Preliminary Long Leading Forecast For 2019: Recession Watch Beginning Q4
- Long leading indicators tend to turn one year or more before the economy as a whole.
- This article updates the forecast from these indicators for the second half of 2019.
- A plurality of the indicators turned negative as of Q4 2018, warranting a “Recession Watch” beginning Q4 2019.
Introduction: What Are The Long Leading Indicators?
I have several systems for forecasting the economy. One is the high-frequency "weekly indicators," which as the name implies is updated weekly, and thus very timely. A second relies on monthly and quarterly data which has been extensively vetted in the past as having a sustained record of turning one year more before the economy as a whole.
For the short term, up to about six months out, the Index of Leading Indicators is a perfectly adequate tool with the inconvenient habit of being right more often than most highly paid Wall Street forecasters. To forecast 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 adjusted by unit labor costs
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 wrote 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.
Previous forecast, and impact of government shutdown
I last did a comprehensive update of these last July. At that time, my conclusion was: “In summary, left to its own devices, while I suspect we will see a slowdown by early next year, I do not see any recession through midyear 2019.”
That forecast so far is aging well.
Unfortunately, due to the government shutdown, several of the necessary indicators have not been published yet. As a result, I am making use of ad hoc proxies in order to make a preliminary forecast that I will amend if necessary once the actual data is in.
Current Trends In The Long Leading Indicators
CORPORATE BOND YIELDS:
With the sole exception of the 1981 "double-dip," corporate bond yields have always made their most recent low over one 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 (red):
While BAA corporate bonds did equal their 2016 low at the beginning of 2018, that was emphatically not confirmed by AAA bonds, and not by mortgage rates either. In any event, another year has now passed, making the issue moot.
Interest rates continued to increase through most of 2018, and thus should continue to dampen the economy, although they aren't yet 1.75% above their lows, which has seemed in the past to be the minimum threshold at which the economy has typically rolled over going back many cycles. Thus they continue to be negatives.
New single-family home sales, and housing permits and starts made new post-recession highs at the end of 2017 and the first three months of 2018, after which they all declined as of the most recent reports:
The less volatile but equally leading single-family permits also turned down after a February 2018 peak:
Further, as of the 3rd quarter of 2018, measured both nominally and in real terms, housing as a share of GDP also declined:
All of these data series were impacted by the government shutdown. As a temporary albeit noisier placeholder, we can turn to purchase mortgage applications. These continued to decline in November and December, although they rebounded in January.
For preliminary purposes, the likelihood is that this decline will ultimately prove out in the more reliable data, meaning another negative for later in 2019. Note that even if the decline in interest rates presages a bottom in this housing market later this year, that will only affect the forecast at some point in 2020
Neither corporate profits nor unit labor costs have been reported for Q4 yet. The former are part of the delayed GDP report due to the government shutdown. In Q3, however, they did continue to increase:
For Q4, as a temporary placeholder, we can make use of S&P 500 earnings to date as reported weekly by Barron’s. As of this week, they are currently at 130.39, roughly 10 points higher than at the conclusion of the Q3 earnings season.
Thus, these are a positive for this preliminary forecast.
REAL MONEY SUPPLY:
No recession has ever started without at least real M1 turning negative or real M2 declining to under +2.5%. Real M2 crossed this threshold at the beginning of 2018, and during the autumn briefly real M1 came close before turning up just before the end of the year:
This is mixed but with a negative bias for late 2019.
THE YIELD CURVE:
This has been an excellent long-range forecasting tool in times of inflation (although, I do not think a positive yield curve is definitive in low interest rate deflationary environments). In the last 60 years, typically a recession has begun after the Fed raises rates to combat inflation, sufficiently so that the yield curve inverts.
This tightened through 2018, and the intermediate portions started to invert on December 4, and have generally remained inverted since, as shown in red below, although neither of the widely watched 3 month- and two year- to 10 year time frames have inverted:
The closest analogous patterns (e.g., 1994) since 1960 are most consistent with a slowdown but not an outright.recession. This indicator is therefore mixed or neutral.
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 is promising. As I reported yesterday, all facets of this survey turned negative in Q4. In contrast, so far the weekly Adjusted Financial Conditions Index from the Chicago Fed, shown in red in the graph below, has not:
Since I view the quarterly Survey as the better measure, although the weekly Index is more timely, while noting the discrepancy I am now treating credit conditions as a negative.
REAL RETAIL SALES PER CAPITA:
These peaked more than a year before the onset of the last two recessions.
These have also been affected by the government shutdown, but boomed through November of 2018:
As a temporary proxy for December only, we can make use of the weekly same store sales reports. Nominal sales as measured by Redbook were up +7.7% YoY in December, while the average of the Retail Economist reports for the month were up +3.3% YoY. Even after inflation, these would give us very positive numbers.
Summary and Conclusion
We have 3 negatives: interest rates, housing, and credit conditions.
We have 2 positives: corporate profits and real retail sales per capita.
We have 2 mixed indicators: money supply and the yield curve.
There has been enough further deterioration in the long leading indicators - metrics I have followed and updated over and over again for years - during the second half of 2018 that a plurality are negative. It had already appeared that the more likely outcome would be that in the second half of 2019, left to its own devices, the economy would just barely escape recession, although poor government policy choices this year could easily tip the balance. The further deterioration described above warrants going on Recession Watch one year out — i.e., beginning Q4 2019.
I will explain how you should treat this “Recession Watch” in a separate article. It isn’t a “Recession Warning,” where a downturn looks certain, but more on the order of the warning given to Scrooge by the Ghost of Christmas Future: what is likely to happen if there is no intervening change for the good.
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