Recession Report Card
Backdrop
On November 19th, 2021, The Nasdaq Composite Index exceeded the $16,000 mark for the first time in history. The index rallied 130% over the course of 18 months, coming out of a global pandemic that kept billions of people around the world locked inside their homes. During those 18 months, the US economy was injected with more fiscal and monetary support than ever before. The US Congress outlaid $13.8T of fiscal spending in response to the pandemic, which represents nearly 65% of the United State’s GDP. How did they finance this spending? By issuing bonds. Who bought these bonds? Its own central bank, the Federal Reserve (Fed). The Fed’s balance sheet grew from $4.17T at the start of 2020, to over $8.75T by the end of 2021. They absorbed over $4.5T of treasuries and mortgage-backed securities in just two years.
Both consumers & the financial markets loved it. Consumers were receiving thousands in stimulus checks every few months and watched the balance in their savings accounts pile up. Meanwhile, financial markets were soaking up the excess liquidity being dumped into the economy. The Dow Jones Industrial Average rallied 90% from the COVID bottom, the S&P 500 rallied 105%, and the Nasdaq Composite Index rallied 130%. The Shiller-Cape PE ratio for the S&P500 jumped to over 35x, a level seen just once in the last century; the dot-com bust.
In the spirit of this pending asset bubble, here is a great quote from 2007:
“As long as the music is playing, you’ve got to get up and dance. We’re still dancing.” — Chuck Prince, Ex-Citi CEO, July 2007
The US economy had a really fun party with lots of dancing and lots of drinks, but now it’s the morning after and it’s time to wake up and smell the roses; there’s a hangover coming. This unprecedented financial support from Congress & the Fed didn’t go without consequence. The economy is now suffering from soaring inflation to the tune of 9.1% year-over-year prints on the Consumer Price Index (CPI).
The Fed has reversed course, and fast. With the goal of taming inflation, the Fed is raising rates while also allowing up to $95B of assets(bonds) to run off their balance sheet every month, a corrective action we haven’t seen in decades.
Outline
With the goal of keeping this review as objective as possible, we will discuss a few popular indicators for the US economy, examine how accurate they’ve been in the past, and break down where those same indicators stand today. We will go through both leading & lagging indicators, so bear that in mind.
But first, let’s make sure we have the fundamentals down. What even is a recession? A recession is typically recognized as two consecutive quarters of negative real GDP growth. It can be as simple as that. However, different entities such as the National Bureau of Economic Research (NBER) break it down even further and define it as a “significant decline in economic activity, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” But for the sake of simplicity, let’s just say two-quarters of real negative GDP growth.
Q1’s GDP release in April 2022 shocked most as it came in at -1.9%, much lower than the 1% gain analysts were expecting. That means one more quarter of negative GDP growth for the US economy and it will technically be in a recession. So that brings us to the indicators…
The indicators. First leading, then lagging.
#1 — Yield Curve Inversion
A yield curve inverts when longer-term yields drop below shorter-term yields for debt with the same risk profile. This happens because investors expect shorter-term rates to decline soon, due to a poor economic outlook, or in some cases, a recession. For this indicator, we will observe the spread between the 2-year and 10-year treasury yields.
In the last forty years, the 10Y yield has dipped below the 2Y yield on just five occasions, of which the US experienced a recession 80% of the time within 18 months. Today, the spread is -0.2% and has been negative since the first week of July 2022. This indicator is waving a red flag for recession.
#2 — Monetary Tightening
Tightening monetary conditions restricts the flow of capital and makes financing new ventures more expensive. This indicator tracks the rate of change in the Fed Funds Rate. The trigger on this indicator is 2%, or a Fed Funds Rate that is 200 basis points (bps) higher than the year prior. Over the last 65 years, we’ve hit this trigger on ten occasions, of which the US experienced a recession 80% of the time within 24 months. Today, the Federal Funds Rate is 1.5% higher than a year ago today. The CME FedWatch tool predicts another 75 bps rate hike at the Federal Reserve’s July meeting in one week's time. If this hike comes to fruition, it will raise this indicator beyond its 2% trigger and wave the red flag for recession.
#3 — Conference Board Leading Economic Index (LEI)
The Conference Board is a non-profit research organization. They’ve created a Leading Economic Index (LEI) that tracks ten different leading indicators and aggregates them into one index. A positive year-over-year change in the index signals the underlying indicators are improving, and vice versa. Over the last forty years, this indicator has gone negative on six occasions, of which a recession had occurred 83% of the time within 18 months. Today, the current reading is +1.7% YoY. This signal is not raising a red flag just yet.
#4 — Brave Butters Kelley Index
The Brave-Butters-Kelley Index (BBKI) is a Federal Reserve Bank of Chicago research project. They use hundreds of dynamic factors to forecast the strength of US economic activity. The data is measured in standard deviation (std) units away from the real GDP growth trend. Since the 1970s, the BBKI has dropped 1.5 standard deviations below trend on just five occasions, each of which the US economy was in a recession, or soon to be in one. Today, the reading of the BBKI is 1.5 standard deviations below the trend. This signal is waving a red flag for recession.
Lagging
#5 — Consumer Sentiment
The University of Michigan tracks sentiment among consumers through monthly surveys and aggregates the responses into an index score. The results are important to consider as consumer spending makes up over two-thirds of US GDP. Therefore, a strong consumer is vital to US economic growth. Over the last 40 years, consumer sentiment has dropped 15% year-over-year on eight occasions, of which the US economy has been in a recession 63% of the time. Currently, consumer confidence is down 30% YoY, a level only seen in the recession of 1990 & the Great Financial Crisis of 2008. This indicator is waving the red flag for recession.
#6 — Energy Prices
This indicator tracks Brent Crude Oil’s price deviation above or below its trend. Energy is the #1 input cost of doing business. Whether you’re an airline paying for jet fuel, an eCommerce brand paying for freight, or a manufacturer running heavy machinery, energy is a huge cost driver for your business. Over the last fifty years, the price of crude oil has jumped 50% above its trend on six occasions, of which the US has been in a recession 100% of the time. Today, energy prices are 65% above trend, well above the trigger. This indicator is waving the red flag for recession.
#7 — ISM PMI
The Purchasing Managers’ Index (PMI) is a monthly indicator for US economic activity based on surveys from hundreds of purchasing managers at manufacturing firms. A PMI reading above 50 signals expansion relative to the previous month. A reading below 50 suggests contraction. Over the last sixty years, the PMI has broken below the 45 level on eight occasions, each of which the US was in a recession. This indicator is certainly “lagging”, but it’s worth noting that the current reading is 47.5, only slightly above the trigger. No red flag for recession yet, but getting really close.
#8 — Stock Market
This indicator tracks S&P500 Index Performance on a year-over-year basis. Markets are forward-looking and there may be some truth to be told if investors begin to price in a recession or a significant drop in corporate earnings. Over the last forty years, the S&P500 has dropped below the -15% YoY threshold on seven occasions, of which the US has been in a recession 71% of the time. On July 14th, the S&P500 index was down -13.4% YoY, just above the trigger, so no red flag for a recession just yet.
#9 — CEO Confidence Index
The Conference Board also has an indicator called the CEO Confidence Index. It is a proxy for the predicted strength of the US economy from the perspective of US-based CEOs. A reading above 50 signals a majority of outlooks being positive, while a reading under 50 signals the majority of outlooks being negative. Since the 1970s, the index has fallen below the 40-level on five occasions, each of which the US was on the way into, or already in a recession. Currently, the index is at 43, just barely above the trigger. This indicator is not waving the red flag yet, but the index is deteriorating quite rapidly.
#10 — Labor Market
The labor market is the backbone of US economic growth & prosperity. If less people are employed, there is less disposable income to be spent on goods and services. Since the 1940s, every single time the unemployment rate ticked up 2% year-over-year, the US was already in a recession. Currently, the US labor market remains strong with unemployment down 2.3% from last year as it bounces around 3.6%. Definitely no recession warning out of the labor market so far. A few things to note: the labor force participation rate dropped from 63.4% pre-COVID to just about 60% during COVID, and people have been slow to rejoin the workforce. Currently, the participation rate is at 62.2% and is trending back to pre-COVID levels, but just another thing to keep your eye on.
#11 — Durable Goods Orders
Durable Goods Orders is a monthly survey conducted by the US Census Bureau that measures current industrial activity. It tracks the number of new orders for durable goods. In the last thirty years, durable goods orders have dropped 20% YoY on four occasions, of which the US was in a recession 75% of the time. The current reading is at +10.8% YoY, which is quite healthy.
Atlanta Fed GDPNow Estimate
That’s it for indicators, but what does the Fed think will happen in Q2? GDPNow is an estimate from the Atlanta Federal Reserve branch for the upcoming quarter’s GDP growth. The estimate constantly changes with new incoming data points. Currently, the GDPNow estimate is -1.6% real GDP growth for Q2. If true, this would technically put the United States in a recession.
Final Scorecard
It’s certainly not the prettiest picture for the next twelve to eighteen months, but it’s always good to know where the fundamental economic data is pointing. I’d recommend keeping track of these indicators as we progress through this turbulent time in the market. Here is the final scorecard:
