a dozen years—September 2007—since I wrote my last “Recession Watch” report. In hindsight, although it was good to have given our investors a heads-up, Warning would have been the better descriptor given that the recession began three months later. Given the recent attention to the topic, and myriad questions I’ve been getting from investors, it’s time for a closer look (perhaps I should source Seth Meyers on that).
We have been on record for more than a year now with our collective view that the trade war represents the most important factor in defining the length of runway between now and the next recession. The impact of trade has been felt most significantly on “soft” (survey/confidence-based) economic data, especially among businesses; with the most notable hit to manufacturing broadly, and capital spending specifically. More recently, key “hard” data has been weakening as well. Even with that weakness though, current economic conditions do not suggest we are in a recession. The rub however is that if we are sliding into one, it’s possible it will ultimately be dated as having already started. When the arbiter of recessions (more on that below) decides the economy is in a recession, it typically dates its start around the peak in the cycle.
Fed’s Recession Probability Model Flashing Yellow
One of the most widely-watched recession risk models is calculated monthly by the Federal Reserve Bank of New York. Their Recession Probability Model (RPM) uses the difference between 10-year and 3-month Treasury yields to calculate the probability of a recession in the United States 12 months ahead. As you can see below, although the model currently shows less than a 32% chance of a recession; with only one exception historically (1967), when it was this high, we were approaching or already in a recession.
Recession Probability Model Based on 10y-3m Yield Curve
Source: Charles Schwab, Federal Reserve Bank of New York, as of July 31, 2019.
A yield curve inversion (when the 10-year yield is lower than the 3-month yield) has historically been a harbinger of recession, with only two exceptions: 1967 and 1998; when the curve inverted briefly each time, but recessions were still several years ahead. The initial inversion of the curve in this cycle was this past March; since which time it’s been in-and-out of inversion (more “in” recently).
The chart below shows the actual yield spread, with inversion periods shown in red and the gray bar representing recessions. A yield curve inversion can be thought of as a symptom of tight monetary policy/short rates having moved too high; but also a cause of recessions given the constraint on lending (banks borrow on the short end and lend on the long end). Broadly, when the yield curve inverts, it suggests investors have little confidence in the economy in the near-term—demanding more yield for short-term investments than longer-term investments.
10y-3m Yield Curve in Inversion
Source: Charles Schwab, Bloomberg, as of August 9, 2019.
Near-Term Forward Spread Flashing Red
Adding a little salt to the yield curve’s wound, the Federal Reserve released a paper a year ago titled “The Near-Term Forward Yield Spread as a Leading Indicator: A Less Distorted Mirror.” For the more voracious of readers, the link to the full paper is here: https://www.federalreserve.gov/econres/feds/files/2018055r1pap.pdf. For those “summarily” inclined, the link to the summary notes is here: https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-20180628.htm. The paper’s authors—Eric Engstrom and Steven Sharpe—detailed a “more economically intuitive alternative, a ‘near-term forward spread’ … a measure of the market’s expectations for the direction of conventional near-term monetary policy. When negative, it indicates the market expects monetary policy to ease, reflecting market expectations that policy will respond to the likelihood or onset of recession.”
The near-term forward spread is the difference between the current implied forward rate on Treasury bills six quarters ahead and the current yield on a 3-month Treasury bill. You can see a chart of this spread below.
Near-Term Forward Yield Spread
Source: Charles Schwab, Bloomberg, Federal Reserve Bank of New York, as of August 9, 2019.
Haver Analytics constructed a recession probability model using the above curve, which was published in Dave Rosenberg’s “Breakfast with Dave” report last week. A shout-out is due to Dave and the folks at Gluskin Sheff Research for allowing me to share this with our readers. As you can see in the chart below, this model has spiked up to as high as more than 80% recently. Although it covers a shorter history, this has been a clear warning in advance of the past three recessions.
Recession Probability Model Based on Near-Term Forward Spread
Source: Haver Analytics, Gluskin Sheff, as of August 2, 2019.
LEI: Trend vs. Level
The traditional yield curve is one of 10 components of the Leading Economic Index (LEI), put out monthly by The Conference Board—which also simultaneously releases the Coincident Economic Index (CEI). The latter has four components—payrolls, personal income, industrial production and manufacturing/trade sales. By the way, those are the four metrics the National Bureau of Economic Research (NBER)—the official arbiter of recessions—uses to declare and date recessions’ start and end dates. Although it’s surprisingly common lore that a recession is two quarters in a row of negative real gross domestic product (GDP); that is not, and has never been, the definition of a recession. The NBER, a private economic research organization, defines an economic recession as: "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
Most readers know that I keep close tabs on the LEI and its components; often reminding investors that when it comes to the relationship between economic data and the stock market, “better or worse tends to matter more than good or bad.” This is especially true regarding those indicators that lead the overall economy. The chart below looks at the six-month annualized change in the LEI (vs. the level). It has declined to near the zero line, which is the third significant move down since the end of the last recession. Although it remains comfortably above the -4.9% average decline historically, the trend is worth watching over the next couple of months.
LEI’s Deteriorating Trend
Source: Charles Schwab, FactSet, The Conference Board, as of June 30, 2019.
More importantly, although the levels of the components remain mostly yellow and green, there is an increasing sea of red in terms of their trends as you can see in the table below. This weakness has yet to verge into the coincident indicators, but a continued weakening of the leading indicators would inevitability hit the coincident indicators.
Source: Charles Schwab, FactSet, The Conference Board, as of June 30, 2019.
Manufacturing’s Links to Consumers
We know that most of the weakness in both the U.S. and global economy has been concentrated in manufacturing. As my colleague Jeff Kleintop has been pointing out in his recent reports and on Twitter, we are in the midst of the longest-ever period of consecutive monthly declines (15 and counting) in the global manufacturing PMI (purchasing managers index). It appears clear we are in a global manufacturing recession, even if the United States is able to skirt one.
Capital spending has rolled over and is increasingly at risk looking ahead given the dent to corporate confidence from the trade war. Capex is an important driver of corporate profitability, productivity growth, job growth, labor force participation and infrastructure spending. The trade war is not the only risk though—the recent downward revision to U.S. corporate profits is also a significant risk (more on that below).
When citing the weakness in manufacturing, economic optimists often cite its limited impact on U.S. GDP at less than 12%. But lost in that simple math is that you can’t separate manufacturing from the rest of the economy. Manufacturing adds more real net value to the economy than any other sector—including the consumer. As highlighted in a recent report from TS Lombard, if manufacturing “falters enough, the spending this sector throws off to the rest of the economy diminishes as well, reducing overall income and employment.”
In fact, employment growth in services aside from healthcare (which has never had a down month of payrolls, even including the last recession) has been softening. And although the consumer has been underleveraged since the housing debt bubble burst, there are cracks in that otherwise positive story as well. As per Leuthold Research, the “consumer deleveraging that occurred during and after the financial crisis was massive, and led to a five-year decline in real personal interest payments of 33% by 2013. But from an income statement perspective, that trend has been fully reversed (see chart below). Just a few months ago, real personal interest payments eclipsed their 2007 all-time high! That’s an impressive feat considering the Federal Reserve never came close to its stated plan of ‘normalizing’ interest rates.”
Real Interest Payments > 2007’s High
Source: Charles Schwab, Bloomberg, The Leuthold Group, as of June 30, 2019.
Interest payments are not just higher for consumers—they were recently revised higher for corporations over the past five years. Flying under the radar in the midst of recent trade turmoil was the Bureau of Economic Analysis’ (BEA) annual benchmark revisions to both U.S. real GDP and National Income and Product Accounts’ (NIPA) measure of corporate profits. There was a significant ~$200 billion downward revision to corporate profits over the past three years due to upward revisions to both corporations’ unit labor costs and interest payments on debt. Those revisions mean the latest five-year trend in the broadest measure of corporate profits is now flat vs. upward sloping prior to the revisions.
Consumer confidence remains “healthy”
Are consumers ignoring the warnings signs or feeling immune to the effects of the trade war? Perhaps the trade war has not yet had a direct hit. This will likely change if the latest threatened round of 10% tariffs on the remaining $300 billion of goods U.S. companies import from China takes affect, given their heavy consumer product bias.
There are myriad forces that drive consumer confidence—including the stock market. Notably though, because it’s a leading indicator, history shows confidence tended to be high (but rolling over) in advance of recessions, as you can see below (using the index from The Conference Board).
Consumer Confidence Resilient
Source: Charles Schwab, Bloomberg, The Conference Board, as of July 31, 2019.
An interesting pair of sub-categories of the monthly Consumer Confidence report is Consumer Expectations and Present Situation Indexes, which (somewhat-obviously) compare consumers’ views looking forward vs. on their current situation. As you can see in the chart below, historically when the spread between the two bottomed and began to turn higher, it was a warning of a recession. It’s too soon to judge whether the recent trough is THE trough, but this is worth monitoring.
Consumer’s Expectations vs. Present Situation
Source: Charles Schwab, Bloomberg, The Conference Board, as of July 31, 2019.
Recession with Unemployment Rate So Low?
One of the most frequent questions I get when discussing recession risks with investors is, “How could a recession be on the horizon with the unemployment rate so low?” What many people don’t realize is that the unemployment rate is one of the most lagging of all economic indicators. As you can see in the chart below, the unemployment rate has always been near its trough each cycle heading into recessions. A rising unemployment rate doesn’t cause recessions; recessions cause the unemployment rate to rise. In turn, as you can see, recessions have always ended with the unemployment rate near its peak; and in many cases it was still rising after the recession had ended.
Unemployment Rate Around Recessions
Source: Charles Schwab, Department of Labor, FactSet, as of July 31, 2019.
In fact, there has historically only been an average 0.4 increase in the unemployment rate by the first month of recessions (only 0.3 if you go to the month prior to each recession’s start). There have even been instances where a recession was declared as having begun, yet the unemployment rate was still at its trough; like in 1981. In sum, don’t take economic turning point cues from highly-lagging indicators.
Source: Charles Schwab, Department of Labor, FactSet, as of July 31, 2019.
What’s different this time
It’s often said that “it’s different this time” are dangerous words for investors to utter. I’ve never heeded that warning because, frankly, every cycle is different—and has different triggers for the inflection points. What is perhaps most notably different this time is that we are quite late in the cycle—at least in duration terms—but we are looking at a very unique fiscal policy picture. As you can see in the visual below, prior to every recession since the late-1960s, fiscal policy was tightening (meaning the deficit was improving).
Fiscal Stimulus Late-Cycle is Unique
Source: Charles Schwab, Bloomberg, U.S. Department of Treasury, as of June 30, 2019.
It was typically in response to recessions that fiscal policy loosened (meaning the deficit was deteriorating as government’s coffers were opened to aid the recessions’ plight). Thanks to the tax cut that was passed in late-2017, along with other government stimulus measures, fiscal policy has been extremely loose since then. It’s one of the most aggressive fiscal accommodations outside of a recession in the post-WWII era.
This is uncharted territory; and frankly, I’m not sure what to infer from it. Is this stimulus enough to offset the drag on the economy from trade uncertainty and manufacturing’s malaise? Or is the commensurate increase in the deficit (and in turn debt) yet another plague on the economy looking ahead. I’m on record as being a worrywart about our burgeoning government/corporate debt burden (https://www.schwab.com/resource-center/insights/content/tyrannosaurus-debt-deep-dive-look-debt-and-its-burdens); but it hasn’t yet caused the economy to topple. That said, the last recession was the result of a massive debt bubble bursting; so the perils of a high/rising debt burden are not just prospective, they are part of our recent history.
We also have monetary stimulus that recently kicked in; with more likely to come. At least on the margin, that should help (especially areas like housing); however, rates being too high was not the problem that caused the slowdown. Trade uncertainty and related-weak global growth have been the problems—begging the question of whether rates cuts are the elixir for what ails the economy.
In sum
We will have a recession. There is nothing bombastic or provocative about that statement. Cycles always end in recession; the tricky part is accurately forecasting them ahead of time. There are flashpoints at present that suggest the risk is rising and/or already high; but the jury is still out. Clearly, whether this is yet another mid-cycle slowdown or the beginning of a recession matters a lot to the stock market. For now, I would declare the market’s “bet” that this is a slowdown, not a recession. But continued weakness could be a “tell,” given that historically the worst performance for the stock market has come in the six months leading into recessions.
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