Investors are nervous about the economy. The year-end volatility in U.S. stocks has erased all of 2018’s stock market gains, causing investors to worry about what to expect in 2019. Rising interest rates coupled with…
Investors are nervous about the economy.
The year-end volatility in U.S. stocks has erased all of 2018’s stock market gains, causing investors to worry about what to expect in 2019. Rising interest rates coupled with an international trade war and uncertainty in Washington has some investors concerned that the 10-year-old bull market may finally be coming to an end. Bank of America economist Michelle Meyer recently compiled a list of frequently asked questions and answers related to a future economic slowdown. Here are nine questions investors should be asking when trying to identify signs of the next recession.
Has the recovery lasted too long?
It’s been roughly a decade since the Great Recession, but Meyer says the recovery’s duration may be deceptive. The post-recession recovery has lasted 113 months, making it the second-longest in history. If the economy continues to grow, it will set a record in July 2019. However, real average annual GDP growth during the recovery has been just 2.3 percent compared to 2.9 percent in the previous recovery and 3.6 in the expansion period before that. One reason for the slow growth has been declining government spending, which accounts for around 20 percent of GDP.
What are the recession models predicting?
An economic model by the Federal Reserve Bank of St. Louis incorporates U.S. nonfarm payrolls, industrial production, real personal income and real manufacturing and trade sales. The St. Louis Fed model currently suggests there is only a 0.24 percent chance of an imminent U.S. recession. Bank of America’s predictive recession probability model relies on the spread between three-month Treasury bill rates and 20-year Treasury note rates. The model currently suggests there is a 26 percent chance of a recession within the next year. That probability remains relatively low, but it’s up 4 percent in the past month.
What Is big data saying about the economic cycle?
Bank of America recently applied a machine learning algorithm to more than 100 economic variables dating back 50 years to gain insights into the current economic cycle. The algorithm determined the current cycle is unique and used the data to sort through the past 50 years of economic cycles. It sorted the cycles into three stages — boom, soft patch and recession. Each of the seven U.S. recessions of the past 50 years have been followed by boom periods within the next five years or so, but the algorithm has classified the entire period since 2008 as a soft patch with no boom.
What should investors be watching?
The National Bureau of Economic Research is a nonprofit organization that officially classifies U.S. recessions. However, Meyer says there are a number of data points to watch to gain insight into the NBER model in advance. She says initial jobless claims, auto sales, industrial production, the Philadelphia Federal Index and aggregate hours worked are the five economic indicators that are the most predictive of the NBER’s definition of a recession. The good news is that all five of these indicators are currently well above levels seen prior to previous recessions, indicating a low probability.
How do recessions begin?
Meyer says recessions are typically triggered by market excesses that produce economic shock. In the past, these excesses have included overheating in cyclical market sectors, commodity price shocks and monetary policy missteps. Fortunately, Meyer says there is currently no market excess based on residential investment. The S&P 500’s cyclically adjusted price-earnings ratio is extremely high relative to its historical average, but it’s less than its peak in 2001. Oil price spikes have preceded most recent U.S. recessions, but Meyer says the U.S. becoming a net exporter of oil may change that dynamic.
How important is the housing market?
Meyer says the housing market has been slow during the current market cycle, and there is currently no indication of excess. In contrast to the period before the Great Recession, the current housing market may be undersupplied rather than oversupplied. One positive sign is that the average household mortgage debt as a percentage of disposable income is much lower than it was before the last recession. In addition, average outstanding home equity lines of credit have declined in recent years. Meyer says another drop in housing prices will not have nearly the adverse impact it had in 2008.
What does the corporate profits cycle indicate?
Meyer says U.S. corporate profits tend to peak about four quarters prior to GDP growth, making them a useful indicator of recessions. But corporate profit peaks have also generated two false positive recession indications since 1953. While the percentage of non-earning companies in the Russell 2000 index has increased to levels typically seen prior to recessions, Meyer says Bank of America’s U.S. corporate earnings regime indicator suggests the economy is currently in in the mid-to-late stages of economic expansion and nowhere near a recession. Corporate profits were up around 25 percent in the third quarter.
How do consumers feel?
Consumer demand makes up 70 percent of U.S. GDP, and consumer confidence is the primary driver of the U.S. economy. The Conference Board and University of Michigan’s consumer confidence indices indicate confidence is at or near its cyclical peak. Jobs data are likely driving that confidence. Meyer says the fact that there are more U.S. job openings than unemployed workers has led U.S. consumers to feel secure about their ability to find jobs. Only 12 percent of consumers currently believe their financial situation will be worse a year from now.
Does the rest of the world matter?
Meyer says the U.S. has relatively low exposure to global demand compared with other leading economies. She says the likelihood that a slowdown in U.S. export demand stemming from a trade war would trigger a U.S. recession is fairly low. The larger concern is whether or not a global slowdown would weaken the U.S. economy indirectly by reducing U.S. business spending and investor confidence. In late 2015, U.S. stocks sold off sharply during a Chinese market drop. In that sense, U.S. investors can’t simply ignore the global economy’s potential domestic impact.