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Indicators can inform our understanding of the economy and investment strategy. For example, economic indicators can help explain the stage of a particular economic cycle, market indicators can help explain how the market is behaving, and sentiment indicators can shed light on how investors are feeling.

With this post, Cardan Capital Partners begins a new, monthly series that examines different indicators we believe are relevant to the current environment. Without further ado:

The economy appears to be at an inflection point in terms of tilting toward a recession — or just evading it via the continued Federal Reserve policy of easing and a potential deal on the trade war front. Will these be enough to stave off recession?  Here’s a look at two indicators supporting the case for looming recession and two indicators that support the case for continued growth.

One for recession

The Cardan Aggregate Yield Curve

Disclosure: Data sourced from Bloomberg LP. Recession dates defined by the National Bureau of Economic Research (NBER). 1/3  is the spread between the 3-year and 1-Year Treasury; 3/5 is the spread between the 5-year and 3-Year Treasury; 2/5 is the spread between the 5-year and 2-Year Treasury; 3M/5 is the spread between the 5-year and 3-monthTreasury ; 2/10 is the spread between the 10-year and 2-Year Treasury; 1/10 is the spread between the 10-year and 1-Year Treasury; 3M/10 is the spread between the 10-year and 3-month Treasury; Fed Fund /10 is the spread between the 10-year and Fed Funds rate (i.e. central bank rate). Data is for illustrative purposes and not meant to be relied upon for consumer trading decisions.

 

The Cardan Aggregate Yield Curve looks at the average spread across different points along the Treasury yield curve, a total of eight observations. If the average yield spread of these observations turns negative (an inversion where longer-dated bonds have an interest rate yield less than shorter-term bonds), a recession is likely. Since 1960, all seven recessions were preceded by this inversion. Only 1965 had an inversion that did not materialize into a recession — although economic growth did slow. Additionally, if at least 75% of the eight curve spreads observed are inverted, recession has followed — again with only 1965 being the outlier. As of yesterday, the aggregate yield curve has moved from inversion to widening again (behavior in-line with prior recessions) and only 50% of the curve is inverted. On a month-end basis, we have had an inversion of the aggregate yield curve in six of the last seven months, and at least 75% of the spreads were inverted in four of the last seven months. This tells us little about the specific timing or magnitude of the potential recession. It suggests only that if history is a guide, the probability of recession has increased.

One for continued growth:

New Home Sales

Housing plays a vital role in the U.S. economy as it drives much of consumer spending and larger purchases. The high for the current cycle was in June 2019, only three months ago. Historically the cycle high has been a median of 28 months before the next recession (arrows), suggesting that recession is still far off.  Notably however, it’s cycle overall has been softer in terms of sales than previous cycles and previous recessions have occurred as early as 11 months after the peak and as late as 78 months. It is possible we may hit a new cyclical high. Given the aftermath of the Financial Crisis in 2007/08, it is understandable that much focus has been given to the housing sector. Nevertheless, we can’t help but feel that the causes of the next recession are likely to emanate from other areas of the economy.


Source: U.S. Census Bureau

Another for recession

Corporate Debt as % of GDP

During economic expansions, corporate debt builds as companies borrow to expand and grow. Eventually, the cycle turns, and businesses refocus on paying down their debts. Corporate debt as a percentage of U.S. nominal GDP is at a record high, and is now an area that could cause economic stress that tilts us into the next recession. Curiously, high yield spreads (the spread between riskier corporate debt and the U.S. 10-year Treasury) have not yet followed the corporate debt pile higher. Historically, as the cycle ages, high-yield bond spreads start to widen as the corporate debt pile grows and as market participants recognize the risks that are building in the system. The investors observe the increasing amount of corporate debt and eventually demand a higher rate of return, widening the spread between high-yield and government debt. Higher absolute debt levels increase the overall risk in the market. Until the high-yield spread begins to widen, there would appear to be no cause for concern. One of the oft-cited reasons for the continued narrow spreads during this cycle has been the prolonged low rate environment Fed policy has driven since the Great Financial Crisis. By keeping rates low, no one has had to pay the piper, so to speak. This does not mean the risk is not real and that the payment will be due eventually.


Source: Bloomberg LP.

Another for growth

Stock Market Reaction to Fed Rate Cuts

The following chart from Guggenheim Investments illustrates how the stock market’s reaction to the Fed’s interest rate cuts is an indication of whether the easing policy fulfills its goal as a mid-cycle adjustment. Since the first rate cut on July 31, 2018, the market is up 10.9% through October 30, 2019, indicating the easing is potentially working. The chart below shows the average return path the S&P 500 has taken since the first rate cut by the Fed happened. For the successful mid-cycle adjustment (blue line), the market moves higher, whereas for the average recession (grey line) the market declines. Thus, the market has moved up positively since the first Fed rate cut in July 2018 is a positive sign.

Conclusions

Any indicator in isolation can be compelling and cause one to reach conclusions hastily. By observing a larger set of indicators, one can develop a better picture of the overall economy, market and investor sentiment.

 

General Disclosures: The content contained in this article represents the opinions and viewpoints of Cardan Capital Partners only. It is meant for educational purposes and not meant for consumer trading decisions.  All expressions are as of its publishing date and are subject to change.  There is no assurance that any of the trends mentioned will continue in the future.  Market performance cannot be predicted, so nothing in our commentaries is ever meant to provide any kind of trading advice or guarantee of future results.  Certain information contained herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed. Any reproduction or distribution of this presentation, as a whole or in part, or the disclosure of the contents thereof, without the prior consent of Cardan Capital Partners, LLC, is prohibited. Investments in securities entail risk and are not suitable for all investors. This is not a recommendation nor an offer to sell (or solicitation of an offer to buy) securities in the United States or in any other jurisdiction.
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