SSLY - Long Leading Forecast Remains Negative With Recession Watch Continuing Through 2023

Summary

• The long leading indicators have a record over many decades of forecasting downturns in the economy 1 year or more early.
• This series of 8 indicators turned negative 1 year ago, giving rise to a “Recession Watch” beginning this Quarter.
• Updated through January, the series is unrelentingly negative, meaning the “Recession Watch” remains in effect through all of 2023.

Introduction

With the report on Q4 GDP and the Senior Loan Officer Survey of bank lending by the Federal Reserve, almost all the information we need to take a long range peer into the likely state of the economy one year from now, via the long leading indicators.

What Are The Long Leading Indicators?

I have several systems for forecasting the economy. One is the high-frequency "Weekly Indicators," which, as the name implies, is updated weekly and is thus very timely. For the short term, up to about 6 months out, a second, K.I.S.S. method, relies on the Index of Leading Indicators, is a perfectly adequate tool with the inconvenient habit of being right more often than most highly paid Wall Street forecasters. I last updated this three months ago in late November, so for now I will reverse my regular order and update the longer term forecast first.

Short Term Forecast: Recession Warning For H1 2023

To forecast the period over 6 months out, I turn to "long leading" indicators, relying for that on monthly and quarterly data which has been extensively vetted in for decades already, and as during that time going back 50 years has a sustained record of turning one year or more before the onset of a recession.

Most of what you read which seeks to forecast the economy falls into two categories of leading you astray:

1. Most observers simply project existing trends into the future, overlooking that there are some data-points that reliably turn before others, and thus completely miss turning points until they are already in the rear view mirror.

2. A great deal - perhaps most - of what you read about the economy starts off with an ideology and a conclusion based on that ideology already baked into the cake. The writer then marshals a series of data-points that confirm that already-determined conclusion. The very same utterly decisive economic metric from last year that was moving in one direction is completely ignored this year when it is moving in the opposite direction, and vice versa.

By contrast, my method is to look repetitively at a bank of indicators that have decades - in a few cases, over a century - of history, and a demonstrable record of being reliable harbingers of the continuation or reversal of an existing trend.

Now let's return to my main topic at hand. Geoffrey Moore, who for decades published the Index of Leading Indicators, and in 1993 wrote " Leading Economic Indicators: New Approaches and Forecasting Records ," identified 4:

• Housing permits
• Corporate bond yields
• Real money supply
• Corporate profits adjusted by unit labor costs

A variation of the above is Paul Kasriel's "foolproof recession indicator," which combines real money supply with the yield curve, i.e., the difference in the interest rate between short- and long-term treasury bonds. This turns negative a year or more before the next recession about half of the time.

Another long leading indicator has been described by UCLA Prof. Edward E. Leamer, who wrote " Housing IS the Business Cycle ." In that article, he identified real residential investments as a share of GDP as an indicator that typically turns at least 5 quarters before the onset of a recession.

Several other series appear to have merit as long leading indicators as well. Real retail sales in several forms also have value as a long leading indicator and, in particular, real retail sales per capita. Additionally, the tightening of credit conditions also appears to have merit as a long leading indicator.

That gives us a total of 7 categories of long leading indicators. All of these economic series have a long-term history of turning a year or more before a recession.

Important Previous forecasts

Last August, in my forecast through the middle of this year, I wrote:

"The indicators have continued to deteriorate in the past 6 months. As of now, not a single one is positive.

"Three are mixed or neutral . . . . The remaining 4 . . . are now negative . . . .

"Based on these indicators, the "Recession Watch" beginning in Q1 of 2023 remains in force."

As indicated above, when the short leading indicators also turned down, I upgraded this to "Recession Warning" in late November. Several coincident indicators; namely industrial production and real manufacturing and trade sales, appear to have already turned down, but several others, notably real personal income and most emphatically payrolls, have not.

Current Trends In The Long Leading Indicators

Corporate Bond Yields

On a monthly basis, corporate bond yields data goes back over 100 years to 1919. With the exception of the 1981 "double-dip," the fiscal contractions underlying the 1938 and 1945 recessions, 1926, and - excusably I think! - 2020's pandemic - corporate bond yields have always made their most recent low over 1 year before the onset of the next recession, as shown in the graph below of the last 40 years (although the correlation goes back much further):

The sharp rise upward in bond yields in 2022 was the most in the past 40 years, even surpassing those before the last 3 recessions. Thus corporate bonds are very negative.

At the same time, note that bond yields have declined significantly since late October, as shown in this close-up of the past 3 years:

On the other hand, most often bond yields have peaked before recessions, and before the Fed is even finished raising rates. Likely this has happened again. If yields fail to make a new high within 4 months of their last, that has been a sign that they have likely started their recessionary descent - which lays the groundwork for the beginning of the next expansion. Thus, should there be no new highs in yields by the end of this month, this indicator will turn neutral, and may be an important signal of when the economy will resume growth.

Housing

Housing, which typically follows interest rates with a few months' lag, has typically declined by over one year, and by 20% or more before the onset of a recession (the mild recession of 2001 being the exception, with only a 10% decline), as shown in the below graph of housing starts (blue), permits (red), as well as new home sales (gold):

As close-up on the past 3 years shows that housing followed the pattern of interest rates in 2021-22, declining by well over 20% by autumn and then recovering somewhat:

Interestingly, sales (the most leading indicator but very noisy) may have bottomed in July, which is another hint that a recession this year may not last that long.

Additionally, housing as a share of GDP, both nominally and in real terms, declined further in Q4, and is now over 20% by either measure from its expansion peak in Q1 2021:

"It's different this time" has been a good way to be wrong about the economy, but the truth is, there *is* one important difference this time about housing's effect on the economy - housing units under construction, the ultimate measure of the economic impact of housing, continue to be at near record highs.

Units under construction reliably follow permits and starts higher and lower, but with the proverbial "variable" lags. And while typically units under construction have followed permits down in 3 - 6 months, occasionally it has taken much longer - just as it has now:

So, while officially housing remains a firm negative, it will not truly impact the economy until units under construction follow permits and starts down by at least 10%.

Corporate Profits

Corporate profits deflated by unit labor costs have an excellent track record going back over half a century as well. Below I show them both with and without inventory adjustments, as well as the placeholder of proprietors' income, for the past 70 years, in log scale:

Here is the close-up for the past 3 years:

Proprietors' income, like corporate profits, recovered from relatively poor performance in the first part of 2022, but are still below their 2021 peak.

Additionally, here is the chart of nominal corporate profits for the S&P 500 through last week by FactSet:

This also shows corporate profits down over 5% from their nominal peak in Q2 of last year.

As a result, this indicator is also a negative, although a slight one.

Real Money Supply

No recession has ever started without at least real M1 turning negative or real M2 declining to under +2.5%. Here is this relationship going back over 60 years until the end of 2019 on a YoY% basis:

And here is the last 18 months:

In March 2022, Real M2 turned negative YoY. It was joined by real M1 in May. Currently both are down more than -10%, the worst level since 1980.

Real money supply is also a negative.

The Yield Curve

This has been an excellent long-range forecasting tool in times of inflation (although I do not think a positive yield curve is definitive in low interest rate deflationary environments). In the last 60 years, typically, a recession has begun after the Fed raises rates to combat inflation, and sufficiently so that the yield curve inverts.

Here is what the yield curve across the spectrum of Treasury maturities looked like at the end of last week (light red):

Here is what 3 popular measures of the yield curve, the 10 year minus 2 year Treasury, 10 year minus 3 month Treasury, and 2 year Treasury minus Fed funds rate, look like for the past 25 years:

All three have inverted, although last week the 2 year minus Fed funds measure un-inverted for at least a few days. Thus the yield curve is also negative.

Credit Conditions

The loosening or tightening of credit also appears to be an important component of changes in the economy over one year out. Although it only has a 30-year track record, two components of the Senior Loan Officer Survey have had a good track record.

The first component, the percentage of banks tightening vs. loosening standards for commercial loans to large (blue) and small (red) firms, has turned very positive in the series, to levels only seen near or during recessions. Note that a "positive" number actually means tightening. Don't blame me!:

The second component, demand for loans by large (blue) and small (red) firms, however, turned even more positive to one of its stronger readings for the entire 30 year series, also at levels only seen near or during recessions - and, confusingly, for this metric positive really is positive!:

On the other hand, the Chicago Fed Financial Service Index, Adjusted Financial Conditions (red) index, and Leverage subindex, which have a good record anticipating the Senior Loan Officer Survey's result re tightening credit, and which went "positive" (meaning bad for the economy) during the autumn, have rebounded to neutral or even "negative" readings:

Because the weekly data has not confirmed the quarterly data, this indicator is only weakly negative.

Real Retail Sales Per Capita

These peaked more than a year before the onset of the last two recessions, but made troughs within six months of each recession bottom.

These made record highs in March and April 2021, during the stimulus spending spree, which I am discounting, and therefore discounting the YoY negative readings from March and April 2022. But since September, these have been unequivocally negative on a per capita basis:

Summary And Conclusion

Let me point out, first of all, that this is a more comprehensive set of indicators, and in some cases, indicators with longer and better track records than are found in my more timely "Weekly Indicators" columns.

Not only have these indicators have continued to deteriorate in the past 6 months, but not only are none positive, for now none are even neutral! Every single one is negative, if even slightly so.

Based on these indicators, the "Recession Watch" that I issued last spring to begin this Quarter, and amplified into a "Warning" in November, remains in effect throughout this year. This does not mean that a recession will last all of this year. Rather, it means that the conditions which were ripe for a recession will continue for the next 12 months, subject to the condition that these indicators typically indicate that a recession is ending more on the order of 6-8 months ahead rather than 1 year ahead. And as indicated above, the first of them, corporate and long Treasury bond rates, may turn neutral by the end of this month.

I will update my short term forecast for the next 6 months separately.

For further details see: