TIMING THE NEXT RECESSION

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1 TIMING THE NEXT RECESSION by Robert F. DeLucia, CFA Consulting Economist The single most reliable indicator of recession is the slope of the US Treasury yield curve. Also referred to as the term structure of interest rates, the yield curve has never failed to predict a recession with a consistent lead time of approximately 12 to 15 months. An inverted yield curve is indicative of tightening monetary conditions, a slowing economy, and a sharp retrenchment by banks in extending credit. Summary and Major Conclusions: The single most important issue for investors is the timing of the next recession, which should be the catalyst for the end of the current bull market in common stocks and the beginning of the next bull market in government bonds. Recessions materialize within an environment of widespread economic and financial imbalances that disrupt the smooth functioning of an economy and trigger a contraction in aggregate spending and output. There is currently very little evidence of the cyclical imbalances that have resulted in recessions in the past. Over the past 60 years, the most common signal of recessions has been an escalation in inflation. Rising inflation undermines the sustainability of a business expansion by squeezing real purchasing power and corporate profit margins, and by propagating excesses within the private sector. Moreover, rising inflation compels the Federal Reserve to adopt an aggressive tightening policy in order to address the emerging inflation threat and to restore an economy to healthy noninflationary growth. The current US inflation rate of 1.4% is well below the FOMC s long-term target of 2%, and has been in a counter-cyclical decelerating trend in recent months. The strong implication is that the Fed will continue to normalize its policy rate, but at a very cautious and methodical pace, creating little risk to economic growth. A combination of rapid debt accumulation and steady erosion in credit quality has contributed to recessions in the past, most recently in 2008 with the implosion of real estate-related debt. Currently, credit conditions are benign: Growth in credit is not excessive and loan delinquencies and defaults are near cyclical lows. As the most credit-sensitive sector of the US economy, housing construction has typically peaked several years prior to the onset of recessions. Currently, because of very strong underlying demand and an acute shortage of housing units, an end of the five-year housing recovery is nowhere in sight. Corporate profit margins are a highly reliable pro-cyclical series that move up and down with the business cycle. Historically, profit margins tend to reach a cyclical peak roughly two years prior to the onset of the next recession. It seems plausible to assume that US corporate profit margins will continue to widen for another several quarters before reaching a cyclical peak, most likely during If so, based upon this indicator alone, the next recession would not begin until

2 The Index of Leading Economic Indicators has an excellent track record of signaling recessions with a consistent lead time. The index is currently in a steadily rising trend, and has increased for 12 consecutive months. It is also important to note that the index has been rising at an accelerating rate in recent quarters, strongly suggesting that the likelihood of recession is currently very low. The Treasury yield curve has been the single most reliable leading indicator of recession, predicting all recessions since 1960 with an average lead time of slightly more than one year. An inversion of the curve typically comes about as a result of long-term bond yields falling below short-term rates. Although the slope of the yield curve has been in a flattening trend, it is far from inverted. Moreover, it seems plausible to assume that the curve will temporarily steepen in future months in response to better economic news. Based exclusively on the yield curve, a recession is not likely within the next two years. The overarching conclusion of my analysis is that the standard preconditions for a recession are not present, and that the current expansion cycle appears to be sustainable through 2018, at a minimum. The most significant issue for investors involves the timing of the next recession. An economy in recession becomes exposed to severe pressures: A surging unemployment rate; plunging corporate profits; business failures, loan defaults, and credit losses at financial institutions; and ballooning government budget deficits. In terms of financial markets, recessions always mark the end of an equity bull market and the onset of the next bull market in government bonds. This week s Economic Perspective provides a check list of key underlying factors that have consistently preceded recessions in previous cycles. TYPICAL PRECONDITIONS FOR RECESSION An analysis of economic cycles in previous decades reveals that recessions come about in response to very distinct underlying forces that undermine the natural growth tendency of an economy. From a technical standpoint, the role of recessions is to restore an economy to normal equilibrium following a period of distortions, excesses, and imbalances. A recession can be best understood as a temporary period of healing and rehabilitation during which time an economy is restored to normal balance, creating a healthy and durable foundation for the next expansion phase. The following is a comprehensive summary of the most important catalysts for recession

3 UNACCEPTABLY HIGH INFLATION Over the past 60 years, the most common catalyst for recessions has been a sustained rise in the inflation rate. High and rising inflation is an unstable condition that is inconsistent with a healthy economy and financial system. Rising inflation undermines a typical business expansion by squeezing real purchasing power and corporate profit margins, and by propagating imbalances, excesses, and speculation within the private sector. Most importantly, rising inflation compels the Federal Reserve to implement an aggressive tightening of monetary conditions necessary to counteract an emerging inflation threat. Price Stability: Fortunately, inflation is currently under excellent control, with very little evidence of inflationary pressures. In fact, core consumer inflation has been in a moderating counter-cyclical trend in recent months, and has fallen even further below the FOMC s long-standing inflation target of 2% (see chart 1). RESTRICTIVE MONETARY POLICY Virtually all recessions since 1960 have been preceded by a period of aggressive monetary tightening. Federal Reserve rate-tightening cycles can take two forms: (1) An unhurried increase in short-term rates merely to achieve a normalization of monetary policy; and (2) A far more urgent and deliberately aggressive policy aimed at conquering inflation. The latter always leads to a recession because price stability replaces sustained economic growth as the primary objective of policy. Normalization of Policy: The current conduct of monetary policy is clearly in the category of a formal normalization process: Rather than declaring war on inflation, the Fed is raising rates in a cautious and methodical manner in order to restore interest rates to normal. Because inflation remains under excellent control, the current thrust of policy can be described as highly expansionary, posing little immediate risk to the economic expansion. EXCESSIVE GROWTH IN PRIVATE DEBT A hallmark of all previous recessions has been excessive growth in debt accumulation by businesses and households, which raises the risk of recession in two ways: A toxic combination of rapid growth in private sector debt and rising interest rates results in an escalation of debt service burdens, which choke off spending

4 CHART 1 US Core Consumer Inflation in a Decelerating Trend The Personal Consumption Price Deflator Excluding Food and Energy, Annual % Change Source: Bureau of Economic Analysis CHART 2 Unprecedented Period of Weakness in Household Credit Demand Household Credit Outstanding, Annual % Growth Source: Federal Reserve Indirectly, rising debt levels and debt burdens add to financial instability, which raises the risk of recession in an indirect manner. A Mixed Picture: Household debt has declined as a share of GDP and is currently rising at a tepid pace. Banking sector debt is also under control. The greatest risk to financial stability involves the corporate sector, in which debt has expanded rapidly in recent years to a record share of GDP. The offset is that corporate debt burdens have declined sharply because of historically depressed interest rates. Economic and financial risk could escalate when borrowing costs begin to trend higher, thereby increasing stress in the nonfinancial corporate sector (see chart 2). DETERIORATION IN CREDIT QUALITY Every recession since 1960 has been preceded and in some cases triggered by a sharp deterioration in credit quality in the household, business, and banking sectors. Many of these instances have led to a financial crisis as in 2008 which has the effect of magnifying the depth of the economic downturn

5 CHART 3 Bank Credit Quality at a Multi-Year High Delinquent Loans as a Percent of Total Bank Loans Source: FDIC CHART 4 Junk Bond Spreads Near Business Cycle Lows Option-Adjusted Spread (OAS) High-Yield Corporate Bond Index Source: Bloomberg Barclays Credit Cycle Still Positive: As a broad generalization, credit quality has deteriorated only modestly over the past several years, and remains healthy. Credit quality is especially strong with respect to residential real estate loans, consumer loans, and bank loans to businesses. Preliminary signs of weakness can be found in speculative-grade corporate bonds and auto loans. The bottom line is that the credit cycle is currently benign and not an immediate threat to the economic expansion but this condition is likely to change as the expansion cycle approaches maturity (see chart 3). Corporate Bond Spreads: Consistent with the lead time provided by measures of credit quality, credit spreads on high-yield corporate debt are another reliable leading indicator of an impending recession. Historically, spreads have reached a cyclical bottom roughly six to nine months prior to the onset of recession. Spreads are currently near cyclical lows and show no tendency of reversing direction any time soon (see chart 4)

6 CHART 5 Homebuilder Optimism Hovers Near 12-Year High Monthly Homebuilder Survey, Index of Confidence Source: National Association of Home Builders CHART 6 US Residential Investment Still 25% Below 2006 Bubble Peak Construction Spending, Residential Buildings (Billions of Dollars) Source: Commence Department HOUSING MARKET WEAKNESS As the quintessential leading indicator of the economy, the housing market has an impressive record of signaling the next recession, albeit with irregular lead times. Since the 1950s, every recession has been preceded by a sharp cyclical decline in housing starts. However, unlike many indicators, the lead times between a downturn in housing and a recession have been highly inconsistent, ranging from as short as one year to as long as four years. Prolonged Up Cycle: There are several factors supporting the thesis that the US housing market may be in the midst of a long-term upswing that could persist for many years: There is an acute shortage of housing inventory Demographics are favorable in terms of household formation Sentiment among home builders is near a cyclical high (see chart 5) There is pent-up demand for housing, especially among young adults Spending is currently 25% below its 2006 peak (see chart 6) The bottom line is that a cyclical peak in housing construction is nowhere in sight, which implies continued growth through 2018, at a minimum

7 NARROWING PROFIT MARGINS Corporate profit margins are a highly reliable pro-cyclical series that ebb and flow with the business cycle. Historically, profit margins tend to reach a cyclical peak roughly two years prior to the onset of the next recession. Margins then collapse during recessions in response to a combination of falling revenue and continued growth in operating expenses. Reversal in Trend: In the current expansion cycle, corporate profit margins peaked in 2014 and entered a declining counter-cyclical trend through the early months of Profits then suddenly reversed course in the middle of last year, and have been in an expanding trend for four consecutive quarters. It seems plausible to assume that US corporate profit margins will continue to widen for another several quarters and reach a new all-time peak, most likely during the first half of If so, based upon this indicator alone, the next recession would not begin until late 2019 or WEAKENING DEMAND FOR LABOR All previous recessions were preceded by a gradual but distinct deterioration in labor market conditions. However, in the current cycle, the US labor market remains at full strength with very few signs of weakness. Most importantly, the underlying demand for labor remains robust, with highly reliable indicators of labor demand at record levels: New job openings nationwide have risen to more than six million jobs (see chart 7), while initial jobless claims have declined to the lowest level in 44 years (see chart 8). FALLING CONSUMER CONFIDENCE Measures of consumer confidence are pro-cyclical indicators, rising and falling with a slight lead to the business cycle. In the current expansion cycle, consumer confidence has risen at an unusually steady pace since 2009, and has recently reached the highest point since In all previous cycles since 1965, a sustained decline in confidence preceded the onset of recession by an average of one year (see chart 9). ECONOMY AT FULL EMPLOYMENT All recessions since 1950 have occurred in the context of an American economy at full employment, broadly defined as full utilization of all productive resources: Labor, plant and equipment, financial capital, raw materials, and energy. There are at least three economic risks associated with an economy at full employment:

8 CHART 7 Business Demand for Labor Near All-Time Peak Levels US Job Openings (Millions) Source: US Department of Labor CHART 8 Initial Jobless Claims Currently at a 44-Year Low Initial Claims for Unemployment Insurance (Thousands) Source: US Department of Labor Further economic growth becomes constrained and ultimately capped by shortages and rising input costs 2. The increase in economic headwinds associated with an overheating economy and spreading misallocation of resources Labor Market Pressures: Of greatest concern at this time is the ongoing tightening of labor market conditions. An increasing percentage of firms are reporting growing challenges in finding qualified workers (see chart 10). Wage pressures are not yet evident, but a combination of very strong business demand for labor and limited availability of skilled workers will eventually push wage rates higher. Conversely, all other productive resources appear to be in abundant supply (see chart 11). INVERSION OF THE TREASURY YIELD CURVE The single most reliable indicator of recession is the slope of the US Treasury (UST) yield curve. Also referred to as the term structure of interest rates, the yield curve has never failed to predict a recession and has a fairly consistent lead time of approximately 12 to 15 months. An inversion of the curve typically comes about as a result of long-term rates dropping below short-term rates. An inverted yield curve is a manifestation of three powerful economic phenomena:

9 CHART 9 Consumer Confidence Surges to a 16-Year High Index of Consumer Sentiment Source: The Conference Board CHART 10 Continued Shortage of Qualified Workers Could Slow Job Creation Small Business Survey: Firms Reporting Difficulty Filling Job Vacancies Source: National Federation of Independent Business Excessive Monetary Restraint: An inverted yield curve is a signal that monetary policy is excessively restrictive in the context of current business conditions. Economic Slowdown: An inverted yield curve is a manifestation of a very slow-growing economy that is steadily losing momentum. Lending Conditions: Because banks typically borrow short and lend long, a higher level of short-term relative to long-term rates removes all incentives to make loans. Current Conditions: Contrary to the belief of many analysts, the yield curve is not signaling the onset of recession anytime soon. The current spread between longterm and short-term rates is well above that of a flat curve, measured by yields on ten-year Treasury Bonds versus the federal funds rate as well as the yield spread between ten-year and two-year government bonds. There is also a high likelihood that the curve will steepen over the next six to nine months which would imply an even later recession prior to entering a cyclical flattening trend during 2018 and 2019 (see chart 12)

10 CHART 11 Labor Compensation Increasing at a Sluggish Pace The US Employment Cost Index, Annual % Growth Wages, Salaries, and Employee Benefits Source: US Department of Labor CHART 12 Current Slope of Yield Curve Near Historical Average US Treasury Yield Curve (%), August 14, 2017 Source: Federal Reserve INDEX OF LEADING ECONOMIC INDICATORS The Conference Board Index of Leading Economic Indicators has an excellent track record of signaling recessions with a consistent lead time. The index tends to reach a peak roughly 18 months prior to recessions, after which it remains on a plateau for approximately 12 months. The index then typically enters a steep decline roughly six months prior to the onset of recession. Strong Outlook: The index is currently in a steadily rising trend, and has increased for 12 consecutive months. Most importantly, the index has been rising at an accelerating rate in recent quarters. Compared with an anemic 1% annual rate of growth one year ago, the index is currently expanding at a 5% annual rate. On the basis of this indicator alone, the likelihood of a recession during the next two years is low (see chart 13). INVESTMENT SUMMARY The overarching conclusion of my analysis is that the typical preconditions for a recession are not now present, suggesting that the current expansion cycle has further to run. Virtually all sensitive leading indicators of recession are at or near equilibrium levels. Because a sustained deterioration in these indicators typically precedes a recession by one year or more, there is a possibility of continued economic growth well into

11 CHART 13 Accelerating Growth in Leading Economic Indicators Index of Ten Leading Economic Indicators Annualized (%) Growth Rate, Six-Month Intervals Source: The Conference Board Assuming my analysis is correct, most risk assets should continue to generate positive returns for a while longer. History is clear with respect to the interrelationship between financial markets and the business cycle: The end of an expansion cycle and onset of recession has always been closely linked to the end of an equity bull market and onset of a new bull market in government bonds. Specifically, the equity market has virtually always reached its cyclical peak roughly three to six months prior to the onset of recession. Similarly, market yields on long-term government bonds almost always reach a cyclical peak six to nine months prior to recessions. Because there is also a very high correlation between credit spreads on high-yield corporate bonds and the equity market, both stocks and junk bonds have typically entered a bear market prior to the onset of recession

12 Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that role, he spent 25 years at CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the Consulting Economist for Prudential Retirement. Bob has more than 40 years of investment experience. For informational or educational purposes, only. This material is not intended as advice or recommendation about investing or managing your retirement savings. By sharing it, Prudential Retirement is not acting as your fiduciary as defined by the Department of Labor's Fiduciary rule or otherwise. If you need investment advice, please consult with a qualified professional. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions. Certain information contained herein may constitute forward-looking statements, (including observations about markets and industry and regulatory trends as of the original date of this document). Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. As a result, you should not rely on such forward-looking statements in making any decisions. No representation or warranty is made as to future performance or such forward-looking statements. The financial indices referenced herein are provided for informational purposes only. You cannot invest directly in an index. The statistical data regarding such indices has been obtained from sources believed to be reliable but has not been independently verified. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. Past performance is not a guarantee or reliable indicator of future results. The information provided is not intended to provide investment advice and should not be construed as an investment recommendation by Prudential Financial or any of its subsidiaries Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc., and its related entities, registered in many jurisdictions worldwide