New York (April 20, 2017)
Economic data since roughly the middle of March is starting to show weakening in the economy and the potential for recession later this year. These five indicators point toward a stronger possibility of recession, in reverse order of importance:
5. Geopolitical Risk The world, and particularly the USA, has not seen this level of geopolitical risk since the first Reagan term in the Cold War before glasnost.
Not only are we facing geopolitical risk in Asia, and possibly our own Western shores and Hawaii with the North Koreans, but Russian nuclear-capable Backfire bombers have twice this week approached the US Air Defense Identification Zone (ADIZ) in Alaska. The Russians have challenged our hegemony in the Eastern Mediterranean after our strike on Syria and sortied a cruiser from the Black Sea, and a flotilla of two corvettes and other support ships from its Baltic fleet, most likely to deter any future US missile attacks on Syria. Just in the last week or two, NATO deployed the troops that had been long-promised to prop up the Baltics, Poland and Romania.
We also face geopolitical risks from the EU, where elections in France might cause "Frexit", which would likely trigger the beginning of the end of the EU.
Finally, in terms of pure political risk, there is increasing risk to "The Trump Trade", as Treasury Secretary Mnuchin has recently said tax reform won't happen until the fall. This makes a retroactive tax reduction back to January 1, 2017, an issue, as major changes in systems, reporting, and other matters would require a major overhaul with less than three months to go to the filing season. While Mnuchin walked back the statement today, after two days of sell-offs, he did not define "soon", and the Congressional calendar allows only 12 weeks of scheduled business from today.
4. Debt service as a percentage of disposable income is at the highest rate since the end of the Great Recession. Absent rising real wages (which we saw lacking in the last two quarters), Americans are going to be reining in their spending on merchandise and consumer experiences.
3. Employment Data
As we discussed in our monthly jobs report, the March jobs print of just 98,000 jobs deeply disappointed. Moreover, the print of average wages showed that a fair number of sector occupations are paying real wages (discounted for inflation) that are just slightly above where they were a year ago.
2. Core Inflation (All Items Less Food & Fuel) has been dropping since January and fell to its lowest level since November, 2015. Core inflation is reportedly the Fed's preferred measure of inflation. We won't see a clear pattern until the April inflation figures are released in May, but the decline over 2017Q1 is indicative of both the higher short-term rates from Fed monetary policy as well as a general slowing of the economy.
1. A more than 50 basis point reduction in the yield curve since Janary
The spread between the 10 year and the 3 month Treasury yield curve has declined 50bps since the beginning of the year.
The tightening of the yield curve certainly does not ensure the likelihood of recession; it has happened countless times without negative impact on the economy. Indeed, New York Fed economists Estrela and Mishkin found that so long as the spread between the 10-year and the 3 month yields were greater than 1.2%, the likelihood of recession was less than 5%.
Nevertheless, the precipitous narrowing of the yield curve since the end of March, displayed below with in the thick yellow line (i.e., the 10 year less the 3 month) should concern investors.
For the first quarter, the average daily difference between the three-month and the 10 year was 1.84%. But since April 1st, the average daily difference between the two has been only 1.49% (turning up slightly with the sell-off earlier this week), a decline of nearly 35 bps. Since the beginning of the year, when the difference between the two stood at 1.92%, to Wednesday, April 19th, when the difference stood at just 1.40%, the spread has narrowed more than 50 bps.
Summary: Several factors point to a softening in the economy, but do not guarantee it. But there is certainly higher risk. Other factors, like margin debt, put equities particularly at higher risk. If the yield curve continues to narrow through the end of April, and particularly if it trends narrower, investors would be well advised to hedge their positions and keep them hedged until circumstances changed markedly.
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