The Big Picture
There is a lot of discussion these days about whether the U.S. economy will have a soft landing or a hard landing (the euphemism for a recession).
What is a recession? The textbook definition says an economy is in recession if GDP contracts for two consecutive quarters.
That doesn't mean there can't be recessions in individual sectors of the economy when you don't have economic activity contracting for two consecutive quarters, yet that doesn't count as far as the National Bureau of Economic Research's (NBER) Business Cycle Dating Committee is concerned.
Why does that matter?
The NBER is the official arbiter of when there is a recession, and its "definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months." The NBER says three criteria -- depth, diffusion, and duration -- are treated interchangeably in the interpretation of its definition.
A Closer Look
What is it, though, that the NBER is looking at insomuch as it relates to "economic activity" as it tries to identify peaks and troughs in an economic cycle? Not surprisingly, the committee emphasizes "economy-wide measures of economic activity," which include the following:
- Real personal income less transfers
- Nonfarm payroll employment
- Employment as measured by the household survey
- Real personal consumption expenditures
- Wholesale-retail sales adjusted for price changes
- Industrial production
The NBER clarifies that, "There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions. In recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment."
Let's look at those two measures a little more closely.
Real personal income less transfers isn't screaming recession. If anything, it could be carving out a message of an economy peaking, but that message can only be read in hindsight.
The chart below, which covers the last three decades, clearly shows that the trend in real personal income less transfer receipts looked good -- until it didn't -- before a recession. What is evident in the chart is that there has been a drop-off in real personal income less transfers during the recessions seen in the last 30 years. That isn't evident now.
The same holds true for nonfarm payroll employment. With each recession since 2000, there has been a notable decline in nonfarm payroll employment. That goes hand-in-hand with the drop-off in real personal income that is integral for consumer spending.
This is why the Fed is pre-occupied now with the labor market and why Fed Chair Powell said in his Jackson Hole speech that, "We do not seek or welcome further cooling in labor market conditions." The Fed recognizes that the key to a soft landing is a stable labor market.
That stability is being put to the test. The 4.2% unemployment rate in August was improved from 4.3% in July, but it is up 80 basis points from the 3.4% rate seen in April 2023. Nonfarm payroll employment, however, continues to be positive.
Looking Ahead
These key indicators for the NBER are in good shape currently, but the NBER readily admits that its determination of turning points in the economy is retrospective. In other words, an expansion will have likely started well before the NBER calls a trough and a recession will likely have started well before the NBER calls a peak. Hindsight for the NBER is 20-20.
The capital markets, of course, are forward-looking and their vision is never 20-20. It can be close, but corrective lenses are often needed.
What the markets are seeing now is a slowdown ahead. A soft landing has been the prevailing view, but there have been enough rumblings beneath the surface to raise some doubt about the economy achieving a soft landing:
- The 2s10s spread has reverted to a normal posture with short rates falling faster than long rates (the 2-yr note yield has dropped 59 basis points this year while the 10-yr note yield has dropped 16 basis points).
- The best-performing sectors this quarter have been the rate-sensitive utilities, real estate, and financial sectors, followed by the counter-cyclical consumer staples and health care sectors.
- WTI crude prices have fallen from $87.00/bbl in April to below $70.00/bbl today despite the ongoing Israel-Hamas war, which has included increased skirmishes with Hezbollah, OPEC+ delaying a plan to increase output for two months, the dollar weakening, and the U.S. government standing as a ready buyer at lower prices to replenish the Strategic Petroleum Reserve.
- The latest Beige Book indicated nine of the 12 Fed districts reported flat or declining activity (up from five in the prior period).
- Trucking company ArcBest (ARCB) said it continues to see lower weight per shipment levels, reflecting the softer macro environment. Fellow trucking company Old Dominion Freight Line (ODFL) said its revenue results in August reflect continued softness in the domestic economy.
- The ISM Manufacturing Index has reflected a manufacturing sector in a state of contraction in 21 of the past 22 months.
- Deep discount retailers Dollar Tree (DLTR) and Dollar General (DG) sharply cut their full-year guidance as core customers, feeling the pinch of inflation, interest rates, and other macro pressures, reduced their spending on discretionary items.
- The Philadelphia Semiconductor Index is down more than 20% from its July high, meeting the generally accepted definition of being in a bear market. Semiconductors are deemed to have leading indicator status because they are used so widely in consumer and industrial applications.
To be fair, there is an indicator that is still flying in the face of a hard landing outcome (or maybe we should say laying low). That would be the spread between junk bonds and Treasuries. That spread typically widens noticeably when economic worries escalate. It has bumped up just a bit recently, but the chart below suggests there isn't undue concern in the corporate bond market about a hard landing.
What It All Means
Just like the other charts for real personal income less transfers and nonfarm payroll employment, the chart of junk bond spreads shows things can look bad in a hurry in hindsight. Things may look good now, specifically with junk bond spreads, but things in general feel a bit uncomfortable when it comes to the economy.
The Treasury market is sensing as much, which is why yields have dropped precipitously. The fed funds futures market is sensing as much, which is why it is pricing in 100 basis points of rate cuts before the end of the year. The oil market is sensing as much, which is why prices are sliding despite several key sources of support. The stock market is starting to sense as much, which is why buyers have shown a lack of conviction of late.
Maybe even the NBER is starting to sense it, even though the two measures its has placed the most weight on in recent decades for identifying peaks and troughs still speak to an economy in growth mode.
The NBER will tell us with confidence in hindsight when the economy peaked and troughed. What it looks like now, clearly, is that growth is slowing. Given that, a stock market trading at a rich valuation is going to be more discerning in terms of where the wealth is spread, and a Treasury market staring at an inverted 2s10s spread for over two years, is likely to spread the wealth further in a curve-steepening trade.
