The US economy has defied the bearish consensus this year, with fears of recession failing to be realized. This has helped US stocks rise, while US bond yields have risen as worst case economic fears fail to materialise.
A large part of the concern around the US economy heading into 2023 stemmed from the recession signals emanating from 2 well-followed leading indicators – namely, the inverse yield curve and the Conference Board Leading Economic Index.
Both indicators have been warning of an impending recession since mid-2022. As a result, the consensus had penciled in a US recession from around the middle of this year.
In contrast to this gloomy projection, the US economy appears to be tracking at an above-trend growth pace in Q3, while unemployment remains near record lows.
An Unusual Post-covid Economic Picture
So, why has the US economy defied the dire predictions from previously reliable leading indicators?
In large part, we think the US economy has some unique attributes in this current cycle. As a result, our own base case was, and still is, that the US is unlikely to succumb to recession this year.
This view was in part based on the amount of excess cash sitting on household balance sheets following the US government’s Covid fiscal splurge. These excess savings have been supporting US consumption this year. The other key supportive factor for the US economy we have been highlighting is the unusually tight labour market.
With a record jobs vacancy rate over and above a very low unemployment rate, the US labor market has been extremely tight. As a result, our view has been to expect solid and very resilient jobs growth in 2023 as companies move to address significant unmet demand for labour.
Due to these unusual economic factors, the prospect of a 2023 recession seemed unlikely in our view, despite the recessionary signals from traditional leading indicators.
Are We just Dealing with Policy Lags?
Is it possible that a US recession has merely been delayed rather than completely averted? This is possible when one considers that both commonly followed lead indicators have long and variable lags. The average lead on recession from the (inverted) yield curve signal has been 14 months, and ranges from 5 - 22 months. The yield curve inverted 14 months ago, in early-July 2022.
In comparison, the average lead from the Conference Board Leading Index has been 7 months (based on the Conference Board’s “fitted threshold” level) and ranges from a lead of 5 - 24 months.
So, both indicators are not outside the bounds of their historical recession leads. Nevertheless, the fact the US economy is seemingly so resilient more than a year after both indicators first began warning of recession is causing market pundits to question the validity of these recession signals.
| Indicator | Signal | Average lead time (months) | Shortest lead time (months) | Longest lead time (months) |
| Yield curve | Inversion of the 10y-2y treasury curve | 14 | 5 | 22 |
| LEI | 6m growth rate falls more than 4% over 6 months | 7 | 5 | 24 |
Source: Refinitiv, Wilsons.
What Might Be Wrong with these Popular Leading Indicators?
The index of leading economic indicators traces its origins to work done at the National Bureau of Economic Research in the 1930s and 1940s, to try to predict US business cycles. The index is composed of 10 economic series; changes in each of these series are divided by their individual standard deviations so that they should each, over time, have a roughly equal weight in determining the change in the overall index. As discussed, the “lead” of the indicator has varied quite significantly over time. However, based on the average lead, a recession is “overdue”.
One issue we have with this indicator relates to its origins back in the 1940s, when the US economy looked quite different. In particular, 4 of the 10 leading indicator components refer directly to conditions in manufacturing, even though manufacturing, as a sector, now accounts for only around 10% of the US economy. Further to this skew to manufacturing, the pandemic saw an immediate surge in the demand for goods and a slump in the demand for services, followed by the reverse as the economy recovered. An index that emphasized manufacturing would therefore very likely underestimate economic momentum over the past two years as the economy shifted toward services led growth.
Where Is the Neutral Policy Rate?
While we can point to potential flaws in the construction of the Conference Board Leading Index, the simplicity and strong performance of the inverse yield curve over time arguably makes it harder to dismiss. Certainly, the yield curve has a strong – if not perfect – track record. We would highlight the mid-1960s as one significant inversion that did not lead to a recession, despite the much claimed “perfect” track record of the yield curve. In the case of the mid-60s, a recession took more than 4 years to arrive post inversion, which we count as 1 very clear false signal. While the record of the yield curve indicator is not quite as perfect as often claimed, it is nonetheless strong and it is possible that we could just be witnessing a longer-than-average lag given we are still within bounds of historical lead times.
Why does the yield curve have such strong historical predictive power? Logically, the yield curve should normally slope upwards. Due to their higher duration, the total return on long-term bonds is more volatile than on short-term bonds, and investors should be compensated for this volatility with a higher yield. In short, an inverse yield is a signal that the market thinks short-term policy rates have moved above “neutral”. Bond investors believe policy is clearly tight, and this is likely to lead to a recession, which would in turn see rates cut significantly.
Indeed, the Fed itself continues to guide to a long-term (beyond 2026) neutral Fed Funds rate of 2.5%, so current policy is “theoretically” very tight on this measure. It is, however, quite possible that the “neutral rate” is much higher than the Fed and the consensus is factoring in, at least temporarily. Fed chairman Jay Powell made a passing reference to this possibility in his discussion last week.
This underestimate of the current neutral rate could stem from the unusual state of household balance sheets and unusual labour market dynamics that we have highlighted. Ongoing very easy fiscal policy beyond the Covid splurge is another consideration in lifting the neutral rate. This would explain why the economy does not appear to be slowing down much even with a policy rate above 5%.
Household savings are not far off being exhausted, and labour hoarding may eventually give way to the usual process of labour retrenchment, although it is difficult to say exactly when.
So, there is a danger that policy suddenly becomes quite tight. This could potentially occur sometime over the coming year. As a result, there is a risk that the Fed leaves policy too tight for too long. Currently the market expects the Fed to start easing around mid-24. Whether this means the Fed can achieve a famous soft landing is still unclear.
For now, the US economy is not behaving like it is in major trouble. Even more encouraging are signs that inflation is easing without much of a slowdown in growth. So, a soft landing still looks plausible to us.
On the cautionary side, when we look at consumer dynamics it is hard to escape the notion that the consumer is set to slow significantly over the coming year, as savings are exhausted and other headwinds (e.g. resumption of student loans repayments) present themselves.
A recession does not appear imminent, but the risk of a recession over the next 12 months does appear to be above average. Nevertheless, a slow down to soft landing remains our central case. If correct, this should see the recent back-up in bond yields fade, which should provide renewed support for equities, particularly in the US market, given its defensive growth bias.
However, with the efficacy of key leading indicators open to question, we continue to watch the consumer and the labour market in real time for signs of weakening.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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