“Give me a one-handed Economist. All my economists say ‘on [one] hand…’, then ‘but on the other…’”
- The ClearBridge Recession Risk Dashboard remains unchanged with an overall yellow signal. The U.S. consumer has been a pillar of strength that has been offsetting a slowdown in manufacturing.
- When accounting for alternative policy tools, the Fed has tightened to a greater degree in the current cycle than at any point going back to the early 1980s. Given the lagged response to changes in Fed policy, more tightening may need to be digested before the effects of recent cuts are felt.
- We do not believe the current slowdown has fully played out and anticipate continued volatility ahead.
Can the Consumer Endure Mounting Headwinds?
As the third quarter draws to a close, the ClearBridge Recession Risk Dashboard continues to indicate elevated recessionary risk with an overall yellow “caution” signal (Exhibit 1). In our view, the economy remains at a crossroads: a strong U.S. consumer and Fed rate cuts could help boost the economy, or manufacturing weakness, a trade war-induced drop in confidence and the lagged effects of tighter Fed policy in 2018 could lead to a recession. While this might bring to mind the old Harry Truman quote, one thing we firmly believe is that the coming quarter will see continued market volatility on the back of weaker earnings and a slowing economic backdrop.
Consumer Strength and an Easier Fed Could Save the Day
The strength of the U.S. consumer has been the rallying cry for bulls over the past several months. Recent data such as Housing Permits, which reached its highest level since before the global financial crisis in September, suggest the consumer remains on healthy footing. Yet consumer confidence has recently started to show some weakness. Specifically, the University of Michigan Consumer Sentiment and Conference Board Consumer Confidence surveys have fallen from peak levels. However, these declines have not yet translated to consumers pulling back and retail sales have reaccelerated after a weaker trend earlier in the year.
Perhaps unsurprisingly, the consumer section of the dashboard has been a pillar of strength with all four indicators showing green signals. This month there are no signal changes on the dashboard. As we look toward year end, we are most intently focused on the health of the consumer. If this foundation starts to show cracks, we believe the risks of a recession would rise meaningfully.
Exhibit 1: ClearBridge Recession Risk Dashboard
The strong consumer isn’t the only reason to be optimistic. Over the last nine months, we’ve seen a
remarkable shift in central bank policy. Be it trade war fears, a softening local economy, currency movements, or other reasons, policymakers around the globe have become more cautious and adopted more accommodative policy. At the start of the year, 42% of major central banks were hiking interest rates, while none were lowering rates. Today, 52% of major central banks are cutting rates while 48% are on hold (Exhibit 2).
Exhibit 2: Global Central Banks are in Easing Mode
Ultimately, this shift in policy could be a major reason why the current slowdown may not metastasize into a recession. Such a pattern would not be unprecedented. Past periods of slowing economic growth — and “false” yellow signals from the ClearBridge Recession Risk Dashboard — that did not turn into recessions saw an easing in Fed policy. Examples include 1995 and 1998, when the Fed cut rates by 75 basis points, and 2016 when the Fed hiked rates only once against a market that was expecting four hikes to begin the year. For more information, please see our Recession Indicators Update: Delving into Yellow Signals. With two interest rate cuts already enacted and a third currently priced into the market by year end, the Fed is trying to manage another “soft landing.”
Do Lagged Effects of 2018 Tightening and Manufacturing Weakness Signal
While the Fed and other central banks have eased policy this year, it could be a case of too little, too late. It can take up to 18 months for changes in short-term interest rates to fully impact the economy. In 2018, the Fed raised interest rates four times and continued to shrink its balance sheet (which has a similar effect of reducing liquidity) into mid-2019. As a result, the Fed’s balance sheet is over $600 billion smaller today than it was at its peak due to the quantitative tightening (QT) program that began at the end of 2017.
"We believe negative U.S. interest rates could be on the table should the next recession prove to be more severe."
This liquidity drain has had several impacts, including turning the Money Supply signal on the dashboard yellow and the recent disruptions in the repo market. Research from academia and the Atlanta Fed suggest that the combined effects of ending quantitative easing (QE), the shrinking of the Fed’s balance sheet (QT), and changes in delivering forward guidance have had the equivalent impact of several hundred basis points of additional rate hikes since 2013. When accounting for these alternative policy tools, the Fed has tightened policy to a greater degree in the current cycle than at any point going back to the early 1980s (Exhibit 3). Importantly, due to the lags associated with changes in Fed policy, the U.S. economy may not be “out of the woods” until the middle of next year.
Exhibit 3: Shadow Fed Funds Rate
The other major dynamic giving investors pause is weakness in the manufacturing sector. Last month, the dashboard’s ISM New Orders indicator turned red. As a reminder, the dashboard looks at the New Orders subcomponent of the ISM Manufacturing PMI survey, which is a good proxy for the business cycle. Going back to the 1950s, when the headline figure rolled over in periods associated with stable or easing Fed policy, it troughed at 49 on average (50 is the breakeven between expansion/contraction). By contrast, when a down cycle occurred in a period of Fed tightening (as is the case today), the average bottom has been at 40.5. This indicates further downside from the most recent 47.8 headline print.
Some investors dismiss the weakness in manufacturing, rightly suggesting that the decline of this sector over the years (to just over 10% of the U.S. economy today) makes it less relevant. But its higher volatility — among the components that comprise GDP, consumption has been about 40% less volatile than investment (which is more representative of manufacturing) since 2000 — suggests slowing manufacturing may be able to still do substantial damage and infect other areas of the economy.
Conflicting Signals from Fixed Income Markets
Fixed income markets appear to be facing a similar conundrum as the ClearBridge Recession Risk Dashboard. On one hand, the relentless drop in Treasury yields can be interpreted as a signal
of economic weakness. On the other, credit performance remains strong and the calm in credit spreads can be viewed as a positive sign.
Many market observers argue cross-over buyers from overseas are pushing down U.S. yields given negative rates in their home markets, and thus low yields can be ignored as less reflective of domestic weakness than in the past. However, currency hedging costs are substantial for overseas investors and only by going to very long-dated Treasury bonds and spread products can an overseas investor earn a positive return. As a result, the influence of negative rates across the globe on U.S. Treasury yields may be less than some believe.
Rather, falling PMIs, which are good proxies for the business cycle and have moved in near lockstep with 10-year Treasury yields since the financial crisis, suggest the slowing business cycle (softer domestic backdrop) is the more likely culprit for low U.S. rates (Exhibit 4). This has important implications for equity investors, as many have dismissed the yield curve’s inversion as a side effect of overseas bond market trends, perhaps unwisely.
Exhibit 4: Low U.S. Rates Reflect Softer U.S. Economic Backdrop
Could the U.S. See Negative Rates?
While negative rates in Europe and Japan may not be influencing Treasury yields to the extent some believe, the next downturn could bring negative rates to U.S. shores. Although we might not get to the point where individuals get paid by their bank to take out a mortgage like in Denmark, the lack of policy ammunition may force the Fed to become more creative during the next recession (Exhibit 5). On average, the Fed has needed to lower short-term rates by 7.4% during past recessions to jump-start the economy. With the Fed Funds rate peaking at 2.5% this cycle (so far) and the Fed having already cut by 50 bps, history would suggest it will need to adopt alternative policy tools in the next recession.
Exhibit 5: The Fed Lacks Rate Cut Ammunition
If the economy were to roll over into a recession, a return of QE is likely. The Fed’s balance sheet is one-fifth the size of Japan’s measured on a percentage of GDP basis, and less than half the size of the ECB’s relative to eurozone GDP. This means that the Fed has ample room to grow its balance sheet (Exhibit 6). These tools should be enough to help ward off a shallow recession, but what would happen in a more dramatic downturn? We believe negative rates could be on the table should the next recession prove to be more severe.
Exhibit 6: U.S. has More Room for QE
If this occurs, the impacts in the U.S. would likely differ from those in Japan and Europe, where local banking systems have been hit hard by negative yields. U.S. banks are much healthier and better capitalized than their global peers after reforms such as Dodd-Frank. Their stronger position should allow them to better deal with the burdens from negative rates.
To be clear, this pattern of events is not our base case. If the U.S. economy were to slip into a recession in the near term, we believe it would be shallow (economically speaking) given the lack of debt imbalances and the health of the banking sector. Furthermore, should the economy reaccelerate, this would give the Fed flexibility to increase rates down the road and build an additional reserve of ammunition with which to fight a more pronounced downturn.
Increased Volatility Likely, Blow-Off Top Not Evident
This discussion of negative U.S. rates may be premature as it remains unclear if the current slowdown will deepen into a recession. Not unlike a Polaroid, it takes time for the economic picture to develop. As we wait for clarity, we believe the ClearBridge Recession Risk Dashboard can help guide the way. Regardless of the outcome, we believe markets will remain volatile and the economy and earnings should remain soft in the near term.
While clouds may be gathering, we do not believe it is appropriate yet for equity investors to return to port. Last quarter’s Long View closed with a chart showing that the final year of a bull market has seen an average return of 26.9% going back to 1975. The most recent all-time high for the S&P 500 Index was reached in late July, and equities saw only a 6.6% rally in the 12 months preceding that high. This dynamic suggests we have yet to reach the stage of a blow-off top and investor euphoria experienced during the end of past bull markets.
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