Leading Indicators Allay Fears Of A Looming Recession

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by: Dulan Lokuwithana
Summary

Leading Economic Indicators have gained importance in forecasting the onset of the next stage of the business cycle as the Fed has adopted a more data-centric approach recently to determine.

Ranging from consumer expectations and new housing construction to manufacturing hours and vendor performance, leading economic indicators could establish a likelihood of a late expansionary phase.

However, the stock market indices, interest rate spread, unemployment, and manufacturing activity had sent a mixed signal on the strength of the economy.

Energy price surges amid supply-side constraints and more Fed rate hikes despite slower real M2money supply could hasten a slowdown in the economy most likely in late 2019.

Investment Thesis

Consisting early and late expansions, peaks, recessions and troughs, business cycles which typically last 1 – 12 years are a recurrent feature in an enterprise-based economy.

With almost a decade passed since the end of the last recession in June 2009, the current business cycle has recorded the second longest expansion in history according to the National Bureau of Economic Research (NBER).

US GDP Growth Rate and Recessions

Sources: The author; Data from Bureau of Economic Analysis (BEA) and National Bureau of Economic Research (NBER)

Amid US-China trade tensions and Fed rate hikes, with economic growth easing to 3.4% in 2018’Q3 from 4.2% recorded in 2018’Q2, further brakes on the economy in late 2018 from stock market volatility and partial government shutdown could push the economy to the brink of a recession.

In a time when the Federal Reserve has leaned towards data to drive its future policy direction, this article analyses some of the widely-used leading economic indicators in an attempt to forecast an imminent danger of a recession to the US economy.

Coincident Indicators conclude a boom

The coincident indicators only verify the existing stage of the business cycle. All three criteria as analyzed below clearly confirm the boom stage of the economy.

When the manufacturing output reached a 10-month high in December 2018, the Industrial Index had risen for 7 months in succession.

MoM Increase in Industrial Index

Sources: The author; Data from Federal Reserve Bank of St. Louis and the Federal Reserve of the United States

Meanwhile, the number of employees on non-farm payrolls also posted a 10-month high in December 2018.

Non Farm Payroll Employees Added

Sources: The author; Data from Federal Reserve Bank of St. Louis

The aggregate real personal income (less transfer payments) therefore has expanded by c.1.8% up to November 2018 (cf. c. 2.7% in 2017) with an overall growth of c.28.0% from the end of the last recession in June 2009 (cf. c.15.5% during the expansion prior to 2008/09 recession).

Real personal income excluding current transfer receipts

Source: The Federal Reserve Bank of St. Louis

With a resultant increase in wage expense, businesses are therefore scrambling to fill their vacancies indicating a boom-stage of an economy. (Read my previous article on Costco Wholesale Corporation where operating margins were impacted by a wage hike last year). Contained by Fed rate hikes, inflation has stayed relatively flat amid softening energy prices which have declined by c.30.0% in the final quarter of 2018.

No yield curve inversion but interest rate spread narrows

Yield curve inversions, where 10-year government securities have a lower yield than the 2-year securities, have preceded every recession since 1980, as shown in the graph below.

Yield Curve since 1979

Source: The Federal Reserve Bank of St. Louis

Even though there was no rate inversion since the end of 2008/09 recession, in December first week of 2018, the spread between 10-year and 2-year treasuries dipped to 0.13%, the lowest since the end of the last recession.

With banks borrowing short-term for long-term lending, the narrowing of the spread will squeeze their profit margins, discouraging their lending which could, in turn, slow down the economy as the money supply already trails the expansion of loan demand.

Loan growth exceeds real M2 money supply

In 2018, the rate of real M2 money supply dipped to c.5.0% from c.4.6% in 2017, indicating the monetary tightening by the Fed. Exceeding the M2 money supply, both commercial/ industrial and consumer loans held by banks have widened at c.8.2% during the year.

M2 Supply vs Loan Demand (All Loans)

Source: The Federal Reserve Bank of St. Louis

Consumer sentiment in January 2019 drops to a 27-month low

The US is a consumer-driven economy with nearly 69% of GDP contributed from household consumption which closely follows the consumer sentiment. The price of consumer credit which fluctuates with changes in short term interest rates determines the strength of the consumer sentiment. Impacting the short-term interest rates, the Fed, in nine occasions since 2015, increased the Fed funds rate by a quarter of a percent, with the latest in December 2018 bringing it up to 2.25% – 2.50%.

University of Michigan - Consumer Sentiment

Source: The Federal Reserve Bank of St. Louis

Against this backdrop, in January 2019, the Index of Consumer Expectations compiled by the University of Michigan slumped to 90.7, a 27-month low. Nearly four years ago, in Jan 2015 the index reached its highest since the end of the last recession, the onset of which was warned four years prior by a peak in the same index.

Consumer Sentiment

Source: The author; Data from the University of Michigan: Survey of Consumers

Steady demand for new housing despite rising mortgage rates

As shown in the graph below, every recession has been preceded by a slowdown of the number of new private housing units authorized by building permits. Therefore, given the sensitivity of the housing sector to the overall economic environment, the changes in the number of building permits granted for new private housing units foretells the end of the expansion.

New Private Housing Units Authorized by Building Permits

Source: The Federal Reserve Bank of St. Louis

With median sales prices of new houses declining by c.6.0% up to October 2018 (cf. c.1.4% gain in 2017), the number of average monthly new private housing units authorized for 2018 January – October period, has remained at c.1.3 mn units, unchanged from 2017.

Helped by an 88bps increase in 30-year fixed rate mortgages in 2018 (cf. 21bps decline in 2017), the stagnation in demand is comparable to the burst of the housing bubble which triggered 2008/09 financial crisis.

The onset of the previous recession in December 2007 followed a c.49.2% contraction of permits granted for new housing units from September 2005 despite a slump of c.6.8% in median sales prices for the period.

New Private Housing Units Authorized

Source: The Federal Reserve Bank of St. Louis

With dull consumer demand, delivery time improves

An increase in delivery time portends the expansionary stage of a business cycle as vendors face supply chain bottlenecks amid rising consumer demand. Signaling lackluster consumer demand, the current delivery time measured by a diffusion index for New York area compiled by the Federal Reserve Bank of New York indicates a drop of - 2.1, from an acceleration of +16.2 in March 2018.

Current Delivery Time; Diffusion Index for New York

Source: The Federal Reserve Bank of St. Louis

Indices decline but not as sharp as in last recession

Beset with issues ranging from US-China trade tensions, the partial government shutdown and more importantly the Fed rate hikes, the stock market indices, an important foreteller of economic outlook capturing investor sentiment, have seen volatility in late 2018.

The markets witnessed the sharpest quarterly decline in seven years in late last year, where Dow Jones Industrial Average (DJIA) and S&P 500 Index slumped c.18.8% and c.19.8% by the Christmas Eve, from their peaks reached in October and September 2018 respectively.

DJIA and SP500

Source: The author; Data from the S&PDow Jones Indices

However, market selloffs preceding recessions have been historically sharper and more persisting with DJIA and S&P 500, in the previous recession, bottoming out by c.53.8% and c.56.8% respectively as of March 2009 from their peaks in October 2007.

Manufacturing activity and employment level send a mixed signal

As the economy slows and consumer demand tapers off, businesses will first reduce overtime before making the excess staff redundant which in turn leads to an uptick in initial claims for unemployment insurance. Therefore, average weekly hours of manufacturing and initial claims of unemployment insurance act as harbingers of a possible slowdown in the economy.

In April 2018, average weekly hours of manufacturing hit 42.3 hours per week, the highest level since 1940s, but declined to 42.0 hours in December 2018.

The 4-week moving average of initial claims for unemployment benefits meanwhile is in a downward trend with 215,000 Americans being laid off as of January third week of 2019, the lowest since December 1969.

Average Weekly Hours of Production vs Unemployment Insurance

Source: The Federal Reserve Bank of St. Louis

Another area highlighting business expectations, the manufacturers’ new orders for non-defense capital goods excluding aircraft, dropped to USD59.3 bn in May 2016, a c.15.2% decline since its previous peak in March 2012.

With the value of orders bouncing back c.17.5% since then up to October 2018, the slump seems to be a false alarm as recessions bring sharper declines in the indicator as in April 2008 when it dropped c.32% within a year.

Conclusion

With leading indicators gauging consumer expectations, new housing construction, vendor performance, and manufacturing activity pointing to a late stage of expansion, milder stock market downturn along with the absence of a yield curve inversion and a significant increase in unemployment counter the likelihood of an imminent recession.

However, impending Fed rate hikes could further narrow interest rate spreads bringing in a near-term yield curve inversion, while restrictions on M2 money supply and a possible rise in energy prices in early 2019 could advance the onset of an economic downturn most likely in late 2019.

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.