August was a tough month for equity investors. Global stocks fell 7% in the first few days of the month as fears of a slowdown caused investors to seek safety. At the same time, $47 billion flowed into global bond funds. This demand pushed longer term yields down to abnormally low levels and even negative in some countries. In the US, the 2-year to 10-year Treasury yield curve inverted for the first time since 2007, stoking fears of a recession.
To help us assess the macroeconomic environment and put the recession fears into perspective, we look at our dashboard, which continuously monitors numerous metrics that provide insights into the health of the economy. Today, five metrics are particularly telling.
FROM OUR DASHBOARD
Before we review these five metrics, let’s discuss our overall conclusion: We do not see conditions that suggest a recession in the near term. While the US economy is decelerating, and we see more risks now than we did just several months ago, GDP growth this year and next should be approximately 2%, which is solid in an overall sluggish global landscape. The crucial metric, however, is the labor market which is robust and, as a result, strong consumer spending underpins the US economy.
During August, the closely watched 2-year to 10-year Treasury yield curve inverted, triggering concern that a recession is on the horizon. The yield curve, however, is not a perfect indicator of recession—it’s been wrong before, and may be again this time, for several reasons. The prevalence of quantitative easing and low/negative interest rates around the globe are anchoring US long rates low. Even with yields of only 1.5%, with approximately $17 trillion of global debt trading with a negative yield, the 10-year Treasury is quite attractive for global investors. This demand is pushing US long rates even lower. So the recent inversion obviously is being influenced by global supply and demand, as well as fears of a recession.
When an inverted yield curve does precede a recession, however, it doesn’t automatically signal the end of a bull market. Although an inverted curve has accurately predicted a recession five out of six times since 1978, over an average of 11 months after an inversion, the stock market rallied by an average of 14%. So, there may still be a tailwind for the stock market, even if a recession is in the offing.
Housing is a key part of the economy and its declines are a component of most recessions. In fact, the number of housing units permitted to be built has dropped well in advance of every recession since 1970. But building permits frequently decline outside of a recession, reducing its signal strength. To account for this, we juxtapose it against other metrics from our dashboard.
This year, building permits declined 5% year-over-year in January, and hovered below last year’s levels for the first six months this year. However, permits rose in July. We believe lower mortgage rates may spur them back into positive territory going forward.
The PMI Composite Index is based on a monthly survey of manufacturing new orders, production, employment, supplier deliveries, and inventories. It’s highly correlated with GDP, and since it comes out more often, PMI is a useful leading indicator.
In the US, a PMI measure below 50—the level of contraction—has occurred ahead of or at the start of almost every recession since World War II. The only times it failed to warn of a downturn were when a recession started outside of manufacturing—the dot-com bubble of the 2000s—or with an unexpected economic shock—the oil crisis of the 1970s.
Since the economic deceleration began last year, global PMIs have been softening and now indicate a downturn in global manufacturing. The US PMI fell from 60.8 in August 2018 to 49.1 in August 2019 (Display). At current levels, the PMI suggests the US manufacturing economy, too, is contracting. Given the manufacturing sector’s close connection to international trade, there is little doubt that the deceleration in activity over the last year is due to the trade dispute. Of all the metrics we watch closely, the PMI is the best indication yet that the US economy is in danger of tipping over into recession … but does not suggest that we are already there.
Corporate margins usually fall when labor and input cost pressures are building, which typically occurs late in an economic cycle. When margins are contracting, companies tend to pull back on spending and may even reduce costs—often through workforce cuts—which may ultimately increase unemployment and hurt consumer spending.
In both the first and second quarters of 2019, the aggregate operating margin of the S&P 500 fell by 60 basis points, reducing profits by close to 4%. So far, this decline has not been enough to spark an “earnings recession,” but it has almost entirely offset the benefit of sales growth. Some of the margin degradation is from higher tariffs, while the balance is from normal wage and cost pressures, which have increased in the current tight labor market. Consensus expectations are for another 40-basis-point decline in the third quarter followed by a 70-basis-point improvement in the fourth quarter.
Business and Consumer Confidence
When business confidence erodes, corporate conservatism often sets in, stoking a feedback loop in which businesses reduce spending, investment, and hiring, ultimately lowering the confidence of their workers—the consumers—who in turn hold back spending, catalyzing a recession.
Dating back to the late 1970s, CEO confidence, as surveyed by the Conference Board, has rarely been at today’s low levels outside of a recession (Display). We worry that business confidence may worsen further if economic data come in weaker than expected, or fears of a prolonged trade war produce enough uncertainty that executives dial back their plans, resulting in lower investment, growth, and hiring.
Like business confidence, consumer confidence also tends to fall ahead of a recession. But it leads by less time—it tends to weaken along with the labor market, stock indices, and other economic data. Right now, consumer spending, which is roughly 69% of GDP, looks solid. However, we wouldn’t expect to see a meaningful downturn in consumer sentiment until the brink of a recession. And if we do avoid a recession, the strength of the consumer will be a major factor.
THE BROADER VIEW
Recessions typically come from one of several places. Imbalances in labor or capital—such as an overinvestment in productive capacity—or financial imbalances—such as the boom in subprime lending in the mid-2000s—can flow through to the overall economy and cause a recession. Policy errors can also lead to recession; for instance, the trade policy and monetary policy widely blamed for the Great Depression. Finally, unanticipated shocks, such as the oil crisis of the 1970s, can be the spark.
At the moment, we are not overly worried about the potential economic or financial imbalances on our radar. We also believe global central banks are more likely to ease rather than tighten. Unanticipated shocks are just that—unexpected and very difficult to forecast. As a result, our broader view is that a recession is not likely in the near term, but the risks have increased and we’ll watch closely for weakening trends over the foreseeable future.
For more on trends in the economy, markets, and asset allocation for long-term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.
The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.