Update 389 — Recessionary Indicators, Pt. 1
What the Economic Tea Leaves Say Today
Over the next two updates, we will look at macroeconomic indicators of the end of the current post-crisis expansion — leading vs. lagging, from coal mine canaries, to red herrings, to black swans.
The political implications of an economic reversal of fortune could be sizable, in electoral terms but also in economic policy outcomes, many of which were hinted at in last night’s Democratic presidential debate in Ohio. The causes, timing, geographical and sectoral location, and severity of any such reversal intimated by the indicators will color next year’s vote.
What do the tea leaves say today about the economy 12 months out?
At the beginning of each month, government entities and private market participants release a trove of data points pertaining to the state of the national economy. These include all-important unemployment figures, wage growth, retail sales, and more. Data from September gives the impression of an economy running smoothly, with other economic variables now signaling trouble on the horizon.
In our first of two perspectives on trends and indicators, we review an inventory of the leading macroeconomic indicators and what they mean for the trajectory of the economy. In the next update, we will look at not at the forecast but at what the lagging and coincident indicators are already signaling — can anything be gleaned, and are we heading for a recession?
Leading Indicators: Flashing Red
- Manufacturing: Last Tuesday, the Institute of Supply Management published its September Manufacturing Purchasing Managers’ Index (PMI) reading coming in at 47.8 percent — the lowest since 2009 and down from 49.1 percent in August. The ISM index is a widely-used indication of economic trends in the manufacturing and service sectors and a reading below 50 percent indicates a contraction in business activity. Manufacturing accounts for a small fraction of the domestic economy — around 11 percent — but weakness in this area can be signal. This slowdown in business activity in the sector was reflected in Friday’s manufacturing jobs number that showed a negative 2,000 month-over-month change.
- Cass Freight Index: This week, the Cass Freight Index, a lesser-known but critical barometer of the overall shipping and haulage industry that measures aggregate U.S. freight delivery volumes, recorded its tenth consecutive month of annual shipment declines for September. The index turned negative in December 2018, and September shipments showed a 3.4 percent decline year-over-year. The index has gone negative before without leading to an economic contraction, but ten consecutive months of negative shipments have some market observers concerned: “the shipment index has gone from ‘warning of a potential slowdown’ to ‘signaling an economic contraction,’” wrote Donald Broughton, the September Cass Freight Index Report’s author.
Source: Cass Freight Index Report
Leading Indicators: Flashing Yellow
- Bond Market: We have covered the signal of the yield curve a number of times in recent updates as it is a reliable leading indicator of recession. The most closely watched measures of the yield curve are the differences between the yield on the 3-month Treasury bill and the 2-year Treasury bond versus the 10-year bond yield. Last week, the 3-month/10-year curve reverted to its normal upward slope, but some market participants are wary of saying that the bond market is no longer predicting a recession, in part because the 3-month/10-year yield curve was inverted for longer than preceded previous recessions.
- Weekly Hours: Per the BLS, nearly 59 percent of the American workforce are hourly workers. A drop in weekly hours is a leading indicator of a recession, as employers are likely to reduce worker hours before laying them off. A reduction in hours also has a compounding effect on the economy, as workers whose hours are cut get smaller paychecks which reduces their spending potential.
The average hours worked for production workers has stayed relatively consistent during the recovery, hovering around 42 hours per week, rising to a high of 42.4 hours per week in April 2018, but the sector has seen a precipitous decline since then, falling to 41.5 last month — the lowest since January 2014. In addition, the average workweek in the private sector as a whole has dipped to 34.3 hours in July, down from 34.5 hours in March — the lowest level and largest decline since early 2017.
Leading Indicators: Holding Steady
- Consumer Confidence: Consumer spending makes up about 70 percent of the US economy, so it follows that when confidence is low, a recession is not far behind. Traditionally, consumer confidence falls sharply about three months before a recession hits. Per the University of Michigan, consumer sentiment rose to 92 in September from 89.8 in August. Despite the positive headline figure, 38 percent of consumers expressed concerns about the negative impact of tariffs, the highest percentage since March 2018. As trade tensions continue to cast a shadow over the economy, consumers may only get more skittish over trade issues as the holiday season fast approaches.
- Corporate Earnings: Corporate profit margins are a good leading indicator of the business cycle because they are reflective of underlying aspects of the economy. Narrowing profits can also result in decreased capital investment and hiring in the future. So far, margins for large-cap companies are showing resilience to much of the geopolitical uncertainty and trade tensions, but margins for small-to-medium-size businesses are feeling the strain, per the BEA’s National Income and Product Accounts (NIPA) profit margins report. 77 percent of Americans are employed by firms with fewer than 500 workers. If margins at these firms continue to be squeezed, layoffs may ensue, having ripple effects throughout the rest of the economy.
- Capital Markets: The big indexes — S&P 500 and the Dow Jones — recently reached record highs since the stock market rallied from its December lows. But percentage gains this year conceal the fact that the indexes are actually little changed since this time last year. The markets are one of the more consistently referenced indicators by the president as a gauge on how well the economy is doing.
The markets recovered since the Fed changed its direction on interest rate hikes, but trade war headlines and developments have created a substantial amount of volatility in recent months. While the stock market plays an important role, it is not as linked to the real economy as one might think. What to watch for: before a sustained contraction in the economy, the equity market will likely experience a substantive decline, in the order of 20 percent or more.
No Black Swan Around, But Troubles Abound
High-frequency data that show monthly and weekly changes in the economy can often be misleading as to grander conclusions about the direction of the overall economy. But some of the incoming data show weakening in key sectors like manufacturing and agriculture and paint a not-so-rosy picture of the rest of the economy. Some market observers are already ringing alarm bells.
In the next update, we will take a look at what some of the other coincident and lagging macroeconomic indicators are telling us about short-term and long-term economic growth. Are any of these indicators showing their cards at this stage in the cycle, and are there any takeaways as we approach November, the beginning of the one-year presidential election countdown?