We're adding a seventh recession indicator to our scorecard. What’s new and why is it being added?
January 10, 2022
Jim Allworth Investment StrategistRBC Dominion Securities
In our view, an equity investor’s principal focus should be on the U.S. economy—the world’s largest and the one that sets the rhythm and tone for much of the developed world. A U.S. recession has usually been bad news for other economies and equity markets. Every U.S. recession has been associated with a bear market for U.S. stocks—and for most other equity markets.
Source – FactSet, RBC Capital Markets
We have monitored six different variables which have done a good job individually and collectively of signaling when a U.S. recession is on the way. Effective with this update we are adding a seventh leading U.S. recession indicator—free cash flow of non-financial corporate business.
All seven indicators are giving readings consistent with this economic expansion having quite a bit further to run. Powerful tailwinds are driving the U.S. economy and most developed economies forward including: extremely easy credit conditions; excess savings totaling about 10 percent of GDP in the U.S. and Canada (somewhat less in the UK and Europe); the need to replenish depleted business inventories; and a U.S. capital spending upswing already underway. It’s worth noting that none of the developed economies, including the U.S. and China, are fully reopened, but we expect they will be as this year progresses.
These economic tailwinds provide good reasons to expect above-trend GDP and corporate profit growth through 2022 and probably 2023 as well. It would be unusual for share prices not to maintain an upward trend for at least another 12–18 months in that case.
The scorecard shows seven economic indicators and the current status of each as either expansionary, neutral, or recessionary. All seven have an expansionary status. The indicators are: Yield curve (10-year to 1-year Treasuries); Unemployment claims; Unemployment rate; Conference Board Leading Economic Index; Free cash flow of non-financial corporate business; ISM New Orders minus Inventories; Fed funds rate vs. nominal GDP growth.
Source – RBC Wealth Management
This measures the cash generated by non-financial corporate business as a percentage of GDP. It is derived from the Financial Accounts of the U.S. published quarterly by the Federal Reserve. It has given only one false positive signal in more than 65 years. When this indicator has fallen below zero, a recession has followed—typically two to three quarters later. More particularly, shrinking corporate cash flows have most often signaled an upcoming period of weaker capital spending, a highly cyclical component of GDP. Today these cash flows are growing far faster than the economy, and this indicator looks to be in no danger of signaling an approaching recession anytime soon.
Source – RBC Wealth Management, Federal Reserve
Most of the time the 10-year Treasury yield is higher than the 1-year Treasury yield, but this relationship usually turns upside down (inverts) several quarters before a U.S. recession begins. The monthly data did in fact invert in August 2019, suggesting a U.S. recession was on the way. Most yield curve inversions are caused by the Fed pushing short-term rates higher in an effort to cool down an overheating economy. This last time, however, the inversion was caused by the 10-year Treasury yield plummeting as European and Japanese investors, dissatisfied with negative yields in their home debt markets, rushed into U.S. Treasuries, thereby pushing the price of those bonds higher and the yields they offer sharply lower. There were few, if any, signs that credit conditions had tightened in the U.S. or elsewhere. Nonetheless, the U.S. fell into recession in February/March 2020 keeping the yield curve’s predictive track record intact—undoubtedly by accident, unless one is disposed to believe the credit markets saw the pandemic coming five months ahead of when it arrived.
As things stand today the gap between the 10-year Treasury yield (1.79 percent) and that of the 1-year Note (0.43 percent) stands at a positive 136 basis points. We think any inversion would be at least a year away, probably further.
A bottoming of unemployment claims has reliably preceded the arrival of a U.S. recession, with the cycle low typically occurring three to four quarters before the recession’s onset. Currently, the smoothed trend of weekly claims continues to move lower. If the trend were to turn higher from here without a new weekly low being set, history suggests a recession would most likely materialize late in 2022 or early 2023. However, with more than 10 million unfilled jobs in the U.S. vs. 6.3 million unemployed and with widespread indications of large, medium, and small businesses unable to find the workers they desperately need, we think a sustained uptrend in new weekly claims is not about to start anytime soon.
When the unemployment rate turns the corner and begins trending higher, the start of a recession is typically two to six months away. The most recent data leaves the 3.9 percent unemployment rate still above its pre-pandemic 3.5 percent low. From here it would take at least six months of readings in the five percent–six percent range to turn the trend convincingly higher and signal a recession is approaching. However, as noted above, with record high job openings and widespread job shortages in an economy not yet fully reopened, we believe any concerning new sustained uptrend in the unemployment rate remains a long way off.
This indicator is something of a hybrid; it is put together by the Conference Board using 10 monthly economic variables. Two of them (Unemployment Insurance claims and the yield curve) figure in our recession scorecard, so there is a bit of double counting here; we don’t know exactly how much, because the Conference Board’s method of dynamically weighting the 10 variables is proprietary. Whenever the LEI has fallen below where it was a year earlier (shown as negative values on the chart), a recession has always followed—typically, about six months later. Currently, the LEI sits about 8 percentage points above where it was a year ago. We think it could take many months of persistent weakness to trigger a negative signal from this indicator.
Source – RBC Wealth Management, U.S. Commerce Department, The Conference Board Inc.
Two components of the ISM Manufacturing Index, taken together, have a helpful track record of signaling recessions as they begin or shortly before they begin. The difference between the New Orders component and the Inventories component has fallen below zero near the start of most U.S. recessions. But it has also occasionally registered a false positive, signaling that a recession was imminent when none occurred. It also only relates to activity in the manufacturing sector (some 15 percent of the economy) and is derived from a survey rather than hard data. Therefore, we view this as a corroborative indicator—one to pay attention to if other, longer-term indicators are implying a recession is on the way. The spread between new orders and inventories has narrowed from its post-pandemic peak of a few months ago but remains well above zero.
Since the federal funds rate arrived in the early 1950s, there has never been a U.S. recession that was not preceded by the fed funds rate rising above the year-over-year nominal growth rate of the economy (the growth rate before adjusting for inflation). As of year-end 2021, we expect the nominal GDP growth rate to have been about nine percent. The fed funds rate is now sitting at 0.1 percent—that’s 8.9 percent below the run rate of the economy, or thirty-five quarter-point Fed rate hikes from here. This indicator implies borrowing rates are nowhere close to high enough to choke off growth in the U.S. economy. Even assuming the nominal GDP run rate has slowed to six percent by the end of this year and that the Fed raises rates three times between now and then (as indicated at its December meeting) rates will still be far short of what it has taken in the past to make a recession likely. This indicator is not a great timing tool—it has signaled recession several times in the past when none has occurred—but it seems to be a necessary pre-condition of recession which we think makes it worth watching.
The unanimity across our recession scorecard strongly suggests the U.S. economic expansion is unlikely to run out of steam anytime soon. However, alongside all the tailwinds noted above are points of contention that are likely to provoke periodic bouts of investor concern and, perhaps, market volatility. These include the course of both inflation and central bank policy as well as China’s property debt issues, geopolitics, Congressional logjams as the midterm elections draw closer, and the prospect of more unsettling curve balls from the pandemic.
While each of these can present problems for equity markets, we think a recession will require a prolonged period of monetary tightening, which has yet to get underway, suggesting the economy, corporate earnings, and share prices have further to run. In our view, the investment climate favours moderately overweight equities positioning until an economic downturn becomes inevitable.
This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.
The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.
This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.
Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.