Wednesday, February 13, 2019

Investment Strategy & Research Deep Dive: The Investor Toolbox & Forecasting Recessions

Ross Mayfield, CFA
Author position
Author position Correspondent Research Analyst

Hilliard Lyons’ Investment Strategy & Research team is dedicated to supporting you and your Wealth Advisor. We provide investment guidance and help you separate meaningful news from idle noise via timely market commentary.

In Deep Dive #006: The Investor Toolbox & Forecasting Recessions, we will discuss several of the indicators that often help foresee recessions in the US. With this piece, we seek to outfit investors with some of the equipment necessary to help understand where we may be in an economic cycle.

The Investor Toolbox

We do not believe we can predict the future with any certainty. Nor do we believe that anyone else can, for that matter. In spite of this, the financial industry tends to be particularly reliant on forecasts (often bordering on conjecture). The media in particular is rife with pundits, money managers, and gurus offering predictions featuring a wide range of outcomes. We approach this task differently. We do not find value in formulating S&P 500 price targets or making future interest rate calls. We simply believe that every person approaches markets with a set of tools (e.g., knowledge, data, analytical capabilities, temperament, past experience). Our goal is both to add to the investor’s toolbox and to sharpen the tools already available.

It is with this goal in mind that we attack the challenge of forecasting recessions. The National Bureau of Economic Research defines an economic recession as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." Recessions have long-lasting impacts, both psychologically and financially; scars from the ’08 crisis are still visible over a decade later, while the Great Depression remains a turning point in American history. Thus, we believe it is exceedingly valuable to monitor economic indicators that have proven fairly predictive in the past. To that end, we present below a discussion on several indicators that our team monitors to keep a pulse on the United States economy.

The Yield Curve

Of all recession indicators, the yield curve has received the most media attention of late. Simply, the yield curve is a graph showing interest rates across different contract lengths for a similar bond. When discussing recessions, the yield curve commonly refers to the spread between the 2-year and 10-year Treasury (though other short- and/or long-term rates can be used). A “normal” yield curve is positively sloped, meaning shorter-term securities yield less than longer-term securities. This is because, in a normal environment, lenders require higher compensation to loan money for longer periods as they assume more risk. The shape is also representative of expected economic growth: A normal curve indicates higher expected future inflation (and thus, interest rates).

Yield curve inversion occurs when short-term rates move above long-term rates. This often occurs when investors have little confidence in the near-term economy. That is, they demand more yield for a short-term investment knowing that they have to reinvest that money in little time. If they believe a recession is coming, they expect the value of the short-term Treasuries to plummet rapidly (as the Fed cuts rates to stimulate the economy). They would prefer to buy long-term bonds and tie up their money for longer even though they receive lower yields.

A 2/10 yield curve inversion has preceded the last six recessions (going back ~50 years), with varying degrees of lead time. The 2/10 spread has been steadily narrowing since late 2013, though over the past eight months it has held between 10 and 35 bps, threatening to invert but never succeeding. Because short-term rates track the Federal Funds rate, many have feared that the Fed would invert the curve with an ill-timed rate hike. Fortuitously, those fears have eased in 2019. Further, stock performance has historically been positive in both flattening environments and in the near-term aftermath of an inversion. The yield curve remains a powerful indicator worth monitoring.

Employment Data

In addition to portfolio positioning, some may have an interest in foreseeing a recession because of the often dire consequences for employment. If economic activity declines significantly, businesses generally respond by laying people off. The inextricable link between recessions and employment can also provide data useful in predicting a downturn.

Specifically, the unemployment rate, wage growth, and weekly jobless claims can together paint an apt picture of an economy’s employment health. The official U-3 unemployment rate measures the number of people without jobs (who have actively looked in the past 4 weeks) against the total labor force. This figure currently sits at 4.0%, just off 50-year lows. The Jobless Claims Report is a weekly release that shows the number of first-time filings for state jobless claims nationwide. This indicator is respected for its reporting frequency, simplicity, and perceived accuracy (i.e., if people do one thing when they’re unemployed, it’s seek to collect unemployment checks). In forecasting a downturn, an investor would be looking for one (or both) of these indicators to trough and begin to roll over.

Wage growth (yr/yr) is a related metric worth monitoring. It tells the story of worker health, but also of inflation. As wages (an input cost) rise, businesses must deal with this increasing expense. This is often done by passing higher costs on to consumers, thereby boosting price inflation. We pay particularly close attention to the Average Hourly Earnings of Production & Nonsupervisory Workers (seen to the left), specifically crossing the 4% threshold. While there is a noteworthy lag on this indicator, the past three recessions have seen wage growth hit 4% and subsequently struggle to go higher, generally marking the beginning of the end of that cycle’s expansion.

Employment data is useful in predicting recessions because labor still drives the economy. If companies foresee a grim outlook, they will often cut costs to protect margins and income. And as discussed above, for most firms the largest variable cost is labor. While the major spikes in unemployment rates and jobless claims occur post- recession, an astute investor can observe cracks in this data ahead of time. According to a Federal Reserve study looking at the past seven recessions, the unemployment rate trough occurred, on average, nine months ahead of the recession. The Fed concluded, “Based on this evidence, it appears that both indicators (unemployment rate and yield curve) tend to be reliable predictors of a business recession.”

Consumer Sentiment

As we’ve noted before, the consumer accounts for ~70% of US GDP. It would not be incorrect to say that the US consumer drives our economy more than any other single factor. But consumer sentiment can change quickly and easily. If consumers expect the economy to enter a recession (or if the stock market crashes, etc.), they will likely hold off on making the larger, discretionary purchases that move the economic needle. Humans despise uncertainty. Thus, we use consumer sentiment indices as a portal into the mind of the American consumer. (To the right is the Consumer Confidence Index from the Conference Board, a monthly release compiled from survey data.) Consumer expectations, which closely track real consumption, specifically tend to trend lower ahead of recessions.

That said, consumer sentiment can be a noisy indicator. It is affected by stock market turbulence, geopolitical uncertainty, natural disasters, etc. An investor would want to see a clear and sustained break in the trend in order to utilize it for any predictive purposes. As with employment data, the trick is that one must identify a clear turning point in the trend, information that can only be known with certainty in hindsight. Consumer confidence has declined sharply ahead of past recessions, but there is a track record of false positives, as well. Some nuance is required; consumer confidence crashed in late 2018, but this was in large part due to the government shutdown and stock market turmoil, exogenous events which are not necessarily reflective of underlying economic strength.

Leading Economic Index

Given the abundance of data we are bombarded with in this chaotic world (and our crunch for space in this piece), we’ll resort to using somewhat of a catch-all for a final gauge to monitor. The Leading Economic Index (LEI) published monthly by the Conference Board is composed of 10 economic indicators whose changes tend to precede changes in the economy. They are:

  1. The average weekly hours worked by manufacturing workers
  2. The average number of initial applications for unemployment insurance
  3. The amount of manufacturers’ new orders for consumer goods and materials
  4. The speed of delivery of new merchandise to vendors from suppliers
  5. The number of new orders for capital goods unrelated to defense
  6. The number of new building permits for residential buildings
  7. The S&P 500 stock index
  8. The inflation-adjusted monetary supply (M2)
  9. The spread between long and short interest rates
  10. Consumer sentiment

On this list we see subjects we’ve already touched on – consumer sentiment, employment data, interest rate spreads – in addition to other data points. New building permits reflect health in the housing sector, a major employer and consumer of raw materials. Change in the money supply can indicate both future spending growth and looming inflation. The S&P 500 reflects investor sentiment, corporate health, and policy. While understanding each piece of this index is valuable, the ease of use is in the aggregation. The Conference Board publishes this data monthly, and the index has reliably topped out and begun to roll over ahead of the majority of past recessions. If one were to only follow a single data point and be mandated to forecast a recession, you could do much worse than LEI.

Takeaways

We would be remiss not to conclude as we began, by acknowledging our limitations as forecasters. With that said, we believe there are clear advantages for investors who are informed and diligent in their research. The economic indicators presented above represent an excellent starting point in analyzing near-term economic activity and thus, recession potential.

Finally, concluding from the data we’ve compiled above, we do not believe a recession is imminent. Consumer confidence has recently fallen sharply and unemployment has ticked up, but we believe both are directly related to the lengthy government shutdown. However, we will be monitoring these indicators closely to see if a trend forms or if they reverse course. LEI has faltered slightly, but we fail to see the top forming that has preceded past recessions. The 2/10 spread remains tight, but positive.

Ultimately, we believe we are entering a period of slowing, but not declining, growth – most have GDP pegged around 2.0-2.5% for 2019. Further, near-term economic success is dependent on both potentially volatile trade outcomes and shifting US politics. Regardless, as data-driven market participants we will continue to closely monitor the indicators we have described today. We end by reinforcing our core belief: the sharper the tools, the better the investor.

 

 


Investment Strategy & Research Department


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