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The Odds Of A U.S. Recession Are Increasing According To The Indicators

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Includes: AMZN, BMY, DDM, DIA, DIS, DOG, DXD, EEH, EPS, EQL, FEX, GOOGL, HUSV, IVV, IWL, IWM, JHML, JKD, MSFT, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UNH, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Henry Stokman
Summary

The bond yield inversion is historically a recession warning signal, but there are several other indicators out there that should be examined before making any kind of judgment.

Economic indicators are mixed with the most recent trends pointing toward a slowing U.S. economy.

If the trade war continues to intensify, the U.S. economy will surely continue to contract, increasing the odds of a recession.

Everywhere you turn now people seem to be talking about one thing. Is the U.S. going into a recession? This is a great question, and something that obviously is not easily answered, but I think with a little help from some economic indicators, we can at least make an educated/informed directional guess.

Bond Yield Inversion

Of all the economic indicators out there, no indicator has gotten more publicity recently than the inverted yield curve. To highlight this point, I recently was in Seattle for a long weekend getaway, and while waiting to go to the top of the space needle, I started to make conversation with another couple in line, and when the conversation turned to the fact that I am actively involved in the financial markets, the immediate next question was do you think we are going into a recession because of the inverted yield curve?

According to Credit Suisse, a yield curve inversion has successfully signaled a recession for the past 50 years. That said, the report also mentions that markets tend to rally 15% on average after an inversion with the recession hitting about 22 months after an inversion. If basing the above question off of that analysis, then the answer is surely yes, we are going into recession, and it will happen sometime in 2021.

Unfortunately, economic and market forecasting is not that easy. Breaking this down a bit further, I think it is important to examine the global economic picture. The US is one of the few places in the world right now where global investors can "safely" put their money and receive a positive return on their money. Couple that with a slowing China and Europe and a Brexit drama that is just heating up, it is no wonder that investors are flocking to the US. All this excess demand for our Treasuries is putting a great deal of pressure on longer-dated rates and helping to further exaggerate the inversion that we currently see in the 2s and 10s.

Bottom line is I am not sure there should be an inversion in yields right now all things being equal, but the added external demand for Treasuries has certainly created a precarious situation. We must now ask ourselves whether this inversion is indeed a precursor to an economic contraction/recession or is this time truly different?

GDP

Next let's examine GDP. The most recent GDP report for Q2 came in a bit light at 2.0% compared to Q1's report at 3.1%. Now, for comparison purposes, we were as low as 1.1% just this past December during the 2018 Q4 report, so even though growth did slow, I don't think it is a major sign that things are completely falling off a cliff.

What is being challenged though is gross private domestic investment, which has fallen by 5.5% this year, making it the worst quarter since Q4 of 2015. This decline in business spending has contributed to almost a full percentage decrease in overall Q2 GDP. All that said, it will be very interesting in the coming quarters to see how GDP fares especially given the most recent escalation in the trade war.

This past weekend (September 1st) marked the effective increase in tariffs that were announced by President Trump at the end of July. This increase is going to have a significant impact on overall output and spending. As was stated on several retailer earnings calls this past quarter, the additional 15% in tariffs will likely be passed onto the consumer. With consumer spending being the primary driver of GDP in the U.S. and the unemployment rate at a 50-year low, it is no wonder that consumer spending has remained strong over the past 12 months. As these tariffs start to be felt by the consumer, the question of whether spending slows down dramatically is yet to be seen. If all these negative factors continue to coalesce, it is very possible that this recent decline in GDP is just the beginning of something bigger.

Manufacturing

The continued uncertainly of a random tweet signaling another increase in tariffs is creating a lot of difficultly for business leaders to plan for CapEx spending going into 2020, which looking out could begin to create a significant drag on the current expansion. This uncertainty in spending on the business front is already being seen in the U.S. manufacturing growth which just recently slowed to its lowest level in 10 years.

The most recent reading of the U.S. manufacturing PMI was 49.9 compared to July's 50.4. For context, any reading below the neutral 50.0 threshold is a contraction signal. The ongoing trade war escalation and a slowing Europe have not helped this sector of the economy and have only created more anxiety with business leaders on what to do next. Additionally, the Cass Shipments Index continues to fall with the index in July falling 5.9% compared to June's 5.3% decrease. The Cass Shipments Index continues to point to continued weakness in the global market and is signaling that we are on the precipices of an economic contraction. All that said, the service sector of the U.S. economy is still doing quite well and has been one of a few bright spots in the economy during this expansion and has helped alleviate some of the pain felt in the manufacturing sector.

The Commodities

During every economic boom and bust, there are always two commodities that are very closely followed that help signal economic direction. Those two commodities are gold and copper. Gold has been viewed by many investors over the years as a flight-to-safety trade and a place to hide out when economic uncertainty hits and/or currency devaluation fears spread. Typically, when market volatility starts to spike, and recession fears spread, investors run to gold for its perceived safety and low volatility. Since the beginning of the year, gold prices have increased by 20%+ as investors flee market securities and hide out in gold.

Copper on the other hand is typically the commodity that signals that the global market is growing, and consumers are spending money. Given the need for copper in new construction and a variety of other consumer products, when copper prices increase, that is a sign that demand is high. Copper prices though are down almost 13% as overall demand for the metal has stalled out globally further indicating that a contraction is coming.

These commodity indicators are useful in gauging overall economic growth and contraction, but it is important to also keep in mind that their price movements are also reflective of investor expectations on future conditions. I mention this because if investors are fearful of a recession, they might buy gold and short copper preemptively creating a self-fulfilling indication of what is to come, even if economically it's not in the cards.

Final Thoughts

After reviewing some of the key economic indicators, it is clear that the U.S. economy is indeed slowing, but as long as the U.S. consumer continues to remain strong, the U.S. should be able to stave off a recession. That said, if the trade war continues to intensify, the trickle-down effect to both the consumer and business community is going to have significantly negative impacts on the above-mentioned economic indicators that are already at a tipping point.

At this point, my recommendation to investors is remain defensive and adopt a wait-and-see approach before being too aggressive in market direction. Putting together a shopping list of stocks and desired price points is a valuable exercise right now especially given the amount of daily volatility that is being seen in the market right now.

When setting ideal price points I would encourage investors to pick stocks that won't get dragged down too much by the trade war. The stocks I like the most as the market continues to come in would be Amazon (AMZN), Microsoft (MSFT), Google (NASDAQ:GOOG) (GOOGL), UnitedHealth Group (UNH), Bristol-Myers (BMY), and Disney (DIS). I would encourage investors to let the market come to them on these names and not chase anything. Until then, patience is a virtue that will be well rewarded.

Disclosure: I am/we are long GOOG, BMY, AMZN, UNH, DIS. 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.