Over the past few months I have been conducting semiannual client reviews. During these meetings I’ve been receiving questions related to the health of the US economy and questions such as “are you nervous about the markets, it’s been 10 years since the last recession". Below are some areas we look at before judging if we are close to a recession.
Here are 5 gauges of recession risks in which we keep a close eye on.
1. Interest rates
How far do interest rates need to raise before the choke the economy..? Looking back 70 years in which interest rates went from 1% in 1950, to 18% in 1980, and back to 1% recently. What we can say is that over the past half century, when interest rates climb above the growth rate of the economy a few months prior to the onset of each recession. Today, the effective interest rate is 2.00% and the year-over-year growth rate of the U.S. economy is 4.5%. So if the growth rate flat-lined over the next two years then interest rates would have to rise by more than 2.5% for this condition to be satisfied (or 10 consecutive rate hikes).
2. Unemployment data & Weakening labor market
The unemployment rate has been trending in the right direction since the lows of 2009. Today, at 3.8% we’re not far off a 50-year low (December 1969 when it was 3.4%). It will be some time before the unemployment rate turns convincingly higher. There are currently 6 million+ jobs available (and unfilled) in the U.S. Hiring is elevated while layoffs remain low. Almost sixty percent of small and medium-sized businesses report they tried to hire last month, but nine out of ten of those failed to find qualified candidates. Investors should take notice when unemployment insurance claims reach an inflection point.
3. Inflationary Pressure
We’re currently at 2.5% year over year and trending higher into 2018. Contrasting to the early 80’s when Reagan was in power we reached upwards of 15% inflation far above the 2-2.5% healthy figure. Amazon is helping keep inflation (or the price of products) low. Hear me out on this. Typically a box of cereal would go for $5 ($1 for packaging, $1 cost of food, $1 marketing, $1 shelf space, and $1 for transport). With Amazon Prime membership, there goes your shipping costs. Marketing is done on the website with no cost of shelf space anymore. Amazon could theoretically deliver the same box of cereal to your door step for $3 and still make a healthy profit..
4.ISM Manufacturing Index
This index is based on surveys of more than 300 manufacturing firms and monitors employment, production, inventories, new orders and supplier deliveries. Whenever the ISM’s New Orders Index minus the Inventory Index falls below zero, recession risks are elevated. It’s not a perfect measure as it’s occasionally given a false signal—calling a recession when none arrived—but it has never failed to give forewarning of every recession since the late 1940s. The current reading from this indicator is a comfortable plus 8%.
5. Capacity Utilization
This indicator is just as it sounds – if we’re running at full capacity we’ll most likely stall at some point. we’re 9 years into a recovery and still below the 80% mark. We’re sitting at 76% and have plenty of capital if we need to build more stuff.
We have not discussed political factors as this requires a separately written newsletter. I’d also like to caution away from anyone stating they can call the next recession.
As things stand, none of our recessionary indicators are giving any indication a U.S. recession is on the horizon and expect some time before they do. Until things change, we think the appropriate course is to give equities the benefit of the doubt.
Kyle Sarai, MBA