Turning Points For The Week Of September 17-21: It's Time To Starting Thinking About A Recession

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by: Hale Stewart

Summary

With the exception of the SPYs, global equity markets are weak.

The yield curve continues to narrow and the Fed is dead-set on tightening; commercial paper yields relative to Fed funds rates remain elevated.

Building permits have been weak all year.

The purpose of the Turning Points Newsletter is to look and monitor the long-leading, leading, and coincidental indicators to see if the economy's trajectory has changed from expansion to contraction -- to see if the economy is at a "turning point."

I normally publish this newsletter over the weekend. However, yesterday's housing permits report was cautionary (I'll explain more in a minute). When combined with several other indicators -- the bearish orientation of global equity markets, the flattening yield curve, and the slightly elevated spread of commercial paper relative to corresponding treasury yields, I now have enough data to say that the economy is moving towards a recession. If I was going to use a traffic light analogy, I'd say we were between green and yellow.

How did I arrive at this conclusion? I think of economic indicators like a slow-moving mobile; they're all slowly rotating and moving with, around and against each other. Eventually, they line up in a bullish or bearish orientation. They've been bullish for a long time -- over eight years. But we've been seeing some changes emerge of the last year or so. And with yesterdays' permits report -- which showed a continuing decline in housing permit activity -- it's time to become more cautious about the economic future.

Let's start with global equity markets, which are a leading indicator:

Traders buy and sell in anticipation of economic events. During the height of a recession when markets are at their absolute lowest, investors start to nibble at stocks, usually arguing equities are a tremendous value (which is a correct assessment). They hold shares as the market rallies. They start to sell in advance of the economy contracting for a number of reasons: simple profit-taking, high valuations, or in anticipation of a recession. The reason doesn't matter; the point is that equity shares decline before the formal start of a recession.

Above are ETFs that track the major global equity markets. With the exception of the SPYs (far, lower right), all the averages are in a very clear downtrend or are at/near 52-week lows. What's the most likely possibility -- that eleven other markets rally to catch-up to the SPYs or that the SPYs are the last to correct? I would argue the latter is the path of economic least resistance.

Currently, the Federal Reserve is tightening. They will continue to do so. Right now, the Fed is working at returning interest rates to "neutral" -- a theoretical level where the rate of interest will neither restrict nor promote economic activity. This is an unobservable interest rate. But there are several theoretical models, one of which (The Lubik-Matthes Natural Rate of Interest ) is on the Richmond Federal Reserve's website:

The median rate was at the "zero-lower bound" for about eight years (roughly 2009-2016). It started to move higher at the beginning of 2016. It is still moving higher. The lower and upper bounds have moved in conjunction with the median level. Pay particular attention to the upper bound, which is now approaching 4% -- about 200 basis points above the current fed fund level (which is 1.75%-2%). The most important feature is that the overall trend is neutral rates are moving higher. This explains why the Fed has every intention of continuing to increase interest rates:

This is the "dot plot" from the Fed's economic projection materials. It shows where various Fed governors think the Fed Funds rate will be at the end of a calendar year. Rates will be about 25-50 basis points higher by years end. They will be at least 3% at the end of next year. The dots don't imply when Fed Funds will hit a certain rate; so, it could be sooner than year-end.

At the same time, the 10-year treasury bond has been trading at the 3% level for the last six months:

Yes, rates could go higher. But I doubt it. Why? Inflation expectations -- which comprise a large percentage of long-term interest rates -- are very much contained:

The Fed has gone out of its way to make sure the market knows the central bank will do everything it can to prevent inflation. Most importantly -- the market believes the Fed and is acting accordingly.

So, short-term interest rates are clearly moving higher while the long-end of the curve should stay at/near current levels. That means we will probably have a yield curve inversion sometime in the next 12-18 months.

Commercial paper spreads remain elevated. Larger companies routinely issue short-term paper to cover short-term funding needs. For example, a company that relies on longer-term accounts receivable might be cash poor as they wait for customers to pay. During that time, they'll sell commercial paper (bonds with a maturity of less than 1-year) to cover their funding needs. Commercial paper is very low-yielding -- especially in the current environment. But commercial paper funding costs relative to Fed funds rates have been elevated for some time:

The chart shows the commercial paper/fed funds spread for the last 10 years Notice that current funding levels relative to the historical 10-year average are high (remember that in this market, five basis points is a lot). Let's look at a shorter chart:

Yields spiked in 2015 when OPEC opened up the oil production spigot and flooded the market with cheap oil. This placed tremendous stress on the energy sector, which led to high rates. They came down through mid-2017. As it became apparent that Congress would pass tax cuts, the short-term funding yields increased, anticipating that US companies would issue commercial paper as part of a multi-prong plan to repatriate funds. Rates did just that after the first of the year. But nine months later, yields are still elevated for no good reason.

Building Permits are in a clear downtrend now. Yesterday's building permits number was the final report that led me to conclude we should be thinking about a recession. First, here's the national number:

Permits peaked in January. They have been in a clear downward trend for the entire year. The latest reading of 820 is below the highs from 2017.

The Census breaks the country down into four regions. The Northeast is a non-issue; it's been fluctuating around 55,000 for the last five years. The South is the most important region, accounting for 54% of total permits:

Yeterday's report had a 448,000 pace, which is below the highs from 2017.

The Midwest (above) has been in a downward trend since the 4Q 2017. The current pace is also below the 120,000 level, which we saw in the Midwest in 2017.

The West region (about 25% of total permits), however, remains a bright spot. While it's been moving lower all year, we can still argue this is a natural pull-back from the ramp-up in 2017.

We have two regions moving lower. Combined, they total about 65% of total permits, which means a majority of the countries housing markets are slowing.

So -- what exactly does all this mean? As of now, four leading indicators -- global equity prices, the yield curve, commercial paper yields, and building permits -- are moving towards a recessionary signal. It's not so much the weight of one indicator but the totality of four of these data points showing a combined modest weakness. And there was nothing special about yesterday's building permits levels; it's simply that the indicator has been trending lower for the entire year that led me to conclude we should be thinking about a recession.

This does not mean that a recession is imminent. These indicators could always reverse, after all. It's simply that the probability of a recession in the next 18-24 months is now higher. I don't have a model that assigns specific percentages to the possibility. If I was going to use a number, I'd say that right now, we're looking at a 25-30% probability in the next 18-24 months.

HS

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.