Seeing Economic Downturns Using A Rear View Mirror?

by: Bondsquawk, CFA

By Rom Badilla, CFA

The problem with economic forecasting lies in the fact that most of the data is backward-looking and provides past information on the state of the economy. In other words, trying to drive somewhere using just the rear-view mirror can be difficult, if not dangerous, and is one of the reasons why economists can be inaccurate at times. In addition, economic data, given the accumulation of massive amounts of data, is subjected to revisions which can often vary dramatically from the initial report to the subsequent final reported number.

Last week we covered that market watchers should not be fooled on the health of the economy with the recent positive Durable Goods Orders since the details were a cause for concern. A weaker Durable Goods Orders corresponds to slippage in future manufacturing activity and capital spending which in turn may put a dent in U.S. economic growth. This scenario of declining business investment may prove to be recessionary when other facets of economic growth such as consumer spending, trade, and government expenditures are lagging.

Having said this, Non Defense Capital Goods Orders-- which is a strong gauge of capital spending-- fell last month, as reported by the U.S. Department of Commerce. If the trend continues where business investment begins to decline from here, then consumer spending needs to pick up the slack (or government spending which is unlikely given the political climate) in order for the economy to maintain growth. So the question is if the decline is an aberration or the beginning of a new trend?

Therefore, all eyes will be peeled on the next round of employment figures since the weight of the economy appears to be falling on the weakened shoulders of the consumer. August Non-Farm Payrolls and the Unemployment Rate will be revealed on September 7, the first Friday of the month which will give the market a snapshot of the health of consumer spending which encompasses about 70 percent of the U.S. economy. The benefit to using the unemployment rate is its relative timeliness, since information is available early on in the following month. Also unlike its Non-Farm Payrolls counterpart, the unemployment rate is rarely revised.

Goldman Sachs economists, Jan Hatzius and Sven Jari Stehn warned that forecasters should always be on the lookout for early signs of a recession. They identified one key measure that may provide the market a hint on the direction of the economy and if a recession is lurking in the corner. In their latest U.S. Economics Analyst report, they highlighted the following:

One of our favorite yardsticks for identifying such downturns has long been based on the observation that over the postwar period, every 1/3-point rise in the 3-month average of the unemployment rate—perhaps the most basic of all US economic indicators—has historically indicated a recession. This rule of thumb is illustrated in Exhibit 1 below, which identifies recessions by a shaded area and the point at which the 3-month average of the (unrounded) unemployment rate had risen 35 basis points (bp) by a vertical line. The key point to note is that every vertical line occurs near the start of a recession, and that the rule has never set off a false recession alarm.

Click to enlarge

While timely, the fact remains that the rule of thumb on the Unemployment Rate is still subjected to some lag despite its accuracy of predicting a recession which usually is declared by NBER well after its onset.

Therefore, the research team from Goldman Sachs attempts to predict the published Unemployment Rate by using worker flow data. Despite the fact that the Unemployment Rate is a snapshot, the employment picture is quite dynamic over time with people entering the ranks of the unemployed while different people are leaving it as they find a job.

So by monitoring the inflows and outflows of workers, which is akin to water being poured into a bathtub while some of it going down the drain, one can hopefully predict what the Unemployment Rate will be in the months ahead. Worker flows can be tracked from various sources in the household survey of the monthly jobs report as well as data on those claiming unemployment insurance.

After providing a statistical framework, the research team provided the following on the state of worker flows and what that might entail for the Unemployment Rate in the months ahead:

At present, the flow-consistent rate is sending a slightly negative signal, pointing to a stable or slightly higher actual unemployment rate over the next few months. Thus, both the slight increase in the actual unemployment rate and the slight deterioration in worker flows over the past few months raise a yellow flag about the US economic outlook.

While the analysis fails to provide an optimistic spin on job growth and the economy, there is still some glimmer of hope in job growth. The research team mentioned that the accuracy of the methodology falters given the tests.

Using worker flows to forecast the unemployment rate for the 1/3-point rule therefore entails a trade-off between an earlier and noisier signal. Although some improvements in the trade-off might be attainable with more sophisticated methods, it seems that worker flows provide no free lunch relative to the 1/3-point rule and a trade-off between timing and accuracy remains.

Click to enlarge

So rather than driving with just using the rear-view mirror, this analysis allows the use of the front windshield, albeit a small portion of it is exposed and it's away from the driver side. So a forecaster, or driver in this case, might be able to figure out the general direction using just a pinhole, but precision is left to be desired.

Given this, the outcome of the analysis should not be ignored and taken lightly. Of course, this will play out as the data is released and market watchers will look for clarity on the health of the economy. For now, the economy should continue to be sluggish but with positive growth going forward according to the Goldman Sachs research team. If that is indeed the case, low yields on bonds should be here to stay.