By Jim Allworth
The U.S. and global economies are signaling there are additional equity market gains to come in 2018 and probably beyond.
Since WWII, all prolonged U.S. equity bear markets—declines of 20% or more—and related slumps in corporate profits have been associated with recessions. The only exception was the crash of 1987, which was short-lived and featured no associated profit decline. The stock market typically peaked right before a recession or in the early stages of one. Most other equity markets tend to follow the same pattern—bear markets come with recessions.
Following we take a look at the status of our favorite recession indicators and other data that can provide clues about the durability of the economy and, by proxy, the equity bull market.
Beware a credit squeeze
Since WWII, U.S. recessions have always been preceded by the arrival of restrictive credit conditions when loans have become prohibitively expensive for borrowers and difficult to get at any price. The gap between short-term and long-term interest rates has been a reliable guide to the ease or tightness of credit conditions.
Long-term rates are usually higher than short-term rates. But during Fed tightening, the gap between short-term rates and longer-term bond yields usually narrows, indicating that credit (liquidity) is in short supply. In the postwar era, whenever the gap between 90-day Treasury bill rate and the 10-year Treasury note yield has narrowed to less than 30 basis points (bps) the economy has weakened significantly. All recessions since the war were preceded by such a tightening.
Today the gap is about 115 bps, comfortably above the “less-than-30 bps” danger zone, and is still within the range that historically delivered attractive equity returns (see top chart).
S&P 500 returns by yield curve steepness
Yield curve measured by 10-year minus 3-month yields (in bps)
Note: Data represents the average of S&P 500 returns 12 months after the yield curve observation.
Source: National research correspondent, Haver Analytics, Standard & Poor’s, Federal Reserve; data from 1954 to November 13, 2017
GDP wilts when the yield gap approaches zero
10-year to 3-month Treasury yield curve and U.S. real GDP growth (%)
Source: RBC Wealth Management, Bureau of Economic Analysis, Federal Reserve; quarterly data through Q3 2017
The unemployment rate tells the tale
The unemployment rate tends to move up steadily upwards in recessions and downwards through economic expansions. Unemployment turning higher on a trend basis is usually one of the most unequivocal signals that a recession has begun or is about to begin.
The unemployment rate has been trending lower since shortly after this economic expansion began in late 2009. Today, at 4.1%, it is about one-tenth of percentage point away from an 18-year low and only six-tenths above a 50-year low.
In our view, it will be some time before the unemployment rate turns convincingly higher, a negative signal that a recession lies immediately ahead. But when the trend in the unemployment rate does turn higher, history suggests that investors should strongly resist the urge to rationalize away the uncomfortable message it will be conveying.
Jobless claims give early warning
Unemployment insurance claims always signal the arrival of a U.S. recession in advance. Claims have typically set a cycle low one-to-four quarters before a recession gets underway. And the trend of claims reverses and pushes higher at least a few months ahead of a recession.
Currently, there are more than 6 million jobs available and unfilled in the U.S. Hiring is elevated while layoffs remain low. Fifty-nine percent of small and medium-sized businesses report they tried to hire last month, but 88% of those failed to find qualified candidates.
Jobless claims are at a new all-time low when described as a percentage of the labor force. The smoothed trend is decisively downward. We believe it would take several quarters of deterioration before this data would signal a U.S. recession was imminent.
Jobless claims in a strong downtrend
U.S. unemployment insurance claims
Source: RBC Wealth Management, Federal Reserve Bank of St. Louis (FRED); data through 10/31/17
Leading Index leads the way
The U.S. Leading Economic Index from the Conference Board has done a good job of flagging the rising risks of a recession’s arrival in advance. The Board’s 10-factor model, incorporating proprietary factor weightings, is based on broader, more diverse inputs, engendering a high level of confidence as a result.
The year-over-year change in this index has always fallen below minus 5% immediately before or a few months after a recession has started. Any drop below zero should be noted. Today the year-over-year percentage change in the index sits at plus 4%. In our judgment a persuasive negative signal from this indicator is nowhere in sight and is unlikely to be for some time.
A recession unfolds when this indicator plunges
Conference Board U.S. Leading Economic Index of 10 economic indicators (y/y % change)
Source: RBC Wealth Management, Bloomberg; data through 9/30/17
Interest rates far from restrictive
“How high do rates have to go before they choke off growth in the economy?” is a difficult question to answer after 70 years during which short-term interest rates “round-tripped” from 1% in 1950, to 18% in 1980, and back to 1% today.
What we can say is that over the past 60 years, the Federal Funds rate has climbed above the nominal growth rate of the economy a few months prior to the onset of each recession. (The “nominal growth rate” is the rate before adjusting for inflation. The rate that is usually reported is the “real rate” which has the effect of price inflation removed.)
Today, the effective fed funds rate is 1.10% and the year-over-year nominal growth rate of the U.S. economy is 4.1%. So if the nominal growth rate flat-lined over the next two years then the fed funds rate would have to rise by more than 3% for that condition to be satisfied. That’s 12 hikes of 25 bps. Given the Fed’s guidance that after a December increase, the FOMC expects to hike three more times in 2018, it would seem it will be quite a while before rates reach a critical level.
Even if the nominal growth rate declined to just 3%, it would require more rate hikes than the Fed currently has penciled in through the end of 2019.
Stockpiles and demand
The ISM manufacturing index is closely watched as a harbinger of future economic activity. However, in our view, while it tells a lot about current activity it is much less useful as a leading indicator. But two subcomponents, the New Orders index and the Inventory index, when combined do tell something useful about where the economy is heading next. Whenever an index comprised of the New Orders index minus the Inventories index falls below zero, recession risks are elevated. This measure has occasionally given a false signal – calling a recession when none arrived – but it has never failed to give some useful forewarning of every recession since the late 1940s.
The current reading from this indicator is a comfortable plus 8.6%.
“All clear” for now
ISM Manufacturing New Orders Index minus Inventories Index (3-month moving average)
Source: RBC Wealth Management, Institute for Supply Management, Bloomberg; data through 10/31/17
Early warning indicators all flashing “green”
For much of the postwar era not only the U.S. equity market, but those of most developed economies, have moved to the cyclical drumbeat of the world’s largest economy. For a global equity investor, seeing a U.S. recession coming in advance or at least acknowledging one when it arrives have been important components in the risk management toolbox.
Several of the indicators cited above have outstanding track records at giving such advance warning. All of them, taken together, in our judgment, provide a valuable risk assessment framework.
As things stand, none are giving any indication a U.S. recession is on the horizon. We expect it will be some time before they do. Until then, as has been the case for several years, we think the appropriate course is to give equities the benefit of the doubt.
Non-U.S. Analyst Disclosure: Jim Allworth, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc., contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.