What is the current level of recession risk? It’s always prudent to ask these questions when conditions are benign, since that’s when the downside of the current good times is usually the most ignored. It seems everyone in the world is bullish (except those selling gold). There are a variety of signposts one could look at to get a gauge on recession risk from an economic cycle standpoint, but below are some of the broader segments, and a few thoughts on their current standing.
Relevance: Releases such as the Conference Board’s LEI (Leading Economic Indicators) and those published by the Fed and others can offer context of where we are in the cycle relative to history, measured by a combination of various economic inputs.
Current Status: ↑ These indicators generally all show positive readings. Indications of deceleration would be a yellow flag to watch for.
Indicator: Yield Curve / Rates
Relevance: An inverted treasury yield curve (short-term rates > long-term rates) is a strong predictor of a coming economic slowdown and/or recession. Later in a cycle, having the Fed move from accommodation to restriction runs the risk of a policy error (i.e. tightening ‘too much’).
Current Status: ↔ The yield curve has flattened as the Fed hikes short rates, while long rates remain anchored by tempered longer-term inflation expectations. However, the curve is not yet inverted, which is the key historical trigger point.
Indicator: Manufacturing / Housing
Relevance: Despite manufacturing representing a smaller part of the economy (relative to services), changes at the margin for manufacturing ISM, etc. have historically coincided with business/economic cycle changes.
Current Status: ↑ Manufacturing levels remain high based on several metrics in the U.S., some at the highest levels seen in years. Housing, however, remains soft, with building not keeping up with demographic demand and persistence of low inventories.
Relevance: Strong corporate profits as a percent of overall GDP (Gross Domestic Product) coincides with a healthy economy. However, it’s important to note that 40% of S&P 500 revenues originate from overseas, so this isn’t as strong of a connection as it used to be.
Current Status: ↑ Earnings growth remains extremely strong, at 20-25% growth from a year ago. Naturally, this can’t persist at the same robust rate, but 2019 is estimated to still be solid, in the high single-digits.
Relevance: Employment growth that runs too hot, with unemployment too low and/or improvement decelerating can be hard to sustain and tends to ultimately reverse.
Current Status: ↑ Multi-decade strength in various labor metrics continues: through a low unemployment rate, jobless claims, and JOLTs (Job Openings and Labor Turnover survey).
Indicator: Credit / Excesses
Relevance: Rising levels of corporate and household debt can add increasing stress, with lessened margin for error if positive conditions reverse.
Current Status: ↔ Corporate debt has been steadily rising in recent years, and loan standards falling somewhat. Government debt remains far higher.
Indicator: Sentiment / Spending
Relevance: Consumer and business confidence affects spending decisions.
Current Status: ↑ Recent tax reform and regulatory rollbacks have helped businesses feel better about the overall climate and spending for the future, including some signs of stronger capex growth—which had been missing. Consumer results are mixed, but more positive than negative.
Relevance: High inflation is a headwind and can accelerate Fed policy; low inflation can be byproduct of sub-par growth.
Current Status: ↑ Inflation has picked up this year with higher oil prices, but offset somewhat by flatter pricing in other areas—overall, inflation remains near the Fed’s target range. Concerns remain tempered.
Relevance: Historically, surprise events such as geopolitical strife, commodity price spikes (oil or food), government fiscal policy, etc. can begin a negative feedback loop.
Current Status: ↔ A protectionist approach through tariffs that weakens trade links could result in lower economic growth and heighten slowdown risks.
Overall, conditions remain fundamentally good—continuing in their ‘Goldilocks’-like state. In fact, an economist at a well-known Wall Street firm recently described America has having a ‘Kevlar’ economy, in it being ‘practically bulletproof’. Hearing these types of superlatives are usually a combination of being both reassuring and disconcerting when considering a recession. If you want to learn more, you might go back and revisit Larry’s recent post: “When to Worry about a Recession.”
There is always the threat of recession. No matter how strong conditions are, the risk is often at least 10-20%, simply due to their historical frequency and average length of business cycles. However, the later an economy moves in a cycle, risks of the cycle ending naturally increase. This is true regardless of whether excesses are present or not, although the presence of excesses certainly could expedite the condition.