by Franklin J. Parker, CFA
- After the data and event deluge of the past two weeks, this week seems relatively calm. Home sales, durable goods orders, and consumer sentiment are the big data points. Consumer sentiment is expected to fall quite a bit as inflation and a gloomier outlook begin to take hold.
- The Federal Reserve raised rates quite aggressively last week, opting for a 0.75% hike. This was on the heels of the previous weeks’ surprising jump in inflation. Markets reacted negatively, largely because the Fed had originally set the expectation for a 0.50% rate hike and had to update their guidance during their blackout period (a time when Fed participants are not allowed to speak to media). In order to update their messaging, the Fed quietly leaked their intent to the Wall Street Journal, causing some confusion and frustration among market participants. The Fed noted their surprise with inflation’s persistence, and reiterated their commitment to getting it under control. While explicitly stating the opposite, the Fed’s economic projections seem to indicate their willingness to tolerate a recession to get inflation back to their target.
- Speaking of recession, it seems that everyone is suddenly talking about one. With the first quarter posting negative growth, we would only need to see the second quarter post negative growth and we have a recession (so, we could already be in one). Despite this, I do not see a recession within the next six months (I pull some highlights from my recession dashboard below). There are serious headwinds for markets, of course, and new data may post in the next few months, but for now I do not see the economy slipping. More in this week’s Details.
A recession is defined as two quarters in a row of negative GDP growth. With so much talk of a recession in the financial press, I find myself scratching my head to locate the data to support this view. While I realize this is a minority opinion, I do not see a recession within the next six months. Here are a few of my go-to indicators to get a sense of when a recession is on the horizon. In all of the charts below, the grey bars indicate recessions.
Purchasing Manufacturer’s Index. Manufacturing tends to decline ahead of a recession, which is demonstrated in this chart. For this indicator, anything above 50 is expansion and anything below 50 is a contraction. Notice how manufacturing tends to slow and contract ahead of a recession. It would be very odd to have a recession with the strong expansion we are currently experiencing in manufacturing.
Manufacturers’ Backlog of Orders. Similar to PMI, manufacturers tend to see their order book decline considerably leading into a recession (this index reads the same as PMI: >50 is more backlogs, <50 is less). This makes sense as order backlogs would indicate high demand for goods. It would be unusual to have a recession with order backlogs as high as they are.
Unemployment Rate. Another look at the health of the economy is the unemployment rate. It is not so much the headline rate that matters, rather it is the general trend in which unemployment is headed. Typically, leading into a recession, unemployment (solid line) moves above its 12-month moving average (dotted line). Currently, the unemployment rate is well below its moving average—largely because employment improved so rapidly coming out of the lockdowns. Again, it would be unusual to have a recession with employment so strong.
Job Openings as a Percent of the Population. Another look at the health of the labor market is to look at the number of job openings as a percentage of the labor force. Typically leading into a recession, we see the number of job openings decline (which is shown in the subplot below). In this environment, job openings are at multi-decade highs, and the number of jobs available, as compared to a year ago, is considerably higher. It is some of the fastest growth on record. It would be unusual to see an economic contraction with the labor market as strong as it is.
GDP Output Gap. Lastly, we look at the difference between actual GDP and potential GDP. Potential GDP is what our economy could theoretically produce, given all the inputs. Actual GDP is, of course, what has been actually produced. What we tend to see leading into recessions is that actual output outpaces theoretical output—a sign that the economy is overheating. This shows up as a negative value on the chart. In fact, this is one of the earliest indicators we get of looming recessions, often giving signals years in advance of the actual recession. What we see currently is that output is still well below the economy’s theoretical capability. Again, it would be unusual to see a recession with a positive output gap.
Yield Curve. The most widely followed recessionary indicator is the yield curve. In a normal environment, you get paid more to tie up your money for 30 years than you do to tie it up for 3 months. Ahead of a recession, that relationship tends to invert. I like to look at the difference between the yield on 30-year US Treasuries and 3-month US T-bills. As you can see, this difference tends to turn negative ahead of recessions. At the moment, it is at non-recessionary levels and has been trending higher (It is true that other parts of the yield curve are inverted, but I find those to be much noisier).
Of course, all of this data is changing rapidly, and when new data comes in I will update my view. For now, however, I am struggling to see a recession in the near-term. Which means that (1) if no recession hits the current market is likely near a bottom, and (2) if a recession does hit it is likely to be fairly mild.
As I have repeatedly talked about, flexibility is key in this environment. We must be able to update our views and portfolios in the face of ongoing changes. And that is what I will do.
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