As the controversy about a possible U.S. recession taking place has been gaining strength in the last months, it would be vital for investors to spot emerging danger signs of a coming recession.
John Hussmann pointed out in his weekly newsletter on July 31th:
Investors are tenuously sticking to the first story line – moderating growth with no risk of recession, moderating inflation, beliefs that stocks are reasonably valued, and hopes for an end to the tightening cycle. Yet the data are actually consistent with a second story line – emerging (though not imminent) recession risks, persistent “structural” inflation, rich valuations, probable contraction of profit margins, and an incoherent Fed policy that is likely to become even more incoherent in attempting to battle weaker economic growth and persistent inflation simultaneously (not that I believe Fed actions will be effective in any event).
Even Ed Yardeni wrote about a possible U.S. recession in his Morning Briefing on Monday July 31th:
We think if a recession is in the cards, then it is more likely to happen over the next 6 months than 6-18 months from now. If the economy continues to grow over the rest of the year, then it should continue to do so all of next year. In other words, it's Showtime for the economy. If it has the resilience we believe it does, then the housing recession, flattening home prices, gasoline prices over $3, heightened geopolitical risks, and one more (and last?) hike in the federal funds rate shouldn't cause a significant slowdown or a recession.
John Hussmann already pointed out on May 15th:
That sudden dollar weakness would probably be among the first signs of oncoming economic weakness, especially if accompanied (at the same time or shortly thereafter) by widening credit spreads.
However, if the Fed has reached the end of the road on rate hikes at 5.25%, and other central banks are still raising their interest rates, then the US dollar could fall sharply lower. Given the onging dispute between the US Congress and Beijing about the revaluation of the Chinese yuan, the dollar could fall against the yuan. That would translate into much higher prices for US consumers and higher inflation. A weaker dollar could also exert upward pressure on gold, base metals, crude oil, and other commodities, and elevate inflationary pressure with higher import prices.
William Gross also believes that sometime within the next few years, a U.S. recession is likely, due to currency, commodity, and housing related influences. In PIMCO´s October 2005 Investment Outlook, he wrote:
If real housing prices decline in the U.S. in 2006 or 2007, a recession is nearly inevitable.
A continued fall in the homebuilder stocks could indicate the start of a bursting U.S. housing bubble and that the U.S. consumers would be strapped by falling home prices.
Regarding the corporate credit spreads, Mark Kiesel showed in PIMCO´s September 2005 U.S. Credit Perspectives that corporate credit spreads are mainly influenced by the following five factors:
1. Balance sheet leverage (Debt/EBITDA)
2. Interest coverage (EBITDA/Interest)
3. Stock returns
4. Risk appetite or banks’ willingness to lend
5. Volatility or the VIX index
However, the first four factors can only describe historical credit spreads, as there are only back-dated time series available. By contrast, as the figure below shows, the VIX can give some indications about future credit spreads.
To summarize, there seem to be four main leading market-based indicators that are helpful in predicting a possible recession:
1. A falling U.S. dollar (measured by the US Dollar Index)
2. A continued fall of homebuilder stocks (measured by the SPDR Homebuilders (NYSEARCA:XHB)
3. Widening corporate credit spreads (measured by the difference between Moody's BAA and AAA yields and 10-year Treasury yields)
4. high equity volatily levels (measured by the VIX)