The financial news has been awash these days with fears of trade talks and concerns of economic decline and geopolitical worries. The basic fear which is at the back of many minds is the question of when and if we will have a recession. It is my belief that in the coming months, we will see a recession which will drag down economic indicators and global equity markets. Specifically, I am making a call that we will be in a recession within one year. I believe this opportunity can be captured by shorting or avoiding the Dow Jones (DIA) as an index which is exposed to the major companies which comprise the economy.
The 10-Year and 3-Month Spread
The first variable which I believe indicates that we are entering into a recession is the widely-watched 10-year and 3-month interest rate spread. As you can see in the following chart, this spread has a history of forecasting recessions (shared areas) in recent decades.
The basic idea behind this spread and why it is so important is that it measures risk across different time frames. By comparing two different time frames, the underlying interest rates can be ignored and the relationship of risk perception and tolerance can be examined. When the 10-year yield is greater than the three-month yield, this means that a normal situation in which interest rates increase with duration exists. Since risk tends to increase with borrowing time, interest rates in general increase with bond duration. When the three-month yield is greater than the 10-year yield, things get weird.
When you examine an interest rate, you can basically think of it in one simple term: risk. When a short-term interest rate is above a long-term interest rate, this implies that immediate conditions suggest higher immediate risk versus the future risk. Historically speaking, when the 10-year interest rate falls below the three-month interest rate, we see recessions hit within one to two years.
The basic reason why you generally see recessions following this event is that the business slowdown associated with an increase in risk is not immediately felt but takes time to percolate through the economy since many corporate discount rates for new projects are based off of government benchmarks. When short-term interest rates go above longer-term interest rates, the practical implication is that short-term projects are riskier than long-term projects. How this plays out is that businesses require higher returns in the short term and are therefore less likely to pursue projects. This leads to overall and immediate slowing of business activity which snowballs into additional declines across the economy.
This key economic indicator is currently giving a loud and clear warning signal to the market and it has successfully called all the last five recessions. Investors generally don't do well in situations in which their reasoning boils down to "this time is different," and I believe that in the coming months, we will see this reliable indicator call the next recession once again.
Gains in Employment
The next economic indicator which tells me that a recession is coming is the employment rate. Specifically I am concerned about how good the employment rate currently is. The problem with a great and improving rate is that unemployment is a cyclic measure. This means that trends in unemployment reverse rather than advancing indefinitely. In other words, the longer you've been in a trend, the greater the likelihood of it reversing.
As you can see in the following chart, unemployment is simply astounding. We continue to see growth in jobs and a tightening labor market.
However, when you examine the data from another angle, you can see that the current trend in growth is off the radar.
We have had 107 months in which the one-year change in unemployment was either flat or better than the previous month. This means that the employment rubber band is incredibly tight. The current trend is around twice the previous highs in prior periods of improvement in employment. There really isn't much more room to the upside left in this move, and we are likely to see unemployment rise.
Another indicator that concerns me is the ISM manufacturing index. This index is a good quality index which calls economic activity very well in my experience. As you can see in the following chart, we have seen manufacturing decrease consistently over the last year. In fact, the recent readings of the index are even coming below expectations, which indicate that underlying conditions are worse than assumed.
What is particularly worrying about the ISM manufacturing index is that the current trade war discussions between Trump and China have the potential to strongly exacerbate this situation. It is entirely possible that the ongoing dialogue will result in a slowdown of activity as corporate decision makers and planners refrain from long-term manufacturing contracts given the uncertainty. As manufacturing activity slows, unemployment is likely to increase, and the overall economy is likely to worsen.
Technically speaking, I believe the breakdown may have already started. As you can see in the following chart, the market is currently in a strong sell-off, which seems to have been triggered by the latest trade discussions.
Reading the price action, we can say a few key things. First, there is real urgency to the selling pressure. As you can see in the most recent bars, there is strong bearish sentiment contained in the last few days of trading. In fact, about a week of trading wiped out a month of gains. The next thing of importance is the fact that the drop in price shows no immediate support. In other words, the market hasn't found its footing yet to indicate that further upside is in the works. When the market technically shows support, we will see a base form and tests against it resolve to the upside. We currently do not see this in place yet, which means that prices may continue to fall in the short and medium term.
When it comes to market action, it has been my observation that in general price leads fundamentals. In other words, we are likely to see the stock market begin selling off several months before the actual recession shows up in the economic data. This tangibly could mean that the current sell-off is actually indicating that we are in the first few weeks of the coming recession. If this is the case, then there is much more downside left in all likelihood.
To put it all together, I believe that we will see a recession within the next year. I believe that the three key indicators of the 10-year and 3-month yield spread, the trend in unemployment rate, and the disappointing and falling ISM manufacturing index all indicate that the economy is in for an immediate switch towards slower growth and recession. For investors, I would suggest trimming long exposure or potentially shortening the outright major stock indexes.
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.