As promised, once the GDP report came out, I can now give the second part of my 2018 forecast. To forecast Q1 and Q2, 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 and in particular real retail sales per capita. Additionally, the tightening of credit conditions also appears to have merit as a long leading indicator.
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. The below graph shows both AAA and BAA corporate bonds for the last five years, together with 30-year mortgage rates (green):
While BAA corporate bonds did equal their 2016 low at the beginning of this year, that was emphatically not confirmed by AAA bonds, and not by mortgage rates either.
In 2018, overall the effects of the 2017 mild increase in interest rates should act to dampen the economy, thus a small negative.
This has been a complicated and changing picture. After stagnating for most of 2017, both new single-family home sales and single-family permits just made new post-recession highs in December:
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:
Like interest rates, I expect the stagnation from 2017 to dampen the economy until later in this year when the Q4 strength should come through.
Corporate profits continued to rebound in 2017 from their 2015 low. Proprietors' income, a less reliable but more timely and worthwhile placeholder, also made a new high in Q4's GDP report last week:
These are a positive.
Real Money Supply:
No recession has ever started without at least real M1 or real M2, minus 2.5%, turning negative. While real M1 has remained relentlessly positive, real M2 decelerated through 2017 until finally turning into a negative at the beginning of 2018:
This is a positive for 2018, as the negative M2 just happened in the past month.
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. While the yield curve tightened significantly in 2017, it is not near an inversion:
This is thus a positive. But I 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. A good but much more timely - as in weekly - metric is the Adjusted Credit Conditions Index from the Chicago Fed:
Both of these are nominally negative, the weekly number at expansion lows. Since negative numbers mean loose credit, this is a positive.
Real Retail Sales Per Capita:
These peaked more than a year before the onset of the last two recessions:
These have boomed in the last several months. Needless to say, this is a significant positive.
To summarize the results:
- There is only one outright negative, and mixed one at that: Corporate bond yields and mortgage interest rates.
- There are five positives: real M1, the yield curve, credit conditions, corporate profits, and real retail sales per capita.
- Housing is mixed, neutral to mildly negative for most of the year, but a positive late in the year. Real M2 is also positive for this year, having just turned negative.
My sense is that later 2018 will be weaker than 2017, as the housing market stagnation of Q2 and Q3 2017 feeds through into the coincident indicators. On the other hand, the clear majority of long leading indicators remain positive. Left to its own devices, I do not see any recession for the economy at any point in 2018.