FORECASTING THE NEXT BIG RECESSION
Our new
analytical tools point to a high probability that the next recession will start
in late 2019 to mid-2020.
Guggenheim’s Model Points to
Recession in Late 2019 or 2020
The business cycle is one of the most important drivers of
investment performance. As the nearby chart shows, recessions lead to outsized
moves across asset markets. It is therefore critical for investors to have a
well-informed view on the business cycle so portfolio allocations can be
adjusted accordingly. At this stage, with the current U.S. expansion showing
signs of aging, our focus is on projecting the timing of the next downturn.
Predicting recessions well in advance is notoriously
difficult. Using history as a guide, however, we find
that it may be possible to get an early read on when the next recession will
begin by analyzing the late-cycle behavior of several key economic and market
indicators. Together, they would have provided advance warnings of a
downturn. Our analysis of these metrics suggests that the current expansion
will end as soon as late 2019.
Source :
RECESSION REPORT SUMMARY
- It is
critical for investors to have a well-informed view on the timing of the
business cycle because of its importance as a driver of investment
performance.
- Our
Recession Dashboard includes six leading indicators that exhibit
consistent cyclical behavior ahead of a recession—and can be tracked in
real time.
- Based
on the dashboard and our proprietary Recession Probability Model, which
shows 24-, 12-, and six-month ahead recession probabilities, we believe
the next recession will begin in late 2019 to mid-2020.
- Risk
assets tend to perform well two years out from a recession, but investors
should become increasingly defensive in the final year of an expansion.
RECESSIONS LEAD TO OUTSIZED MARKET
MOVES
Treasury Rally/S&P 500 Drawdown from Trailing 12-Month
Low/High
See Chart
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IDENTIFYING COMMON LATE-CYCLE
SYMPTOMS
The charts below help to tell this story by identifying six
indicators that would have exhibited consistent cyclical behavior, and that can
be tracked relatively well in real time. We compare these indicators during the
last five cycles that are similar in length to the current one, overlaying the
current cycle. Taken together, they suggest that the expansion still has room
to run for approximately 24 months. At the end of this report, we assemble
the SIX INDICATORS into our single-page
Recession Dashboard, which we will update regularly going forward.
1. LABOR MARKET BECOMES
UNSUSTAINABLY TIGHT
The first indicator is the unemployment gap, which is the
difference between the unemployment rate and the natural rate of unemployment
(formerly called NAIRU, for the non-accelerating inflation rate of
unemployment). A strong labor market prompts the Fed to tighten because an
unemployment rate well below the natural rate is unsustainable by definition,
and can lead to a spike in wage and price inflation. Looking at the current
cycle, the labor market is in the early stages of overheating. We see
unemployment heading to 3.5 percent, which would be consistent with the
pre-recession behavior of the unemployment gap in past cycles.
See chart:
2. FED RAISES RATES INTO RESTRICTIVE
TERRITORY
The second chart shows the reaction function of the Fed. Subtracting
the natural rate of interest—which is the neutral fed funds rate, neither
contractionary nor stimulative for the economy—from the real fed funds rate
gives us a gauge of how loose or tight Fed policy is. Leading up to past
recessions, the Fed has usually hiked rates beyond the natural rate to cool the
labor market and get ahead of inflation, only to inadvertently push the economy
into recession. Looking at the current cycle, we expect quarterly rate hikes to
resume in December. This will put Fed policy well into restrictive territory
next year, barring a sharper increase in the natural rate than we expect.
See chart:
3. TREASURY YIELD CURVE FLATTENS
One of the most reliable and consistent predictors of
recession has been the Treasury yield curve. Recessions are always preceded by
a flat or inverted yield curve, usually occurring about 12 months before the
downturn begins. This occurs with T-bill yields rising as Fed policy becomes
restrictive while 10-year yields rise at a slower pace. Looking at the current
cycle, we expect that steady increases in the fed funds rate will continue to
flatten the yield curve over the next 12–18 months.
See chart:
4. LEADING INDICATORS DECLINE
The Conference Board Leading Economic Index (LEI), which
measures 10 key variables, is itself a recession predictor, albeit a fallible
one. It has been irreverently said that the LEI predicted 15 out of the last
eight recessions. Nevertheless, growth in the LEI always slows on a
year-over-year basis heading into a recession, and turns negative about seven
months out, on average. Looking at the current cycle, LEI growth of 4 percent
over the past year has been on par with past cycles two years before a
recession, and we will be watching for a deceleration over the course of the
coming year.
See chart:
5. GROWTH IN HOURS WORKED SLOWS
Other indicators of the real economy, including aggregate
weekly hours, decline in the months preceding a recession as employers begin to
reduce headcount and cut the length of the workweek. Looking at the current
cycle, aggregate weekly hours growth has been steady, albeit at weaker than average
levels, reflecting slower labor force growth as baby boomers retire. We expect
growth in hours worked to hold up over the coming year before slowing more
markedly in 2019.
See chart:
6. CONSUMER SPENDING DECLINES
Real retail sales growth weakens significantly before a
recession begins, with the inflection point typically occurring about 12 months
before the start of the recession. Consumers cut back on spending as they start
to feel the impact of slowing real income growth. This shows up most noticeably
in retail sales, which are made up of a higher share of discretionary purchases
than other measures of consumption. Looking at the current cycle, real retail
sales growth has been steady at around 2 percent. This is weaker than the
historical average, but is consistent with slower-trend gross domestic product
(GDP) growth in this cycle.
See chart:
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MODEL-BASED RECESSION PROBABILITY
As the chart below illustrates, we believe the current
likelihood of a recession in the next six or 12 months is low, at 4 percent and
9 percent, respectively, as of the third quarter of 2017. Within a two-year
window, recession risk appears more meaningful at 22 percent. We also show
forecasts for the model, which is based on a continuation of current trends for
each of the indicators, and assumes the Fed resumes quarterly rate hikes
starting in December. If these trends play out, the model indicates a high
probability of a recession starting in late 2019–mid 2020.
A-NEAR-TERM RECESSION RISK IS LOW,
BUT LONGER-TERM RISKS ARE RISING
Model-Based Recession Probability
Hypothetical Illustration. The Recession Probability Model
is a new model with no prior history of forecasting recessions. Actual results
may vary significantly from the results shown. Source: Haver Analytics,
Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Shaded areas represent
periods of recession.
See chart:
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Investments implications:
B-STOCKS RALLY TWO YEARS OUT FROM
RECESSION BEFORE DECLINING IN FINAL YEAR
Cumulative S&P 500 Index Total Return Starting 24 Months
Before Recessions
Chart source: Source: Bloomberg, Guggenheim Investments.
Data as of 9.30.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and
2007. Past performance does not guarantee future results.
See chart:
…
C-HIGH-YIELD SPREADS BEGIN TO WIDEN
ABOUT ONE YEAR OUT FROM RECESSION
Cumulative Change in Basis Points Starting 24 Months Before
Recessions
In credit markets, high-yield spreads tend to stay flattish
in the penultimate year of the expansion before widening in the final year, on
average. Rising defaults and increasing credit and liquidity risk premiums
drive a sharp pullback in the performance in high-yield bonds before and during
recessions.
See chart:
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Bloomberg, Guggenheim Investments. Data as of 9.30.2017.
Includes cycles ending in 1990, 2001, and 2007. Past performance does not
guarantee future results.
…
If history is a guide, then by the
final year of the expansion (2019), investors should turn defensive,
positioning for widening credit spreads and falling equity valuations. Treasury
yields are likely to decline once the Fed stops hiking. As we noted in Stocks
for the Long Run? Not Now, elevated stock valuations portend meager
returns over the next decade, and one key reason is that a bear market is
likely a couple of years away. Maintaining some dry powder in the final year of
the expansion will allow equity and credit investors to take advantage of more
attractive valuations, as some of the best investment opportunities present
themselves during recessions.
Guggenheim Investments’ Recession Dashboard
See charts
At the bottom source
Read here also: Important
Notices and Disclosures
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