If a Recession is Coming, Can We Know Ahead of Time?

Regular readers of our blogs know that we broadly adhere, at least with respect to financial markets, products and services, to the adage “If it can’t be measured, it doesn’t exist.” That said, we also acknowledge the old saw that there are “lies, damned lies and statistics.” From long experience, we have developed a healthy, seasoned skepticism toward widely expressed, simplistic financial and economic “truths” like the recent media effusions regarding yield curve inversion as an almost faultless predictor of recession.

So, it was with great interest that I attended a conference breakout session on the “Anatomy of A Recession” during a very pleasant sojourn in San Diego last August. (August is, in my opinion, the only time of year when leaving Boston to go there doesn’t make sense weather-wise. As anyone who has ever spent late August in Boston or on the Cape knows, there’s no better place to be. However, the allure of continuing education and regulatory requirements credits was enough sufficient to draw me forth!)

In sum, here is what I learned: Although yield curve inversion has, in the past, anticipated recessions, it is a longer-term leading indicator. That is to say, yield curve inversions often occur many months, and sometimes years, before a recession actually begins. However, by expanding one’s view to include other “Recession Risk Indicators” a more nuanced and useful framework can be created.

A “dashboard” developed by ClearBridge Investments, a LeggMason Company, tracks 12 criteria, or indicators, in four categories[1]:

• Financial indicators: The yield curve, credit spreads, and the money supply

• Inflation indicators: Wage growth, and commodity prices

• Consumer-related indicators: Housing permits, jobless claims, retail sales, and job sentiment

• Business activity indicators: ISM New Orders (also known as the Purchasing Manager’s Index), corporate profit margins, and truck shipments

Each category is assigned to one of three statuses: Green (which means the category/indicator is positive, indicating an expansionary economic environment), Yellow (mixed, caution), Red (negative, recession). Yield curve inversion is included and is a binary (either/or) criterion. If the yield curve inverts, the indicator goes red.

As of June 30, 2019, the overall reading moved from positive to caution due to commodity prices going negative while job sentiment and New Orders moved from positive to “caution”. As of that date, 6-of-12 categories were positive (versus 8 as of 3/31/19), 4-of-12 mixed (versus 3) and 2-of-12 were negative (versus only one, the yield curve, three months earlier). Using our own rough estimating, it seems we’re neutral-to-positive at this point, depending on how you weight the criteria.

How has this combination of indicators performed in the past? According to the data presented during the session (which we have not and will not attempt to independently verify), their back test indicates that for seven recessionary periods in the last 50 years the “Recession Risk Indicators” correctly signaled six and flashed “caution” for the seventh. For the one period, 1973-75, where the “Indicators” flashed “caution” but not “recession”, the distribution was 5-of-11[2] red, 4 yellow, 2 green.

For the others:

· 1969-70: 8-of-11 showing red (recession); 3-of-11 showing caution

· 1980: 10-of-12, red; 2 yellow

· 1981-82: 12-of-12 are red

· 1990-91: 12-of-12 are red

· 2001: 11-of-12, red; 1 yellow

· 2007-09: 10-of-12 red; 2 yellow

Looking more closely at the financial crisis period of 2007-2009, the data are also very interesting:

· Q2 2006: 6 green, 3 yellow, 3 red

· Q4 2006: 3 green, 5 yellow, 4 red

· Q2 2007: 2 green, 6 yellow, 4 red

· Q4 2007: 2 yellow, 10 red

· Q2 2008: 1 yellow, 11 red

Clearly we see a deteriorating pattern, somewhat analogous to where we are today if, as is smart, we don’t worry about exact parallels. This isn’t about reading tealeaves, it’s about assessing data and that takes time. Stay tuned, it seems there may be something here worth watching.

Since the dashboard is updated regularly, we plan to report on its distribution and overall status once each month.

[1] The “U.S. Recession Risk Indicators” & “U.S. Recession Risk Dashboard” are resources developed and maintained by ClearBridge Investments, A LeggMason Company. “Anatomy of a Recession” is a trademark of ClearBridgeInvestments, LLC. Legg Mason Investor Services, LLC and ClearBridgeInvestments, LLC are subsidiaries of Legg Mason, Inc. ©2019 Legg Mason Investor Services, LLC, member FINRA, SIPC.

[2] The 1969-70 and 1973-75 periods do not have “truck shipments” information.

Ed Lynch is founder and CEO of FPG. He has worked with ERISA-qualified plan sponsors and designated fiduciaries in most aspects of plan development and maintenance since the early 1980s. Ed founded FPG with the mission to be a leader in the field of employee benefits and the most trusted source of information and evaluation in the retirement plan industry.