The ClearBridge Recession Risk Dashboard continues to flash an overall yellow signal with healthy consumer spending balancing weaker manufacturing.
Give me a one-handed Economist. All my economists say ‘on [one] hand…’, then ‘but on the other…
— Harry Truman
- The ClearBridge Recession Risk Dashboard remains unchanged with an overall yellow signal. The U.S. consumer has been a pillar of strength that has been offsetting a slowdown in manufacturing.
- When accounting for alternative policy tools, the Fed has tightened to a greater degree in the current cycle than at any point going back to the early 1980s. Given the lagged response to changes in Fed policy, more tightening may need to be digested before the effects of recent cuts are felt.
- We do not believe the current slowdown has fully played out and anticipate continued volatility ahead.
Can the Consumer Endure Mounting Headwinds?
Consumer Strength and an Easier Fed Could Save the Day
Perhaps unsurprisingly, the consumer section of the dashboard has been a pillar of strength with all four indicators showing green signals. This month there are no signal changes on the dashboard. As we look toward year end, we are most intently focused on the health of the consumer. If this foundation starts to show cracks, we believe the risks of a recession would rise meaningfully.
Exhibit 1: ClearBridge Recession Risk Dashboard
Exhibit 2: Global Central Banks are in Easing Mode
Do Lagged Effects of 2018 Tightening and Manufacturing Weakness Signal Further Downside?
This liquidity drain has had several impacts, including turning the Money Supply signal on the dashboard yellow and the recent disruptions in the repo market. Research from academia and the Atlanta Fed suggest that the combined effects of ending quantitative easing (QE), the shrinking of the Fed’s balance sheet (QT), and changes in delivering forward guidance have had the equivalent impact of several hundred basis points of additional rate hikes since 2013. When accounting for these alternative policy tools, the Fed has tightened policy to a greater degree in the current cycle than at any point going back to the early 1980s (Exhibit 3). Importantly, due to the lags associated with changes in Fed policy, the U.S. economy may not be “out of the woods” until the middle of next year.
Exhibit 3: Shadow Fed Funds Rate
We believe negative U.S. interest rates could be on the table should the next recession prove to be more severe.
— Jeff Schulze
Conflicting Signals from Fixed Income Markets
Many market observers argue cross-over buyers from overseas are pushing down U.S. yields given negative rates in their home markets, and thus low yields can be ignored as less reflective of domestic weakness than in the past. However, currency hedging costs are substantial for overseas investors and only by going to very long-dated Treasury bonds and spread products can an overseas investor earn a positive return. As a result, the influence of negative rates across the globe on U.S. Treasury yields may be less than some believe.
Rather, falling PMIs, which are good proxies for the business cycle and have moved in near lockstep with 10-year Treasury yields since the financial crisis, suggest the slowing business cycle (softer domestic backdrop) is the more likely culprit for low U.S. rates (Exhibit 4). This has important implications for equity investors, as many have dismissed the yield curve’s inversion as a side effect of overseas bond market trends, perhaps unwisely.
Exhibit 4: Low U.S. Rates Reflect Softer U.S. Economic Backdrop
Could the U.S. See Negative Rates?
Exhibit 5: The Fed Lacks Rate Cut Ammunition
Exhibit 6: U.S. has More Room for QE
To be clear, this pattern of events is not our base case. If the U.S. economy were to slip into a recession in the near term, we believe it would be shallow (economically speaking) given the lack of debt imbalances and the health of the banking sector. Furthermore, should the economy reaccelerate, this would give the Fed flexibility to increase rates down the road and build an additional reserve of ammunition with which to fight a more pronounced downturn.
Increased Volatility Likely, Blow-Off Top Not Evident
While clouds may be gathering, we do not believe it is appropriate yet for equity investors to return to port. Last quarter’s Long View closed with a chart showing that the final year of a bull market has seen an average return of 26.9% going back to 1975. The most recent all-time high for the S&P 500 Index was reached in late July, and equities saw only a 6.6% rally in the 12 months preceding that high. This dynamic suggests we have yet to reach the stage of a blow-off top and investor euphoria experienced during the end of past bull markets.
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
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.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) placed major regulations on the financial industry following the financial crisis of 2008-2009 including the possibility of breaking banks up if any of them are determined to be “too big to fail.”
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
The federal funds rate (fed funds rate, fed funds target rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
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 ISM New Orders is the new orders component of the ISM PMI.
Purchasing Managers Indexes (PMI) measure the manufacturing and services sectors in an economy, based on survey data collected from a representative panel of manufacturing and services firms. PMI greater than 50 indicated economic expansion; below 50, contraction.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.
Quantitative tightening (QT) refers to a monetary policy implemented by a central bank in which it reduces the excess reserves of the banking system through the direct sale of debt securities from its own inventory.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
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.
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
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