Predicting the weather proves to be a challenging task. While we can anticipate an impending storm, the precise timing and the extent of its impact remain uncertain. Despite analyzing copious amounts of data and making forecasts, it’s evident that discerning the exact course of a storm remains an elusive endeavor.
Likewise, forecasting an upcoming recession shares some similarities. It’s relatively straightforward to foresee an impending economic downturn, as it’s not a question of “if” but rather “when” and “how severe.” The primary focus lies in determining the timing – how soon are we approaching one of the most anticipated recessions in history? This question is paramount for most investors, as the market sentiment has shifted from a belief that a profound recession is imminent to a realization that the Federal Reserve might successfully engineer a gentle economic slowdown.
This month we review the significant economic data commonly used to determine the health of the economy and its present stage in the cycle. The objective is not to draw definitive conclusions, but rather to gain insights into the direction indicated by the data.
We will begin by looking at the individual data components that make up the Conference Board Leading Economic Index, a widely regarded composite index.
We will follow with a review of the economic data the National Bureau of Economic Research (NBER) uses to determine the start and end of a recession. The group relies heavily on trailing data, but we will look at what signals the data is sending.
Each economic indicator will be graded using the following scale –
Conference Board Leading Economic Index (LEI)
The Conference Board LEI is an economic indicator published by The Conference Board, a non-profit research organization. The LEI is designed to provide insights into the future direction of the overall economy. It is considered a composite index because it combines several individual economic indicators into a single measure.
- LEI is used to predict the turning points in the business cycle. By analyzing trends and changes in the LEI, economists can identify potential shifts in economic activity before they occur.
- With very few exceptions over the last 50 years, every time the index has hit -1, the US economy was in a recession or on the brink of one.
- The index hit -1.2 in February of this year and is currently at -0.7.
Below are the ten components of The Conference Board Leading Economic Index®. To start, we will focus on the first four as these are currently sending the most significant warning signals. We will then examine the remaining six to determine what the Conference Board’s LEI is telling us at this time.
- Average weekly hours production
- ISM® New Orders
- Leading Credit Index
- Yield Curve – Spread between 10T and 2T
- Initial jobless claims
- Building permits
- Consumer confidence
- Manufacturers’ new orders (consumer goods)
- Manufacturers’ new orders (non-defense)
- S&P 500® Index
Average Weekly Hours Production: YELLOW
“Employment, weekly hours, and overtime hours are all highly cyclical indicators of economic activity. Of these three measures of labor inputs, changes in employment, however, tend not to be a firm’s first response to changes in demand due to the costs of labor adjustment. As a result, firms typically adjust their employees’ hours of work before changing employment. This response has been so cyclically consistent that average weekly hours of production workers has appeared on the list of leading indicators since it was first developed by Mitchell and Burns (1938).”
Source – Federal Reserve Website
- Over the past 7 recessions, average weekly hours production has decreased on average 5.3% from peak to trough.
- There have only been a few ‘false’ signals, such as in 1996.
- While the Covid recession experienced a dramatic drop in weekly hours worked, it was driven by the quarantine and bounced back quickly.
- Generally, a 3% decrease is associated with a recession… the index is currently down 2.4%.
ISM New Orders: ORANGE
The New Orders Index reflects the demand for manufactured goods and provides a glimpse into future economic activity. It captures the intentions of businesses and their customers to purchase goods, indicating potential growth or contraction in the near term. By tracking changes in the index, analysts can anticipate shifts in production levels, inventory management, and overall economic performance.
The ISM New Orders Index has historically exhibited a strong correlation with other key economic indicators, such as industrial production, employment, and GDP growth. As a leading indicator, it often precedes changes in these broader measures, providing valuable signals about the direction of the overall economy.
A reading above 50 indicates expansion in new orders, while a reading below 50 suggests contraction.
- The data has a very clean trend; when ISM New Orders drops below 40 we are in (or very close to) a recession.
- There have been no false signals in the past 50 years.
- The latest reading is 42.6.
Conference Board Leading Credit Index: YELLOW
“This index is consisted of six financial indicators: 2-years Swap Spread (real time), LIBOR 3 month less 3 month Treasury-Bill yield spread (real time), Debit balances at margin account at broker dealer (monthly), AAII Investors Sentiment Bullish (%) less Bearish (%) (weekly), Senior Loan Officers C&I loan survey – Bank tightening Credit to Large and Medium Firms (quarterly), and Security Repurchases (quarterly) from the Total Finance-Liabilities section of Federal Reserve’s flow of fund report. Because of these financial indicators’ forward looking content, LCI leads economic activities.”
Source – Conference Board Website
- The index can be a little noisy, so we looked at the 6-month moving average.
- Every recession over the last 30 years (since the index was first published) has been accompanied by the moving average breaching 2.
- There is only one period over the last 4 recessions (end of 1998 and beginning of 1999) the moving average exceeded 1 and a recession didn’t follow. The index is currently at 1.
Yield Curve – Spread between 10T and 2T: RED
The 10/2 spread is influenced by market expectations and investors’ outlook on the economy. When the spread widens, it suggests that investors are demanding higher yields for long-term bonds, potentially anticipating stronger economic growth and inflation in the future. Conversely, a narrowing spread may indicate investor concerns about economic prospects or expectations of lower inflation.
Historically, changes in the 10/2 spread have shown some predictive power for future economic activity. In particular, when the spread becomes negative or inverts (i.e., short-term rates exceed long-term rates), it has often preceded economic downturns or recessions.
- Though the focus is usually on the yield curve inverting, it almost always normalizes ahead of the following recession.
- On average the spread turns back positive about 4 months BEFORE a recession begins.
- The current spread is -100bps.
- The yield curve is pointing towards a recession, but not in the next 6 months unless the spread normalizes quickly.
Initial Jobless Claims: YELLOW
The initial jobless claims data reflects the number of people filing for unemployment benefits for the first time. It provides an indication of the number of individuals who have recently lost their jobs and are actively seeking unemployment assistance. This data point can reflect layoffs, business closures, or other factors affecting employment. It offers insights into the cyclical fluctuations of the labor market and can signal shifts in hiring patterns or labor market trends.
- The jobless claims data is less significant than the figures in the monthly jobs report. But since it is released weekly it can provide a timely signal to a softening jobs market.
- The data appears to have bottomed and is trending higher, but this indicator has sent false positives in the past.
- In isolation, the pickup in initial claims is not significant enough to stroke recession concerns.
Building Permits: YELLOW
An increase in building permits suggests that construction activity is likely to rise in the future. It serves as a leading indicator of the health and expansion of the construction sector, which has significant implications for employment, investment, and overall economic activity.
- While we have seen a small bounce recently, the overall trend has been sharply lower in the face of tighter financial conditions combined with an uncertain outlook.
Conference Board Consumer Confidence: YELLOW
Consumer spending is a key component of economic growth, and changes in consumer confidence often precede shifts in spending habits. When consumer confidence is high, individuals are more likely to feel positive about their financial prospects, leading to increased willingness to make major purchases and discretionary spending. On the other hand, declining consumer confidence can signal reduced spending and caution among consumers.
- As you would expect, consumer confidence starts to fall as economic conditions weaken into a recession.
- The index is currently trending down, but far from plummeting.
Manufacturers’ New Orders (Consumer Goods): GREEN
New orders for consumer goods and materials serve as a leading indicator for production and business activity. When manufacturers receive more orders, they are likely to increase their production to meet the demand. This, in turn, leads to increased employment, higher capacity utilization, and potentially more investment in the manufacturing sector. Therefore, changes in new orders can provide early signals of economic expansion or contraction.
- Monthly data can be volatile, so we looked at the 6-month moving average.
- The data is starting to roll, but does so frequently without an associated recession.
Manufacturers’ New Orders (Non-Defense): GREEN
New orders received by manufacturers reflect the level of investment in the production of goods. An increase in new orders suggests that businesses are expanding their operations and investing in the production of goods. This indicates a positive outlook for business investment and economic growth. Conversely, a decline in new orders may indicate a slowdown in business investment, which can have implications for economic activity.
- Similar to the graph above for Manufacturers’ New Orders for consumer goods, the data is showing signs of softening but is not yet trending sharply lower.
S&P 500 Index: YELLOW
The performance of the S&P 500 is closely tied to investor confidence and sentiment. When the index is rising, it indicates positive investor sentiment and optimism about future economic prospects. Conversely, a declining or volatile S&P 500 can signal increased investor caution, uncertainty, or concerns about the economy.
- Equities are currently up about 100% from COVID recession lows.
- The 2022 selloff was driven by tighter financial conditions and recession fears, but markets have largely retraced in 2023 and are down only 6.5% from the March 2022 peak, as the odds of a “soft landing” improve.
National Bureau of Economic Research (NBER)
The organization tasked with defining the start and end of a recession is the National Bureau of Economic Research, so we will continue by looking at the data points they consider.
Note, there is always a lag between when a recession starts and when the NBER announces that the recession officially began. Said another way, the NBER is looking at trailing data and only knows a recession began after the fact. Over the previous 6 recessions the NBER confirms a recession over 7 months after the recession began on average.
From the NBER: The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies.
- Nonfarm payrolls
- Retail sales
- Personal income less transfers
- Industrial production
- Core PCE
- Unemployment rate
There is no fixed rule about what measures contribute information to the process or how they are weighed in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.
Nonfarm Payrolls: GREEN
The Total Nonfarm Payroll Employment provides a snapshot of the overall job market and serves as an important indicator of economic health and labor market dynamics. A higher number of jobs added signifies growth and strength in the labor market, while a decline in employment indicates job losses and potential economic challenges.
- Over the last 3 months, NFP has averaged over 240,000 jobs added each month and is not sending strong recession signals.
- The average NFP print over the last 10 years is roughly 170,000 jobs added per month.
Retail Sales: YELLOW
Since consumption expenditure by households is the largest component of US GDP, market participants pay close attention to the retail sales data. Retail sales is also important in assessing inflationary pressures in the economy. Rising retail sales may indicate increased demand, which can potentially lead to higher prices if supply struggles to keep pace. Central banks closely monitor retail sales data as part of their decision-making process regarding monetary policy.
- The data is very “noisy” from month to month, so we smooth it out by using the 12-month moving average.
- While still positive, retail sales have seen a significant slow down over the past year, but is not screaming recession warnings yet.
- Much of the slowdown is likely attributed pandemic related stimulus running out in conjunction with higher prices.
Personal Income Less Transfers: GREEN
Real Personal Income Less Transfers is an essential component in determining personal consumption expenditures, which is a key factor in calculating Gross Domestic Product (GDP). By tracking changes in real personal income less transfers, economists and policymakers can gauge the potential impact on economic growth and adjust policies accordingly.
- The trend generally starts to plateau ahead of recession, though does not pivot until the recession is underway.
- We have seen a similar plateau in the data over the past few months, but is too soon to make a definitive statement regarding a recession.
Industrial Production: GREEN
Industrial production is a crucial indicator of overall economic growth. It measures the volume of physical output generated by industries, including manufacturing, mining, and utilities. Changes in industrial production can reflect shifts in business activity, investment, and productivity. Increasing industrial production often indicates economic expansion and can contribute to GDP growth.
- The index is “noisy”, so we are looking at the 3-month moving average.
- The moving average typically turns negative at the onset of a recession.
- The moving average is currently positive, at 0.16, but is trending lower.
CORE Personal Consumption Expenditure: YELLOW
The PCE index covers a wide range of goods and services that individuals and households purchase, including healthcare, housing, and financial services. This comprehensive coverage seeks to provide a more accurate representation of consumer spending behavior compared to other inflation measures, making PCE (core) the Fed’s preferred inflation gauge.
PCE uses a chain-weighted index, which considers changes in relative prices and consumer behavior over time. This feature makes it responsive to shifts in spending patterns and reduces potential biases in inflation estimates.
- Core PCE remains at levels not seen since the 1980’s, but is trending lower.
- Year-over-year PCE is currently at 4.1%, still double the Fed’s 2.0% target.
Unemployment Rate: GREEN
The unemployment rate is a crucial economic indicator that reflects an economy’s health, labor market conditions, and policy effectiveness. It influences consumer spending, inflation, social stability, and investment decisions. Governments, businesses, and individuals rely on it to assess economic performance, make policy interventions, and gauge market opportunities. A low unemployment rate signifies economic growth, while a high rate may indicate recession or challenges for job seekers.
- The resilience of the labor market in the face of tighter financial conditions has been a challenge for the Fed in its inflation battle.
- The unemployment rate is currently at 3.5%, only slightly higher than the all-time low of 3.4%.
What does the data indicate? The NBER components aren’t sounding an urgent alarm. This isn’t particularly surprising, given that the NBER’s data primarily reflects historical trends, and the job market has displayed resilience despite the Federal Reserve’s interest rate adjustments.
Turning to the LEI components, which possess a more forward-looking nature, they aren’t signaling an immediate recession, but they are certainly conveying a more pronounced caution compared to the NBER indicators. Notably, the 10/2 yield curve spread and ISM New Orders data are showing the strongest indications of potential economic fragility, although most of the other components are also advising prudence. It’s worth noting that the 10/2 spread, while significantly inverted, historically shifts to positive territory before a subsequent recession. Therefore, in terms of timing, this particular data point isn’t indicating an imminent recession.
Bottom Line: These forward-looking indicators are signaling potential weakness, but not an imminent recession. This aligns with our long-standing belief that a recession is coming Q2 or Q3 of next year. While the depth of the recession is subject to debate, we feel that the restrictive monetary policy will ultimately push the economy into a period of contraction.