This is the second part of my 2017 forecast. To forecast Q1, I employ the K.i.s.s. method of following the Index of Leading Indicators plus several other short-term data points. For the period over 6 months out, I turn to long leading indicators.
A "long leading indicator" is an economic metric that reliably turns a year or more before the onset of a recession.
Geoffrey Moore, who for decades published the Index of Leading Indicators and in 1993 wrote Leading Economic Indicators: New Approaches and Forecasting Records, identified 4:
- housing permits
- corporate bond yields
- real money supply
- corporate profits
A variation of the above is Paul Kasriel's "foolproof recession indicator," which combines real money supply with the yield curve, i.e., the difference in the interest rate between short and long-term treasury bonds. This turns negative a year or more before the next recession about half of the time.
Another long leading indicator has been described by UCLA Prof. Edward E. Leamer who has written that "Housing IS the Business Cycle." In that article, he identified real residential investments as a share of GDP, as an indicator that typically turns at least 5 quarters before the onset of a recession.
Several other series appear to have merit as long leading indicators as well. Real retail sales in several forms also have value as a long leading indicator. Doug Short has identified real retail sales per capita as another important metric.
It also appears that the Fed' Labor Market Conditions Index also turns negative serves as a long leading indicator, typically turning negative at least one year before the onset of a recession.
Finally, the tightening of credit conditions also appears to have merit as a long leading indicator. Two measures, the Senior Loan Officer Survey, and the TED spread, are worth noting.
That gives us a total of 8 long leading indicators. All of these economic series have a long-term history of turning a year or more before a recession.
Corporate Bond Yields:
With the sole exception of the 1981 "double-dip," corporate bond yields have always made their most recent low over 1 year before the onset of the next recession. Following Brexit, in the beginning of July, BAA corporate bonds yields made a new all-time low, and AAA bonds tied their all-time low. Treasuries yields also made new lows, but interestingly, mortgage rates did not. While that was a big positive, in November and December interest rates made two-year highs, as shown by the Bloomberg corporate bond index:
Treasuries also made new lows at the beginning of July, while significantly, mortgage rates didn't, before these too made 2-year highs in November and December:
The post-Brexit stimulus effect of low rates will fade as the second half of 2017 progresses and the post-US election highs will move to the forefront by the end of the year, a negative.
This is a complicated and changing picture. For example, new single-family home sales made a new post-recession high in December, but the more leading but more volatile new home sales last peaked in July:
Although I haven't shown it, the slightly less leading and more volatile housing starts made a new high in November, while housing permits overall have not made a new peak since the NYC affected spike 18 months ago.
And mortgage applications have not made a new high since June, and for several weeks recently negative YoY (h/t Calculated Risk).
Further, housing as a share of GDP declined for two quarters, before turning up but not to a new high in Q4 as just reported last week:
So the ultimate input is mixed for Q4 of this year, although almost all signs point to positivity through Q3.
The picture is mixed here as well. Corporate profits last made a new high over a year ago, but it looks like it may have bottomed in Q4 of last year, while a reasonable, but not so accurate proxy, proprietors' income, did make another new high in Q4 as reported last week:
This cannot reliably be scored as either positive or negative.
Real Money Supply:
No recession has ever started without at least real M1 or real M2, minus 2.5%, turning negative. Both have remained relentlessly positive.
The Yield Curve:
This is an excellent long range forecasting tool in times of inflation. Typically, a recession begins after the Fed raises rates to combat inflation, sufficiently so that the yield curve inverts. Neither the 2-year nor 5-year vs. 10-year spreads are anywhere near inversions:
I do want to caution that the yield curve did not invert during the deflationary 1930s and low-flation 1940s, and several recessions happened anyway, so while I am including it, I suspect this is the long leading indicator most likely to signal falsely before the next recession.
In addition to money supply and interest rates, the loosening or tightening of credit appears to be an important component of changes in the economy over one year out. Although it does not have a lengthy track record, the Senior Loan Officer Survey looks promising, as does whether or not the TED spread is in excess of 0.5% (inverted in the graph below):
Both of these are negative, the former for a year, and the latter for the last 3 months. The senior loan officer survey for Q4 will be released within the next several weeks.
Real Retail Sales Per Capita:
These peaked more than a year before the onset of the last two recessions:
Through December these remain positive.
This is a recently compiled index of 19 indicators from the Fed. This too typically turns negative at least one year before the onset of a recession:
It had been negative for most of 2016, before most of the negative readings were revised away. It is not negative now.
So, to summarize:
- There are only two outright negatives: interest rates and credit conditions.
- There are four positives: real money supply, the yield curve, real retail sales per capita and the labor market conditions index.
- Two series - housing and corporate profits - are too mixed to be scored either positive or negative for the entire half, although housing is on balance a positive through Q3.
The bottom line is that I am not going to call for a recession with at most 3 or 4 of them negative. Q3 looks solidly positive, and more likely than not Q4 as well. I do believe we are well past mid-cycle, and even several positive long leading indicators appear to be decelerating. But they haven't tipped to negative yet, and neither will I.
Endnote: The above analysis is what I anticipate the economy will do if left to its own devices. There is a new Administration in Washington which may or may not make substantial changes to fiscal policy and may or may not institute new tariffs or similar trade rules, which obviously could have an impact, but that is a totally speculative matter for now.