Timing is everything
The U.S. economy is signaling that the decade-long business cycle upswing following the global financial crisis and the Great Recession is nearing – or might have already reached – its apogee. This should be recognized as neither good news, nor a surprising development, given the proliferation of risks to the outlook. The monetary authority appears to have shifted the focus of policy from responding to a growing economy (and the effects of unconstrained fiscal policy) to responding to spillover from a global economic slowdown, as well as further disruption to domestic and foreign enterprise brought on by continual threats to the global supply chain linked to trade policy. We now anticipate that the Fed will move to cut the federal funds rate by 50 basis points before the end of the year in an attempt to provide a cushion for an economy that is decelerating amid slower hiring and wage growth.
It’s safe to say that inertia is almost always a factor when forecasting economic cycles and when making investment decisions based on those expectations. After all, it’s human nature to make personal or business judgments based on past experience, extrapolating the future from the current environment.
Unfortunately, a business decision to expand capacity can take years to implement, only to find that technology and tastes have moved on or that the demand for additional goods has been dampened by unforeseen events such as the oil shortages or financial crises that have distorted economic growth in the modern era. Invest in the face of a downturn, and capital will be underused and unprofitable. Fail to invest in the face of an upturn, and risk losing market share and potential profits to competitors. This is a sustained management challenge for businesses of all sizes.
The current business-cycle expansion is just days shy of becoming the longest in the modern (post-World War II) era. That alone lends to the adage that all good things must come to an end. But there are also indications in the financial markets and the real economy that conditions for a downturn are falling into place.
The following sections explore some of those signals, the estimated probability of a recession, and how it might affect expectations of further investment.
Signal #1 – An inverted yield curve
Financial markets have been anticipating a slowdown for the past seven months. The government bond market yield curve has become inverted since the third quarter of 2018, with money market rates moving higher than the yield on 10-year Treasury notes (see Figure 1). While not necessarily forecasting a recession in the months ahead, the bond market is signaling that the conditions necessary for a downturn are in place. The bond market is now anticipating that the Federal Reserve will seek to avert the onset of lower growth by cutting short-term interest rates in hopes of stimulating investment and consumption.
Signal #2 – A downturn in the leading economic indicator
In the real economy, recent data releases suggest a climate of slower growth. The Conference Board’s Leading Economic Indicator – a composite of trends in manufacturing orders, labor-market activity and consumer spending (as well as the financial sector) – has been trending down since the third quarter of 2018, suggesting a pivot point for the economy (see Figure 2).
While the economy is far more complicated than the 10 components that comprise the leading indicator, it is a useful tool to ascertain where the economy is going. While the intent of the Conference Board is to provide estimates of the turning points in economic activity rather than to present a forecast of future growth, we can nevertheless argue that the leading indicator is pointing toward GDP growth centered on a 1% rate.
Signal #3 – Reduced wage growth
Wages likely peaked at 3.43% in the current cycle, which should signal to businesses that a broader slowdown is in train. On a three-month, average annualized pace, wage growth slowed to 2.73% in May, which implies a much slower trend than the top line, and is down for three straight months. With hiring in the household survey, which is used to estimate the unemployment rate, having only added 10,000 jobs over the past three months, it is likely that the unemployment rate will begin to rise in coming months.
Signal #4 – Slipping into a low-growth profile
Real GDP in the first quarter increased by 3.2%, arguably a robust rate of growth so late in a business cycle. But there is lots of room for interpretation, with about two-thirds of that increase due to “a huge inventory build-up, a substantial decline in imports, surprising strength in exports and a bulge in state and local spending due to road repairs associated with this winter’s storms,” according to Professor David Shulman in a June 2019 report by the UCLA Anderson Forecast.
The consensus among analysts was that the 5% first-quarter inventory growth rate was outsized (see Figure 4), and we would argue perhaps transient, with inventory stockpiling leading to reduced production in coming quarters if future consumption outlays are reconsidered. Disregarding the one-off surges in inventories and other sectors listed above, the UCLA analysis suggests the core economy grew by only 1.2% in the first three months of the year. This supports our call and the interpretation of the leading economic indicator that the real economy is decelerating in a manner not reflected by top-line growth.
Looking forward, the Federal Reserve Bank of Atlanta’s GDPNow estimate for second -quarter real GDP growth jumped from 1.4% on June 6 to 2.1% as of June 14 (see Figure 5). Note that the GDPNow model reacts to the staggered release of economic indicators and will therefore move as the quarter progresses and new data becomes available. Also note that the range of estimates from the Blue Chip survey of economic analysts has moved lower during the quarter, with the survey now indicating expectations of 1.25% to 2.25% second-quarter growth with an average forecast of 1.75%.
Slipping into a 1% percent growth range appears to be a significant threshold. Like the inverted yield curve we discussed above, 1% growth suggests a climate ripe for an economy to slip into recession. As shown in Figure 6, economic growth leading into a recession can often be at high rates, like garbage time at the end of a basketball game, with benchwarmers jacking up threes and tomahawk jams.
Figure 7 shows that average growth rate during the first quarter of modern-era downturns was 2.5%, with a range of 1.4% to 4.3%. But growth in the second quarter of the downturn has averaged only 0.6%, with a range of -0.8% to 1.3%. So if the core economy grew by only 1.2% in the first quarter, and if the overall economy were to grow by only 1.4% in the second, then the table would be set for an event (Brexit perhaps, or repercussions from the U.S.-inspired trade war with its allies and with China) to push the economy into outright recession.