Recession Warning Signs
Recession Warning Signs

Recession Warning Signs

 

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Kevin Rice
Kevin Rice
Investment Analyst
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Recession Warning Signs

A look at current trends and data points.

Introduction

Although predicting a recession with certainty is not possible, there are indicators we can watch that have shown consistent trends when the economy is heading into a one. Today only the yield curve is telling us a recession could be near, but the current trends of other data points have us concerned. In this paper we will look at each in more detail to see what they are signaling.

Recession Warning Signs Source: TC Wealth Partners, Bloomberg, Morgan Stanley Research

Average Hourly Earnings (AHE)

  • What Are They?
  • Average hourly earnings are the average amount of dollars employees make per hour in a given month. It is calculated monthly by the Bureau of Labor Statistics and is used by the Federal Reserve to decide whether to raise or lower interest rates.
  • Why Do They Matter?
  • As earnings growth slows, consumers tend to spend less, which negatively influences economic growth. The slowing of economic growth impacts the willingness and ability of businesses to hire and pay employees. To mitigate the effects of slowing demand, companies typically reduce hiring and freeze wages. For this reason, AHE growth tends to stagnate and fall before recessions (Exhibit 1). During the past five recessions AHE growth slowed within a year before a recession began and then slowed further after the recession started.
  • What Is the Current Signal?
  • AHE growth has been slowing over the last three quarters but sits at the top end of the range established before prior recessions. We believe AHE growth will continue to slow as uncertainty regarding the international trade situation is likely to keep businesses from raising wages higher than the current pace. Overall, we believe that wage growth remains solid and is not currently signaling a recession is near.
Exhibit 1 Source: TC Wealth Partners, Bloomberg

Consumer Confidence Index

  • What Is It?
  • The Consumer Confidence Index is based on a survey by the Conference Board that measures the overall confidence, relative financial health and spending power of the average U.S. consumer. The survey asks 5,000 households five questions: two related to present economic conditions and three related to future expectations. Each response can be answered with one of three responses: positive, negative or neutral. The index is used by manufacturers, retailers and government agencies to plan their future actions.
  • Why Does It Matter?
  • When consumer confidence is high, consumers feel good about the economy and tend to make more purchases. When it is low, consumers do not feel good about the economy and they save more and spend less. A fall of 15% in the year over year (y/y) change in consumer confidence tends to be a clear signal of an imminent recession. Consumer confidence can turn lower very quickly, and a recession can start soon after it turns.
  • What Is the Current Signal?
  • Consumer confidence is currently at an eight-month high as consumers are optimistic about the future of the economy and are willing to look past uncertainty abroad (Exhibit 2). We believe that the confidence of the consumer will continue to support robust spending and drive the economy in the second half of the year, dampening any concerns of recession.
Exhibit 2 Source: TC Wealth Partners, Bloomberg

Nonfarm Payrolls

  • What Are They?
  • The Department of Labor Bureau of Labor Statistics surveys 141,000 businesses and government agencies in order to provide monthly data on the number of workers on nonfarm payrolls. The payroll data is used by policymakers and economists to determine the current state of the economy and predict future levels of economic activity.
  • Why Do They Matter?
  • A negative nonfarm payroll’s number is a clear indication of a recession. As discussed in my post last week, job growth is the key data point defining recessions because the loss of jobs greatly impacts spending of the U.S. consumer and negatively influences economic growth. The last five recessions have all exhibited negative growth in nonfarm payrolls, with payroll growth generally declining for a year or more before the recession started.
  • What Is the Current Signal?
  • While nonfarm payrolls haven’t been negative, the three-month trend has turned lower since February (Exhibit 3). We believe that additional tariffs and the ongoing weakness abroad will modestly impact payroll growth in the second half of the year, but the growth should continue. We will continue to watch this indicator closely, though, because it can turn negative very quickly.
Exhibit 3 Source: TC Wealth Partners, Bloomberg

Unemployment Rate

  • What Is It?
  • The unemployment rate tracks the number of unemployed persons as a percentage of the labor force. The Bureau of Labor Statistics defines unemployed people as those who are willing and available to work, and who have actively sought work within the past four weeks but are not employed.
  • Why Does It Matter?
  • The unemployment rate rising on a y/y basis is a consistent pre-recession signal. Typically, the rate goes higher when the economy experiences hardship and goes lower when the economy is improving. The unemployment rate has hit a low for the business cycle before prior recessions, but with varying lead times.
  • What Is the Current Signal?
  • The current unemployment rate is near a 50-year low but is down on a year-over-year basis. The trend is slightly worrisome, though, because it has moved steadily higher since bottoming in late 2017; however, it is still on the low end of historical changes before prior recessions. We will continue to watch the data because the unemployment rate tends to jump an average of 40 bps y/y in the month before recessions begin (Exhibit 4).
Exhibit 4 Source: TC Wealth Partners, Bloomberg

Institute for Supply Management (ISM) Manufacturing Index

  • What Is It?
  • The ISM manufacturing index is based on a monthly survey of purchasing managers at more than 300 manufacturing firms. The index monitors changes in production levels from month to month. A value of more than 50 indicates expansion, 50 indicates no change and a reading below 50 suggests a contraction of the manufacturing sector.
  • Why Does It Matter?
  • Manufacturing is a small portion of the overall economy but comprises a large share of its volatility. Swings in manufacturing impact corporate profits and can influence future spending and hiring plans. The lead time before a recession is inconsistent, but the ISM index tends to fall below 50 before or at the start of recessions and approaches the low 40s in a recession.
  • What Is the Current Signal?
  • U.S. manufacturing activity deteriorated in July to an almost three-year low, dragged down by slower production. This was the fourth straight monthly downturn in the overall index of factory activity and is consistent with the recent trend of manufacturing weakness throughout the world. The current level (51.2) remains just above 50, but the trend (Exhibit 5) is heading lower at a rate consistent with periods a few months before prior recessions.

    We believe that the downward trend could reverse after looking at more recent reports on industrial production, factory jobs and durable goods, which suggest manufacturing should grow modestly in the second half of the year.
Exhibit 5 Source: TC Wealth Partners, Bloomberg

S&P 500 Profit Margin

  • What Is It?
  • Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents the percentage of sales converted into profits. The S&P 500 profit margin is a weighted average of all the profit margins of companies in the S&P 500.
  • Why Does It Matter?
  • S&P 500 profit margins tend to narrow ahead of recessions as top-line sales start to shrink faster than costs can be cut. As margins contract, businesses pull back on investment and hiring, which can further slow the economy. Margins have typically peaked ahead of recessions, so declining margins are a good warning sign for a recession.
  • What Is the Current Signal?
  • At the end of the first quarter of this year, margins peaked and have since been declining (Exhibit 6). During second quarter earnings calls, companies mentioned that their profit margins have been negatively impacted by higher labor costs, higher raw material costs and a slowdown in global growth. We expect this decline to continue into the second half of the year as tariffs impact companies and global growth continues to slow, but is not signaling a recession is near.
Exhibit 6 Source: TC Wealth Partners, Bloomberg

Conference Board’s Coincident Indicators Index (CEI) and Leading Economic Indicators Index (LEI)

  • What Are They?
  • The CEI is an index made up of four cyclical economic data sets (Industrial Production Index, Manufacturing and Trade Sales, Nonfarm Payrolls and Personal Income) and measures current economic activity. The LEI index incorporates the data from 10 economic releases1 that traditionally have peaked or bottomed ahead of the business cycle. Both indexes are published monthly by the Conference Board and help economists determine which phase of the business cycle the economy is currently experiencing.
  • Why Do They Matter?
  • The CEI and LEI have historically turned downward before a recession and upward before an expansion. A CEI growth rate below 2% and a LEI growth rate below 0% have indicated in the past that a recession was on the horizon.
  • What Is the Current Signal?
  • Currently the CEI has been below the 2% level for 4 months, and the LEI has been slightly elevated relative to the periods before prior recessions (Exhibit 7). If the LEI index remains flat over the next three months, it would bring the y/y growth rate to 0%, and we believe that is a moderate risk that a recession is near.
Exhibit 7 Source: TC Wealth Partners, Bloomberg

Yield Curve

  • What Is It?
  • A yield curve is a graph that depicts yields of all the U.S. Treasury bills ranging from short-term debt, such as one month, to longer-term debt, such as 30 years. The curve, in a normal market environment, is upward sloping as bond investors are likely to get higher rates in a longer-term market environment as opposed to short term. When longer-dated yields are less than shorter-dated yields the yield curve inverts.
  • Why Does It Matter?
  • A yield curve’s shape helps investors understand how interest rates are expected to change in the future. It also indicates likely economic fluctuations. When the U.S. economy starts moving from healthy growth to a contraction, the yield curve usually first flattens and then inverts. Since 1955 the inversion of the yield curve has preceded all nine recessions except for one in the mid-1960s. The time varies between the inversion and the start of the recession, but it generally occurs within a 24-month period.
  • What Is the Current Signal?
  • On March 22nd, the yield of U.S. 3-month T-Bill moved above the yield of the U.S. 10-year Treasury (U.S. 3s10s) and the yield curve inverted for the first time in 12 years (Exhibit 8). That metric reverted on March 29th and then inverted again in May and has continued to stay inverted. The yield curve has been flattening for several years but has recently accelerated into negative territory as the Fed’s dovish tone has lowered U.S. economic expectations. We believe the yield curve’s shape today has been driven by intense global demand of positive-yielding U.S. Treasuries amid negative sovereign debt yields internationally. We do not interpret the shape of the yield curve as a sign of an imminent recession, but we will monitor it closely because historically it has predicted recessions.
Exhibit 8 Source: TC Wealth Partners, Bloomberg

Conclusion

After examining each indicator above we currently do not believe that a recession is imminent. Current trends of some of the indicators are worrisome because they are near where they were prior to the start of past recessions. History tells us these indicators can deteriorate rapidly, so we will monitor them closely and keep you posted if we see any major changes.

 
 

Sources
  • The Next Recession: Lessons from History, Goldman Sachs, June 23, 2017
  • Learning from a Century of U.S. Recessions, Goldman Sachs, January 20, 2019
  • Can America’s Oldest Expansion Last Much Longer?, Goldman Sachs, July 12, 2019
  • Known unknowns: Uncertainty, volatility, and the odds of recession, Vanguard, March 2019
  • The Recession Playbook, Morgan Stanley, July 22, 2019
     
  • 1 (1) The average weekly hours worked by manufacturing workers. (2) The average number of initial applications for unemployment insurance. (3) The number 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. (9) The spread between long and short interest rates. (10) Consumer sentiment.

 

Tags:  August 2019, Economic Recession, Federal Reserve Policy, Financial Risk, Fiscal Policy Tightening, Historical References, Inflation Targeting, Market Knowledge, Oil Prices, Recessions, TC on the Markets

Note:  The content of this article is for guidance and information purposes only and is not intended to be construed as advice. Information provided is not intended to provide investment, tax, or legal advice.