Is The U.S. Heading Toward Recession? by Marie M. Schofield, Columbia Threadneedle Investments
- Higher recession risks will center on a further slowdown of economic momentum and continued tightening of financial and credit conditions.
- Any weakness in job growth and consumption will signal the expansion is at extreme risk and hopefully prompt the Fed to delay hiking rates.
- While there is little near-term risk of recession, that risk is likely to grow later this year and into 2017.
Fed Chair Janet Yellen was correct when she recently said that economic expansions don’t die of old age. However, the last expansion ended when the recession began in December 2007, and no one rang a bell. Even the National Bureau of Economic Research, the group that officially dates business cycles, did not alert the public until June 2008, after the recession had started and well after markets had begun to sink. This is the typical process. Post-war business cycles have averaged about six years, with the current one close to seven years old. So during these late-cycle periods, it is prudent to monitor data and various recession risk indicators that have proved useful in the past. Probit modeling (a statistical technique where the dependent variable can only take two values) points to a roughly 30% probability of recession in the next six months, which is still low but higher than at any time this cycle. This is because the economy has lost some momentum and financial conditions have tightened. Unfortunately, there is no set of consistently accurate indicators — experience and judgment play key roles. But using leading and real economy indicators coupled with financial indicators and historical insights can improve signaling.
Many leading indicators of U.S. growth continue to flag warnings with the Conference Board Index and the Chicago Fed National Activity Index seeing downside momentum, but both still some distance from a contraction signal. The manufacturing and industrial sectors are bearing the weight of the adjustment to dollar strength, weak trade and softer global demand. While it may not account for a major share of the economy, manufacturing typically leads — and weakness here often leaks into the larger service sectors. The ISM Purchasing Manager Indexes show the manufacturing sector already in contraction and the service sector activity still in expansion but softer (Exhibit 1). We should note that whenever these and many other measures have shown this much weakness, the Fed is usually either easing monetary policy or beginning new rounds of quantitative easing (QE). But this time, the Fed favors tighter monetary policy.
Exhibit 1: Economic Indicators Are Flagging Caution
Source: Institute for Supply Management, February 2016
Many assume last December marked the start of tighter Fed policy with the first rate hike in a decade. But overall financial conditions have been tightening since the Fed began to unwind unconventional monetary policy back in 2014. We believe the removal of unconventional monetary policy (QE tapering and ending) since that time, in combination with the strong dollar, acted like a tightening cycle even though the Fed only just raised rates. Interestingly, the yield curve, as measured by the difference between the 2-year and 10-year Treasury yields, also started to flatten at that time, which is typically a hallmark of tighter financial conditions. Currently, that spread is near 100 basis points, having just hit an eight-year low. Declines in the benchmark 10-year Treasury yield against Fed rate hikes indicate an advanced tightening cycle and slowing nominal growth. This suggests financial conditions have become much less supportive of economic growth. Keep in mind that shifts in financial conditions work with a lag, so the recent tightening will be felt mainly in the period ahead.
Late stage business cycles are also characterized by uneven shifts in economic data and trends. We know that manufacturing is suffering, inventories are too high, capital spending is scarce, trade remains depressed by constrained global demand, and corporate profits are in contraction. These drags have kept growth and inflation soggy, but not dire. Job gains, consumer spending, and housing are the bellweathers for recession, and these appear healthy even though they have cooled on the margin. Labor markets historically are the last area to weaken, as companies have over-hired, profits begin to crack, and productivity falls even further late in the cycle. Once this occurs, income and consumption growth then begin to slow. For now, these remain the biggest factors floating economic growth. Housing also remains on track with only a slight loss of momentum. Recently, the contraction in manufacturing has eased as dollar strength has abated. But the global growth outlook remains shaky, and recession risks troublesome, although other central banks are easing.
Recession risks – U.S. economy is late cycle
For now, we can say the U.S. economy is late cycle, with recession risks rising but not yet elevated. Higher recession risks will center on a further slowdown of economic momentum and continued tightening of financial and credit conditions. This can result from more onerous lending standards or Fed rate increases that are out of sync with underlying fundamentals. Unless those risks are reversed, the possibility of recession later this year and into 2017 will grow. The Fed is clearly intent on hiking rates this year with a myopic focus on low unemployment igniting wage inflation. Flatter yield curves and lower long-term rates will signal rate hikes are hindering growth. Pay attention to leading indicators, especially job growth and consumption. Any weakness in these metrics will signal the expansion is at extreme risk and hopefully prompt the Fed to hold. Both monetary and fiscal policy will then need to nurse this business cycle. So while there is little near-term risk of recession, that risk is likely to grow later this year and into 2017.