Update 390 — Recessionary Indicators, Pt. 2
What the Best 8-Balls Say about the Economy
While much of the political world is preoccupied with constitutional concerns, the economy also continues to confound. Some indicators point to continued expansion, record low unemployment, and the stock market close to record highs. Others point ominously at the next recession and tell us not if, but when, it will hit.
In this second of two updates on the leading versus lagging macroeconomic metrics, we hope to elucidate the complex current picture as well as one-year outlook for the economy, displaced for now as the nation focuses on impeachment.
Good weekends all…
As we noted in Wednesday’s update, many leading macroeconomic indicators are pointing to a contraction and hinting at a recession. In part two of our coverage of macroeconomic indicators, we review the lagging and coincident metrics that begin showing weakness when a recession is much closer on the horizon, if not already upon us. When these turn, it may be too late to head off a contraction or recession.
Lagging Indicators Holding Steady
Lagging indicators are helpful in diagnosing economic conditions insofar as they show where the economy has been and how the economy has performed in the past under similar conditions. The issue with these indicators is in the name — they lag behind other economic data points that are better bellwethers of the economy in the early stages of a contraction. Lagging does not mean the data is reported after the fact: even leading indicators are reported after they start to change; rather, lagging indicators are more responsive to the business cycle, less predictive, and warning signs may only present themselves after a downturn begins.
- Employment: September’s monthly jobs report was undeniably strong. Nonfarm payrolls rose by 136,000 in September, and the unemployment rate dropped to 3.5 percent — its lowest since December 1969. But unemployment data infamously lags behind other economic trends. The economy worsens, then businesses start laying people off — not the other way around.
Take the Great Recession: when the recession officially began in December 2007, the unemployment rate was 5 percent, well within the bounds of normalcy. In September 2011, more than two years after the recession ended and the recovery began, the unemployment rate was 9 percent. Monthly unemployment figures can however be used as a proxy gauge for recession — some market observers consider that if the unemployment rate rises by more than a quarter point over a one-month period, a recession may have already begun.
- Real GDP: Gross Domestic Product (GDP) measures whether (and by how much) the economy is growing or shrinking. Real GDP is derived by adding the value of national consumption, investment, government spending, and net exports, correcting for inflation. This is an incredibly useful indicator because it looks at what all households, businesses, and the government are spending. A recession occurs when real GDP growth is flat or negative for two consecutive quarters. The U.S. Bureau of Economic Analysis released 2019 Q2 real GDP growth data in late August. Growth increased at an annual rate of 2 percent, a slowdown from Q1 rate of 3.1 percent.
- Inflation: Another closely watched lagging indicator is the inflation rate, measured using the Consumer Price Index (CPI). CPI examines how certain prices on products across the economy change. Economists like to say that prices are ‘sticky,’ and that the CPI reflects, rather than predicts changes to, the business cycle. Changes to CPI do cause ripple effects throughout the economy which can worsen economic downturns: high inflation rates erode consumer and business spending power and, as a result, the average standard of living declines. Spikes in inflation can weaken job growth, labor participation, and GDP growth.
Some experts dispute the notion of inflation being a lagging indicator. Rather than looking at CPI, they point to trends in the Producer Price Index (PPI) and how rising costs throughout the manufacturing pipeline — from raw material to finished goods — escalate faster than the CPI reflects. This, they argue, indicates that future inflation is set to increase. After months of slightly outstripping CPI, PPI unexpectedly fell in September, meaning inflation is still under control, but also indicating weakened aggregate demand and overall slowing growth.
Lagging but Already Flashing Warnings
- Business investment: According to the Commerce Department, new orders for core capital goods fell by 0.2 percent in August, and core capital goods shipments fell by 0.6 percent in July — the sharpest fall since October 2016. Trade tensions between the U.S. and China are likely to blame, and continued softness in business investment will surely be reflected in Q3 GDP growth, which will be reported at the end of this month.
- Service sector: Per the BLS, in FY 2018, the service sector accounted for nearly 80 percent of all jobs in the US, and a little more than 80 percent of US GDP. The ISM Non-Manufacturing Index which measures employment trends, prices, and new orders in non-manufacturing industries reported a figure of 52.6 in September, down 3.8 points from the previous month. September’s report was the 116th consecutive month of growth in the service sector, and while one month’s reading doesn’t make a trend, the September number fell considerably short of analyst expectations and was the lowest reading since August 2016.
Coincident indicators are real-time metrics of the condition of the economy. They occur at approximately the same time as the changes they signal. Personal income rates and personal spending patterns are two of such indicators. They are both procyclical, as they move in the same direction as the economy: when personal income and spending are high, the economy is doing well and vice versa.
- Personal income rates: Personal income rates plus transfer payments tell economists how much money individuals in the economy are actually receiving, which can determine how much they have available to spend. This indicator coincides with macroeconomic performance because it shows, in real time, the capacity of individuals to consume. According to a Reuters report in August, wages increased by only 0.2 percent since 2Q19, and savings fell to $1.27 trillion, the lowest level since November 2018, from $1.32 trillion in June. The anaemic growth in wages should be a concern. Given the record unemployment rate, you would expect we are close to full employment and this should be reflected in higher wages.
- Personal spending patterns: Personal spending correlates directly with the state of the economy, because increased spending boosts economic activity, job creation, and, eventually, wages. Though personal spending bolstered the 2018 economy, in September of this year, personal spending dropped to its lowest rate since February. Americans are tightening their belts, and might be losing confidence in the economy. One figure to watch for in the event of a downturn is credit card debt. 39 million U.S. adults have been in credit card debt for at least two years, and with interest rates near all time highs, averaging 17.61 percent, and delinquencies increasing, this population will be one of the first groups affected in the next recession.
Lagging and coincident indicators may not have the predictive value of leading indicators in predicting a recession on the horizon, but they can help confirm or dispel patterns, and reflect real-world responses to the business cycle. Topline numbers seem good on the surface — unemployment is low, inflation is under control, and the economy is growing. But digging deeper, we find some rot.
On the surface, strong economic fundamentals may present a rosy picture — manufacturing, business confidence, and the bond market are telling a different story. These factors combined, we are likely 12-18 months away from an economic contraction of some sort. Because unemployment is low and growth is stable; historically, this portends a mild recession.
We may not have the fiscal space to maneuver in the event of a recession. Though the 2017 GOP tax cuts did not overheat the economy, they also did not deliver on long-term, sustainable growth. Concerns remain about timing: why not save fiscal ammunition for when the economy needs it, rather than during a period of steady growth? We may not be able to afford another $2 trillion tax cut, even if such stimulus is desperately needed, and monetary policy will be theoretically constrained by low and lowering interest rates.
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