SMU Recession Monitor: "Economic Expansion Has Legs"

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. This means that corporate managers whose business is related to steel must be ready with preemptive financial measures when the thunder clouds form. This Steel Market Update analysis attempts to provide guidance on the future of economic growth.

On Aug. 2, Lawrence Fuller, a portfolio strategist, summarized: “Personal income rose 0.4 percent in June, led by the wages and salaries component, and is now up 4.9 percent in the past year. Personal spending rose 0.3 percent in June and has risen 3.9 percent over the past year. The savings rate jumped to 8.1 percent. There were also significant upward revisions to personal income dating back to January 2017. Annual income growth since that time was revised up from 4.3 percent to 5.3 percent. Real consumer spending, which is adjusted for inflation, rose 0.2 percent in June and is up 2.5 percent over the past year. These are strong numbers that suggest the economic expansion has legs well into 2020.”

In this report, we have identified eight indicators that have some predictive ability about the short-term likelihood of a recession (definition below.) 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 are 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 first estimate of U.S. GDP for Q2 2019, the BEA reported growth of 2.1 percent. This is a quarter-on-quarter result. On a trailing 12-month basis GDP grew 2.8 percent in the second 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 Aug. 5, 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, of expectations, and a composite of the two. It appears the consumer’s view of the present situation is the best predictor of future recessions, and this is shown in Figure 6. The present conditions sub-index has been wobbly in 2019 with no sign of a sustained decrease.

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). Currently, 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 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 decline, but through June this was not excessive (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 put 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 decline in the spread has stalled and stood at 0.16 on August 5.

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 has narrowed in 2019 as the leading component has stalled but is still 3.8 points, which is historically high.

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. 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.”