Our Recession Risk Dashboard continues to signal caution, with no changes from September. Meanwhile, we continue to explore how the model would have fared ahead of past pullbacks -- such as the recession of 1990.
- There are no changes to the ClearBridge Recession Risk Dashboard this month, with the overall signal remaining yellow.
- Tight Fed policy, the savings and loan crisis and the Gulf War all contributed to the 1990-91 recession. The ClearBridge Recession Risk Dashboard would have reflected these building pressures in its financial and inflationary segments early on while the consumer segment wouild have deteriorated last.
- The overall dashboard signal would have turned red in June 1989, just over one year before the start of the recession.
ClearBridge Recession Risk Dashboard Still Signals Caution
The S&P 500 Index made another new all-time high in October, as trade tensions eased, the Fed cut interest rates another 25 basis points (bps), and corporate earnings came in stronger than anticipated. Against this backdrop, the ClearBridge Recession Risk Dashboard remained at an overall yellow signal, with no changes during the month (Exhibit 1). Third quarter gross domestic product (GDP) came in above consensus expectations at 1.9%, representing a slight slowdown from the pace of 2.0% in the second quarter and 3.1% in the first quarter. With both the U.S. and global economies clearly slowing, the question remains if we are on the cusp of a recession or a late-cycle slowdown.
Data as of Oct. 31, 2019. Sources: ClearBridge Investments, BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. 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.
A Closer Look at the Early 1990s Recession
The early 1990s recession was one of the shallower recessions in modern history with GDP contracting just -0.2% in nominal terms and the S&P 500 experiencing a selloff of 20%. For reference, this compares with -3.3% and -57%, respectively, during the global financial crisis (GFC) in 2009. Like many U.S. recessions, a myriad of factors contributed to slower economic growth.
However, the 1990 recession differs from history in that it lacks a clear single catalyst like housing in the last cycle or the tech bubble in the late 1990s. Instead, three major themes led to the recession: an aggressive round of Fed tightening, the savings and loan (S&L) crisis, and the oil shock associated with the first Gulf War. Importantly, numerous indicators on the ClearBridge Recession Risk Dashboard would have flashed caution prior to the recession.
Early 1987 marked the cycle low for both inflation and interest rates, with Core CPI troughing at 3.8% and moving to 4.5% by late 1988. In response, the Fed acted quickly and aggressively with the recent memory of double-digit inflation from the early 1980s. The Fed funds rate was hiked by 387 basis points, peaking at 9.75% in early 1989. This hawkish Fed policy response would have caused the Money Supply indicator to flash yellow early on and to be in red territory by the end of 1988 as Fed interest rate hikes took hold.
The Fed didn't raise interest rates in a straight line, however, and cut rates by 75 bps in the wake of the October 1987 Black Monday stock market crash. This was the only single-day bear market (a drop of -20% or worse) in history. The crash, which could not be repeated today due to the “circuit breakers” stock market exchanges implemented in subsequent years, ultimately did not spread to the real economy.
A final dynamic in this period was the beginnings of the S&L crisis. Between 1986 and 1989, 296 savings and loan associations failed. As interest rates began to rise, S&Ls were faced with higher funding costs while many of their assets were fixed rate loans (often backed by real estate). As funding costs began to move higher than the returns these institutions could earn, they began to engage in more speculative activities. In 1986 and 1987, the Federal Savings and Loan Insurance Corporation (FSLIC) — a central institution similar to the FDIC for commercial banks — was recapitalized by over $25 billion to help backstop insolvent S&Ls. However, by 1989 it was insolvent itself, with losses approaching $4 billion.
In 1989, the FSLIC was wound down and Congress created the Resolution Trust Company (RTC), which helped resolve the growing crisis. While 747 S&Ls would shut down by 1995, the losses to taxpayers were partially offset by equity partnerships to liquidate the assets of insolvent institutions.
The ClearBridge Recession Risk Dashboard would have reflected this growing systemic risk, as financial indicators such as Credit Spreads and the Yield Curve would have moved from green to red in 1989. The overall signal would have turned yellow in early 1989, as the consumer section of the dashboard would have remained the last pillar of strength for the economy. However, in the second half of that year, three of the four consumer signals would have turned yellow, while business activities indicators such as ISM New Orders and Truck Shipments would have turned red, driving the overall signal to red.
Sources: ClearBridge Investments, BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. 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.
By the time equity markets peaked in May 1990, the dashboard was deep into red territory. While the Fed had begun to lower interest rates in mid-1989, the lagged effects of prior Fed tightening were still being digested. The recession was cemented when Iraq invaded Kuwait in early August. Oil had been trading in the $15-20 range prior to the invasion, and peaked at $40 in October before settling back to $25 by year end.
The runup in oil prices immediately hit both consumer and business confidence, which plunged in the months following the invasion. The unemployment rate began to climb in mid-1990, and the final consumer signals which had been yellow - Housing Permits and Retail Sales - would have turned red, making for an all-red dashboard. Equities sold off by 20% in a relatively truncated period of 87 days. The recession was relatively shallow and oil prices stabilized in 1991 as Operation Desert Storm led to the liberation of Kuwait. Consumer confidence rebounded and the stock market recovered its losses and more by the end of 1990.
Recession Risk Indicators Can Help Guide Investors
Our analysis finds the ClearBridge Recession Risk Dashboard would have been effective in helping clue investors into the growing economic pressures ahead of the 1990-91 recession. While the Gulf War was not something the dashboard could have predicted, the overall signal from the dashboard would have been red well before this event, suggesting the economy was weakening and particularly vulnerable to shocks such as a rapid rise in oil prices. Ultimately, the economy recovered fairly quickly and embarked upon a 10-year period of growth.
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
Black Monday on October 19, 1987 was the date when a sudden, severe and largely unexpected systemic shock impaired the functioning of the global financial market system, roiling its stability through a stock market crash, along with crashes in the futures and options markets.
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
The Core Consumer Price Index (Core CPI) excludes the prices of food and energy, which are volatile on a monthly basis, from the basket of goods used to determine the CPI.
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 Federal Deposit Insurance Corporation (FDIC) is an independent agency of the U.S. federal government that preserves public confidence in the banking system by insuring deposits.
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.
The Federal Savings and Loan Insurance Corporation (FSLIC) is a defunct U.S. government institution that provided deposit insurance to savings and loan institutions until its dissolution at the end of the 1980s.
The financial crisis of 2007–2008, also known as the global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.
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 Gulf War (2 August 1990 – 28 February 1991), codenamed Operation Desert Shield (2 August 1990 – 17 January 1991) for operations leading to the buildup of troops and defense of Saudi Arabia and Operation Desert Storm (17 January 1991 – 28 February 1991) in its combat phase, was a war waged by coalition forces from 35 nations led by the United States against Iraq in response to Iraq's invasion and annexation of Kuwait arising from oil pricing and production disputes.
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 Index is the new orders component of the ISM PMI.
The Resolution Trust Corporation (RTC) is a now-defunct temporary federal agency. From 1989 to 1995, it largely resolved the savings and loan (S&L) crisis of the 1980s.
The savings and loan (S&L) crisis was a slow-moving financial disaster. The crisis came to a head and resulted in the failure of nearly a third of the 3,234 savings and loan associations in the United States between 1986 and 1995.
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.
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.