Are indicators pointing boney fingers towards a scary recession?

Halloween was confusing. All my life, my parents said, “Never take candy from strangers.” And then they dressed me up and said, “Go beg for it."

– Rita Rudner

An Irish myth about a man nicknamed “Stingy Jack” is believed to have led to the tradition of carving scary faces into gourds. According to the legend, Jack tricks the Devil into paying for his drink and then traps him in the form of a coin. The Devil eventually takes revenge and Stingy Jack ends up roaming Earth for eternity without a place in Heaven or Hell. Jack does, however, have a lighted coal, which he places inside a carved turnip, creating the original jack-o’-lantern.

As Halloween approaches, there seems no shortage of ghoulish headlines regarding the slowdown of the U.S. economy. These back-of-the-neck hair-raising tales include:

• Supply chain disruptions leading to an increase in prices for consumers
• Risk of rising interest rates and their impact on corporate profits and consumer balance sheets
• From the middle of August, an increase of nearly 34% in oil prices, measured by West Texas Intermediate (WTI), from approximately $US62/bbl to nearly $US83/bbl as we near Halloween.

The headlines in newspapers and on websites provide no shortage in sights of spooky dangers lurking around the corner for the U.S. economy. Our work would suggest that the U.S. economy is likely to slow down over the next year. But let’s be clear; despite the slowdown, the probability of a U.S. recession over the next 12 months remains very low. Historically, there are warning signals prior to falling into a recession. Some of the signals that we look at are highlighted in the table below. Other than inflationary pressures, we don’t believe that any of the typical signs of a recession are present today. Let’s look at a few of these conditions in more depth.

Recession risk signals

Typical signs of a U.S. recession aren’t present

Leading economic indicators

A metric that we follow closely is U.S. leading economic indicators, as shown in the Leading Economic Index (LEI). The Index consists of 10 economic components whose changes tend to precede changes in the overall economy, including average weekly manufacturing hours, number of new building permits, and consumer sentiment, to name a few. As of September, the LEI registered 9.3. Since 1970, a recession occurred six months, on average, after the LEI became negative, and the most recent figure would suggest a strong and stable U.S. economy.

Financial conditions

Since the beginning of August, the 10-year U.S. Treasury yield has increased from 1.17% to 1.67% as of October 22, 2021, increasing concern that financial conditions are tightening, which tends to have a negative impact on economic activity. In tighter financial conditions, it’s more difficult for corporations and individuals to access credit for consumption. A measure that we follow closely is the Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt, and equity markets within the traditional and shadow banking systems. As the chart below illustrates, this metric turns positive (indicates tighter financial conditions) prior to a recession. As of September, the metric was -0.24 which signals that financial conditions are still very accommodative, and supportive of low odds for a recession within the next year.

U.S. employment

Despite a weak September non-farm payroll figure, the employment environment remains constructive. A measure that we follow as a recessionary indicator is the U.S. unemployment rate versus its three-year moving average or longer-term trend.

As the chart below illustrates, when the long-term measure (green line) crosses the short-term measure (blue line) to the upside, historically, it has forecasted a U.S. recession. The U.S. unemployment rate continues to improve, following last year’s recession. There were nearly 10.4 million open positions in the U.S. in August, according to the Department of Labor. And there’s no shortage of news stories quoting employers who say it’s extremely difficult to find workers. Many companies are going as far as offering monetary incentives just to come in for an interview. But with decreasing COVID-19 cases and a decrease in very favourable unemployment benefits, we believe that September’s weakness was a blip and the positive employment trends of 2021 will continue into next year.

The one potential signal that our table above suggests is higher inflationary pressures. As we highlighted in our Investment Note, “The inflation train is about to leave the station,” at the beginning of the year, we thought inflationary pressures were less likely to be transitory. Our inflation model suggests that the Consumer Price Index will be more persistent, and will remain above 2.5% into 2022 but will moderate from current levels. We believe this level of inflation will put pressure on bond yields and remains one of the key risks worth watching into 2022. However, inflation between 2.5% and 3.0% without the other signs of a recession over the coming year is unlikely to result in a recession.

Taking advantage of opportunities

How should investors react if the negative headlines influence market returns over the short term? The chart below illustrates the one-year forward turn for the S&P 500 Price Index since 1990 after selloffs of -5% to -10%, -10% to -15%, -15% to -20%, and greater than -20% for all periods — recessionary periods and non-recessionary periods. The bottom line: history would suggest that if we were to experience a pullback, investors have benefitted from buying the dip since we don’t believe we’re likely to be entering a recessionary period over the next year.

As the negative headlines surrounding the U.S. debt ceiling, China, oil prices, etc. dominate the front pages, we return to the fundamentals that continue to be supportive of equity prices and recognize that the headlines are all just a bunch of “hocus-pocus!”

Macan Nia, CFA
Co-Chief Investment Strategist
Manulife Investment Management