Signals Change, Caution Remains

Recession Indicators Update

Signals Change, Caution Remains

With two signals deteriorating and one improving, the ClearBridge Recession Risk Dashboard remains unchanged with an overall yellow signal.


Key Takeaways
  • Two indicators in the ClearBridge Recession Risk Dashboard have worsened: ISM New Orders to red from yellow following a weak August reading and Corporate Profit Margins to yellow from green following NIPA revisions and continued weakness.
  • Job Sentiment strengthened to green from yellow as “jobs plentiful” responses saw their second-strongest increase on record and “jobs hard to find” returned to cycle lows.
  • With two signals deteriorating and one improving, the ClearBridge Recession Dashboard remains unchanged with an overall yellow signal.

ISM Manufacturing New Orders Turns Red

The Institute for Supply Management’s (ISM) Manufacturing Purchasing Manager Index (PMI) is a widely followed measure of U.S. business activity. This survey is synonymous with the business cycle, foreshadowing periods of increasing and decreasing economic activity. The headline figure fell to 49.1 in August, below the breakeven 50 level, signifying that the domestic manufacturing sector contracted for the first time in four years.  

While many market participants focus on the headline ISM figure, our research has pointed us to the New Orders subcomponent, which tends to lead the broader ISM by several months. Intuitively, focusing on business pipelines should provide a good advanced reading on future activity, with the caveat that there can be more noise to this signal if some orders are cancelled or deferred. Typically, ISM New Orders fall below 48 in advance of a recession. This measure fell to 47.2 in August, tied for the weakest reading since the global financial crisis (Exhibit 1) and turning the indicator to red from yellow.

Exhibit 1: Manufacturing New Orders is Signaling Contraction

Source: Bloomberg, as of 8/30/19. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Corporate Profit Margins Turn Yellow

The second signal on the ClearBridge Recession Risk Dashboard to change this month is Corporate Profit Margins. While margins for large- and mega-cap companies are holding up fairly well, margins for small- and mid-size businesses are coming under increased pressure. According to the NFIB Small Business survey, the cost of labor continues to be a major headwind for these smaller companies. In fact, 77% of Americans are employed by firms with fewer than 500 workers. For reference, the average company in the Russell 2000 Index has 3,679 employees. Not surprisingly, it is Main Street that drives the U.S. economy.

As a result of this dynamic, the National Income and Products Accounts (NIPA) profit margins (which the dashboard evaluates) are a much better barometer for the economy. This series saw a large downward revision to several years of data over the summer and has continued to soften more recently (Exhibit 2). As Main Street businesses are forced to cut back on spending to preserve margins, their suppliers may also be forced to curtail activity. Typically, firms reduce hours first before laying off workers due to the significant costs associated with hiring and firing. The good news is that unemployment claims (layoffs) in manufacturing-heavy states such as Pennsylvania, Ohio and Wisconsin are not yet increasing. However, weekly hours worked by the average manufacturing sector employee have fallen by 0.7 hours over the past year, and overtime has been cut by 0.5 hours while margins could also face pressure from increasing tariffs.

Exhibit 2: NIPA Profit Margins Could Come Under More Pressure


Source: Bloomberg, as of 8/30/19. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Jobs Sentiment Improves, Back to Green

In late June, the Job Sentiment signal turned yellow after the fifth-largest leap in “jobs are hard to get” responses in the Conference Board Consumer Confidence Survey’s history. Although headline consumer confidence took a nosedive in August — the University of Michigan’s Consumer Sentiment Index fell from 98.4 to 89.9 — the Conference Board consumer confidence data looks much healthier. Specifically, “jobs hard to get” responses have fallen back to cycle lows, while “jobs plentiful” responses saw their second-largest increase on record. While the number of jobs created over the last several years was recently revised lower by slightly over 500,000 jobs, job openings still outnumber unemployed workers by more than 1.25 million, suggesting a strong labor market. Importantly, our Job Sentiment indicator has returned to its trend from the last several months, suggesting that the U.S.-China trade war has not materially impacted the labor market.

Exhibit 3: ClearBridge Recession Risk Dashboard

Source: ClearBridge Investments, as of 8/31/19.
 

With two signals deteriorating and one improving, the overall signal from the ClearBridge Recession Risk Dashboard remains yellow. It remains to be seen whether the economy worsens further into a recession or the current slowdown remains a soft patch. In the interim, we continue to believe that equity markets will see increased volatility as bulls and bears butt heads.


The ClearBridge Recession Risk Dashboard was created in January 2016. References to the signals it would have sent in the years prior to January 2016 are based on how the underlying data was reflected in the component indicators at the time.

Definitions:

The Conference Board is a US-based business membership and research association.  The Leading Economic Index (LEI) for the US is designed to signal peaks and troughs in the business cycle.

The Conference Board Consumer Confidence Index is a barometer of the health of the U.S. economy from the perspective of the consumer. The index is based on consumers’ perceptions of current business and employment conditions, as well as their expectations for six months hence regarding business conditions, employment, and income. The Consumer Confidence Index and its related series are among the earliest sets of economic indicators available each month and are closely watched as leading indicators for the U.S. economy.

The Institute for Supply Management (ISM) is an association of purchasing and supply management professionals, which conducts regular surveys of its membership to determine industry trends.

The Institute for Supply Management’s (ISM) Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.

The National Federation of Independent Business (NFIB) is a US small business advocacy association, representing 350,000 small and independent business owners.

The NFIB Small Business Optimism Index is produced by the National Federation of Independent Business from data compiled in its monthly survey on small business owners that belong to the NFIB

The national income and product accounts (NIPA) are part of the national accounts of the United States. They are produced by the Bureau of Economic Analysis of the Department of Commerce. They are one of the main sources of data on general economic activity in the United States.

The Russell 2000 Index is an unmanaged list of common stocks that is frequently used as a general performance measure of U.S. stocks of small and/or midsize companies.

The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters. The index is normalized to have a value of 100 in December 1964. Each month at least 500 telephone interviews are conducted of a continental United States sample (Alaska and Hawaii are excluded). Fifty core questions are asked.

About the Authors

Jeffrey Schulze, CFA

Director, Investment Strategist

  • 14 years of investment industry experience
  • Joined ClearBridge Investments in 2014
  • BS in Finance from Rutgers University

Josh Jamner, CFA

Vice President, Investment Strategy Analyst

  • 10 years of investment industry experience
  • Joined ClearBridge Investments in 2017
  • BS in Government from Colby College
Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia:

This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) (“Legg Mason”). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client’s professional advisers.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.