3 Signs A Recession Is Coming Soon

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Summary

Interest rates will put pressure on a highly-levered economy.

Inflation is rising, and the Fed will become increasingly hawkish.

The unemployment trend may have bottomed.

In a surprising turn of events, Donald Trump's election has breathed new life into the markets. Since the November 8th election, the Dow Jones Industrial Average (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY) and Nasdaq (NASDAQ:QQQ) are flirting with all-time highs, financials (NYSEARCA:XLF) have rallied about 10% and the fear gauge (VIX: VXX) has eased back towards the lower end of its recent range.

Any reasonable observer would think all signs point to a robust economy for the foreseeable future. I agree that this might be true for the short term as spending ramps up significantly on new infrastructure projects in the United States. Donald Trump has indicated he plans to spend $1 trillion on infrastructure projects over a decade. Despite this, there is growing evidence of a US recession arriving in the next 12-18 months. Below, I have outlined three of the most significant signs.

1: Rising Cost of Debt Will Strangle the Economy

Regardless of who pays for Trump's infrastructure plans, in aggregate, there will be more competition for capital. In anticipation, the 10-year US Treasury yield has accelerated its march higher, which began during the summer. The correction in US Treasuries extends across the yield curve, with iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) down about 13% between August 1 and November 16th, with about half of that drop coming in the days after the election.

Jeff Gundlach of DoubleLine Capital has publicly suggested that bond yields could hit 6% in five years! There will be bond rallies along the way, but ultimately Gundlach believes Trump's 'growth agenda' will 'hurt bonds and help TIPS.' The trillion dollar question is whether the debt-laden economy can withstand any significant rise in the cost of borrowing. Any sudden movements could easily push borrowers to the sidelines, causing a recession for the credit-based US economy.

2: Rising Inflation Expectations Will Force the Fed to Slam the Economic Brakes

The rise in bond yields isn't simply in anticipation of government borrowing crowding out the private sector. The big underlying story that is only starting to hit the newswires is the reversal of inflation expectations. After hitting an all-time low this summer, inflation expectations - as measured by the 5-year, 5-year forward inflation expectation rate (chart below) - have sharply risen. I think this is partly due to higher expectations for nominal GDP growth and real interest rates. However, any reasonable investor would also be factoring in the near-doubling in West Texas Intermediate since the February lows in their inflation expectations calculations.

The inflation outlook is critical to forecasting future recessions. Most modern recessions were ultimately triggered by a rise in the Federal Funds rate in the effort to combat inflation. So if inflation is expected to rise, so too is the Federal Funds rate. As implied in the chart below, the Federal Funds rate tends to peak 6-18 months ahead of a recession.

While the US is in the first inning of a rising rate cycle, unlike previous cycles, today's may prove to be a three-inning game. The US is entering the rate hike cycle with much higher duration than in previous cycles, so small moves may have an amplified impact on both the financial and real economy. Consequently, the peak of the current rate hike cycle - and its subsequent damaging effect on the real economy - may not be that far away.

3: The End of the Employment Driver

The third element pointing to recession is the direction of the US unemployment rate. Let me start by saying this has been the jobless recovery to end all jobless recoveries. While employment has grown since the bottom of the last recession, I don't think anyone would describe the jobs recovery as robust. Regardless, the employment situation has moved in the right direction, thus stimulating the overall economy over the past few years. This contributing factor - however muted - may now be coming to a halt.

A measure Jeff Gundlach refers to in his presentations compares actual unemployment with its 12-month moving average. Although this measure is somewhat rudimentary - not considering the composition of the unemployment rate, for instance - it does provide a directional measure on the state of the US economy. It appears that the actual unemployment rate is about to rise above its 12-month moving average.

According to this measure, recession arrives within 12 months (in 49% of observations) of when the actual unemployment rate crosses above its 12-month moving average. This occurs because unemployment reaches the rate at which it starts to generate wage inflation (incidentally intensifying the pressure on the Federal Reserve to raise rates). This is currently occurring, as demonstrated by median weekly earnings rising significantly since its cyclical low in Q2 2014. It is becoming increasingly difficult to find qualified labor and so wage costs are rising, eating into profit margins. As it becomes increasingly difficult and costly to hire, the unemployment rate reaches its trough, eliminating a major contributing factor to economic expansion. If the situation deteriorates further and unemployment actually starts rising, one of the pistons of economic growth begins to move in the opposite direction.

In summary, a recession may be coming in the next 12 months or so for three reasons: 1) the rising cost of debt in response to growing competition for capital, 2) tightening monetary policy in response to rising inflationary expectations and 3) a reversal of fortunes in the labor market.

What does this ultimately mean for investors? The stock market is a mechanism for discounting the future, so if this forecast is correct I would expect the S&P 500 to account for a recession several months before it actually occurs.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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