SMU Recession Monitor: Few Signs of Economic Distress

We are now in month No. 118 (June) of the current expansion, double the post-WWII norm, and two months from becoming the longest ever. The reason for steel people in particular to know where we are in the business cycle is that steel demand is related to GDP but is vastly more volatile. Figure 1 compares the change in GDP and in apparent steel consumption over a period of 26 years. Steel consumption routinely varies by plus or minus 10 percent or more and this will happen again.

Recessions are defined by the National Bureau of Economic Research (NBER), the organization tasked with identifying when a recession starts and ends. A rule of thumb is that a recession is defined as back-to-back quarters of negative economic growth. The problem with this definition is that it is about six weeks after the second quarter of negative growth before we know we are (or were) in a recession. For example, we could find out in late 2019 that a recession began in the spring. This is not likely, but we are now 118 months into the current expansion, which is the second longest on record. The official definition of a recession from the NBER is: “A recession is 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.”

In this report we have identified eight indicators that have some predictive ability. Viewed individually, these don’t offer much insight into the future, but viewed collectively they give subscribers a better idea of present and future business activity. While one indicator may fail, the probability of a majority of these sectors providing a false signal is significantly diminished. Our recommendation is that readers examine Figures 4-12 and look for signs of a turnover in recent results. If the majority is heading south, we should be concerned. Since World War II, most recessions have been preceded by an overheated economy as indicated by low unemployment, tighter monetary policy and rising long-term interest rates.

Figure 2 is what we describe as a heat map that summarizes the present state of the eight indicators tracked in this analysis. Color codes show the degree of distress of each item. Red, of which there are none today, would indicate a cause for concern. All except the yield spread are reported as changes to the three-month moving average. (3MMA). The yield spread is shown as the actual value of the 10-year minus 2-year Treasury interest rates.

Figure 3 provides a history of U.S. recessions since 1970. Recessions occurred in 1974, 1980, 1981, 1990, 2001 and 2008. In its second estimate of the growth of U.S. GDP for Q1 2019, the BEA reported the growth of GDP to be 3.1 percent. This is a quarter-on-quarter result. On a trailing 12-month basis, GDP grew 3.21 percent in the first quarter. Congressional Budget Office economists expect economic growth to decline in upcoming quarters but not to become negative through 2020.

Figure 4 shows the three-month moving average of the S&P 500 at the middle of each month from January 1990 through June 2019. The stock market did predict the recession of 2001, but failed in 2008. Since then there have been several blips that proved of no significance. The tendency is that stock prices decline as investors anticipate a weakening economy and flagging corporate earnings. Fed tightening has also been a factor in the recent past.

Figure 5 records new weekly claims for unemployment compensation. This indicator failed to predict the 1981 and 2008 recessions. It had a lead of over a year on the other four. Initial claims for unemployment insurance, reported weekly, are a sensitive measure of layoffs. Initial claims are at a 50-year low and are not hinting at an imminent problem.

Consumer Confidence

When consumers, businesses and investors lose confidence it sets up a downward self-reinforcing spiral of reduced spending and investment, causing even higher unemployment and further depressing confidence. Consumer confidence is reported as sentiment indexes of the present situation and expectations and a composite of the two. It appears that the consumer’s view of the present situation is the best predictor of future recessions and this is shown in Figure 6. There has been a slight downward trend in 2019, but as yet not enough to cause concern.

Chicago Fed National Activity Index

This index is a weighted average of 85 indicators of national economic activity drawn from four broad categories of data: 1) production and income; 2) employment, unemployment, and hours; 3) personal consumption and housing; and 4) sales, orders, and inventories. A zero value for the index indicates that the national economy is expanding at its historical trend rate of growth; negative values indicate below-average growth; and positive values indicate above-average growth. When the CFNAI-MA3, (three-month moving average) value moves below –0.70 following a period of economic expansion, there is an increasing likelihood that a recession has begun. Conversely, when the CFNAI-MA3 value moves above –0.70 following a period of economic contraction, there is an increasing likelihood that a recession has ended. Since our data stream began in January 1970, the CFNAI has predicted every recession, but in-between there have been stumbles and false alarms (Figure 7). At the present time the CFNAI is in negative territory, but not excessively so.

Employment in Trucking

Figure 8 shows total truck driver employment as reported monthly by the BEA. As a measure of economic activity this indicator has predicted the last three recessions and at present has flattened, but is showing no sign of a contraction.

A decline in housing permits has led every recession since 1970. This seems to be a very prescient indicator. In 2019, there has been a flattening in the growth curve but no sign of a sustained decline (Figure 9).

Historically, the most accurate recession predictor has been the bond market, because this massive capital market determines government and business borrowing rates. This is why the famous yield curve has been able to predict every recession since the mid 1960s with a six- to 24-month lead time (and just one false positive). Or to put it another way, if the 10 – 2 yield curve inverts, there’s a 90 percent historical probability that a recession is coming in the next two years.

The Treasury spread is developed by subtracting a shorter-term from a longer-term Treasury yield. Ten-year interest rates minus two-year interest rates, for example, as shown in Figure 10. A spread that is increasing is a sign of higher growth and inflation as bank lending becomes more profitable (borrow short and lend long) and loan growth is expected to accelerate. A declining or contracting yield spread foreshadows lower growth and inflation due to contractions in bank loan growth due to reduced profitability. The current forecast predicts lower growth and inflation will materialize in 2019. That thesis has been unfolding as the yield curve continued to contract last year. We have blown up Figure 10 to show the last 18 months in detail in Figure 11. At present we are dodging this bullet as the spread has strengthened from 0.11 percent on Dec. 11 to 0.25 on June 14.

Figure 12 is the chart we like the best, though we have no history before 2008. This is The Conference Board leading and lagging economic index. We have subtracted one from the other in the rationale that if the lead is better than the lag, the situation is improving, or vice versa. The lead minus lag inverted three years in advance of the 2008 recession; certainly by 18 months before the big event it was clear something was happening. The spread began to narrow in October last year, but in 2019 has stabilized at over 4.0 percent.

SMU Comment: Of the eight indicators summarized in Figure 2, five are green and three are showing slight distress. Taken as a whole, our eight indicators don’t signal a recession in at least the next six months. The U.S. economy is generally healthy, but the yield spread and the CFNAI should be on our radar screen.