What are the prospects for recession at this point?
In the last advisor meeting, we offered an interesting visual that listed a variety of common signposts economists and strategists look to for determining where we are in the business cycle. Some items are easier to gauge, while others are more ambiguous. The following broad categories are ranked in the form of a rough report card per our standard criteria (+ conditions better, 0 conditions neutral/agnostic, - conditions weaker).
- Priv sector borrowing binge, maybe
- Labor market running too hot, no
- Bloated inventories, maybe
- Asset bubbles, no
- M&A frenzy/margin borrowing, maybe
Late-Cycle Financial Indictors
- Inverted yield curve, no
- Falling profit share of GDP, yes
- China/EM hard landing, maybe
- Geopolitical unrest/Brexit, maybe
(0/+) Firstly, we can look to business conditions and potential excesses. These include increased debt and leverage in the private sector, which we've seen more of in recent years but not at pre-Great Recession levels. Low interest rates typically incent businesses to borrow more, but these urges look contained as companies appear more skittish in levering up because of uncertainty in business prospects caused by lackluster domestic and foreign economic conditions, and, indirectly, the government regulatory environment. (There has been wider issuance activity in segments like U.S. high yield debt, but much of this in recent years has been refinancing of older, higher-coupon debt as opposed to taking on new debt.) This lack of growth has also kept business capex depressed and inventories from becoming over-bloated and leaving overhangs, as can occur when higher demand periods fall off quickly. More sophisticated supply-chain management has also helped this become less of an issue in recent years as opposed to more dramatic manufacturing-led slowdowns of past century. Economies based on services, rather than goods production, will also tend to have fewer such dislocations by nature, which explains why emerging markets are still more vulnerable to this than developed markets like the U.S.
(0) From a business profitability side, one can measure total profits as a share of GDP, which tends to align with company peak margins. Historically, these have peaked and then declined towards the ends of cycles. This matters because as margins decline, firms look to cost-cutting measures such as paring back on capex, R&D and labor costs, obviously creating a negative feedback loop. This ratio was in a downward trajectory from 2012 through 2015, but has since picked up again.
(+) Labor markets have been a source of strength, acknowledged by the consensus group of economists that often can't agree on many things. On the other hand, peaking of conditions in the labor markets signify that things couldn't get much better, so, consequently, they could only get worse eventually. It's assumed that we're inching incrementally closer to full employment, but aren't there yet. Jobless claims are at multi-decade lows, and JOLTs readings (while a much shorter data series) is running at a high level. Therefore, overall, labor is looking strong and could be close to peak but we could be able to buy more time. Labor conditions beginning to decline would be a more ominous signal, and, with this being a key part of the Fed's dual mandates, is being monitored closely.
(0) Housing has been a mixed bag, with home prices still on the rise nationally, which has boosted real estate sentiment. Housing starts (as seen in the graph above) have been improving from trough levels, but remain far below the previous cycle overall. Economists have been waiting for years for these to pick up and match potential demographic demand, but this remains elusive. On the other hand, this has kept oversupply in check, so potentially a net neutral.
(0) On the financial side, a less direct situation is the formation of asset bubbles. These are indirect in that they aren't always related specifically to economic growth, but can impact broader conditions in a few key ways. Firstly, performance of asset markets like stocks, bonds or real estate can provide consumers with a 'wealth effect', meaning they feel richer when prices are high and are likely to spend more—promoting further economic growth. Conversely, the bursting of an asset bubble can deflate sentiment along with the size of portfolios, resulting in a pareback of activity with often-deflationary results. While there doesn't seem to be consensus views pointing to widespread asset bubbles, equities are more expensive than they once were with above-average price ratios, bonds are hampered by low interest rates creating risk in longer-duration debt should yields again begin to drift higher, and strong fundamentals in real estate could end up with an eventual oversupply if building picks up (what often happens toward the end of real estate cycles).
(0/+) From a business standpoint, asset class bullishness or bearishness in sentiment can influence the interest of firms to conduct capital market activity, like raising money and promoting merger and acquisition transactions, which may or may not be of actual help to the economy. It is a tendency, though, that strong economies tend to perpetuate such activity, while weak ones do not, as poor fundamentals cause risk-taking to decline. Such activity has waxed and waned over the past few years, but appears to be picking up again.
(+) There are other measures that we can look to from history. One is the appearance of an 'inverted' yield curve. Bond markets are usually positively-sloped, with longer-term rates consistently higher than short-term rates, as investors demand compensation for taking on the risk of tying funds up in longer maturities as well as the uncertainty of future inflation. When the yield curve inverts, causing short-term rates rise above long-term rates, the market is communicating that interest rates are expected to fall—which would happen through central bank intervention to stem falling growth and recession. Interestingly, this has been one of the more accurate measures over the last century, although no data point is ever 100% accurate. Today, of course, we see no such inversion.
(0) Of course, there are the wildcards, which by their nature are very difficult to predict. This includes exogenous economic downturns overseas, such as in China or further deterioration in Europe or to do with Brexit, or geopolitical events like a war or commodity supply hang-up. For the latter, despite apparent lessened sensitivity today, oil price shocks have behind recessions in the past.
So, all-in-all, conditions today do not look immediately threatening, but we're further through the business cycle than we were last year. Based on a rough sample of firms that publish such opinions, the probability of recession in the coming year seems to be about a quarter to a third, so a bit higher than the long-standing 20-25% that's generally in place for any given year. Then again, with growth being as slow as it is, and less leverage and excesses to 'wring out', the impact of an eventual recession could be milder than if there were more imbalances in place (e.g. 2008).
Read our Weekly Review for October 24, 2016.
Read the previous Question of the Week for September 19, 2016.