Current indicators aren't signaling a pullback, and a healthy U.S. consumer suggests the recent expansion has room to run.
- Although current recession odds are low, it’s instructive to understand the signals we view as warning signs of a turn in the economy.
- Only 2 of the 11 recession indicators we follow are currently signaling recession risks.
- A healthy U.S. consumer gives us confidence that the current expansion has room to run.
The optimism surrounding President Donald Trump’s ambitious pro-growth policy proposals would appear to dismiss the near-term likelihood of a recession. Yet the administration’s success in pushing through an ambitious package of tax reforms and increased infrastructure spending is far from assured. Republicans in the House and Senate, for example, are divided on the need for border adjustments as part of a corporate tax overhaul. The market is also failing to discount the risks that the iconoclastic President poses that could negatively impact trade and the fortunes of many U.S. companies and consumers. Trump has already dismantled the Trans Pacific Partnership, which could raise the cost of imported goods from the countries in the pact more than $600 million per year, and suggested a 20% import tax on goods from Mexico.
While we believe the odds of a recession are low right now, it’s helpful to understand the signals that we view as warning signs of a turn in the economy. When determining the probability of a recession, we first need to figure out what type of inflationary environment we’re in. The length of the expansion is highly dependent on the level of inflation. Looking back at all the expansions since the 1960s, the average has been 27 quarters or roughly seven years long. However, excluding the two high-inflation expansions in the 1970s, the remaining low-inflation expansions have averaged 33 quarters. So the average expansion period with low inflation has been over eight years. To get to that average, the current expansion would need to continue until late this year. Given the wait and see stance of the Federal Reserve on removing accommodation from the economy, there’s a good chance we make it past that point.
Predicting recessions is not that easy, but there are data points that can give us insight. The problem, however, is that most economic data points tend to be lagging or coincident indicators, meaning they don’t have much predictive ability. There are, however, data points that can project what will happen in the future. These are called leading indicators. But no single data point can tell you the whole story so it’s important not to look at any one statistic in isolation. The table below lists a number of the risk indicators that can help us form an opinion on the economy. Currently, just two out of 11 are flashing a warning sign of danger ahead: CPI Energy, which reflects the roughly 100% increase in crude oil prices from their trough last February, and Corporate Profitability as a percentage of GDP, which remains well below its 2014 peak.
Leading Economic Indicators Signal All Clear
Let’s examine a few of the more important ones. The composite of leading economic indicators (LEI) is made up of 10 components whose changes tend to precede changes in the broader economy. The LEI suggest a good likelihood of a continuation of this economic cycle. On average, when the index eclipses the previous market’s peak, it takes six years on average before you see a recession. We have come close but have yet to pass the previous peak set in 2005. That is not to say the current cycle will last another six years, but there is a high probability that the expansion will last several more years. There are several indicators we view as most effective in forming a recession forecast.
Building permits are a helpful guidepost because they can tell us about growth years into the future. It takes years to get a building permit, build a house, sell the house and finally furnish it - all of which are additive to the economy. In fact, housing-related activities make up approximately 16% of U.S. GDP. The direction of permits serves as a good compass on where the economy is heading. Just prior to recessions, permits tend to drop aggressively. Today, permits are firmly in an uptrend and should go higher. Just to keep up with population growth and demolitions, the U.S. housing supply needs to increase at a pace of 1.4 million units per year. The current pace (as of December 2016) is 1.2 million. The bursting of the housing bubble led to nearly a decade of underbuilding, creating pent up housing demand. On top of that, banks are finally loosening up their lending standards. While mortgage rates have ticked up since the election, they remain near generational lows and are encouraging a long-sought-after increase in first-time home buyers that is critical to a sustainable housing recovery. On average, permits peak two years prior to a recession, so the trend in building permits projects continued expansion.