“If I can’t picture it, I can’t understand it.”
—Attributed to Albert Einstein
“In order to properly understand the big picture, everyone should fear becoming mentally clouded and obsessed with one small section of the truth.”
—Xunzi, Confucian philosopher
There’s hardly a more hackneyed expression than “painting the big picture,” so I avoided using it in the first article in this series, even though the series is partly about, well, painting the big picture.
In this article, though, I’ll throw in the towel. (Yup, I’m explaining my use of one hackneyed expression by using another.) As the popular Confucian rhyme goes, “If it’s good enough for Xunzi, it’s good enough for me.”
So we’ll follow Xunzi’s advice, along with that of Albert Einstein, and paint the big picture. From the painting advice I offered in the intro article, we’ll apply the following principles to the U.S. economy:
- Just as your overall health depends on a complex web of interacting bodily systems, the economy’s health depends on a web of interacting cycles, which I’ll call component cycles.
- The most important component cycles are the core business cycle, business credit cycle, stock price cycle, household credit cycle, home building cycle and house price cycle.
- The component cycles demand our attention both individually and collectively—they help us determine the economy’s balance of positive and negative forces at a point in time.
- At a threshold defined as the momentum of negative forces (think vicious loops) exceeding the momentum of positive forces (think virtuous loops), a recessionary process is underway and probably irreversible.
- A well-constructed checklist—one that separates leading from coincident and lagging indicators within each of the component cycles—can be an effective tool for weighing positive and negative forces and predicting recessions.
- That checklist should assign predetermined roles to predetermined indicators (each has a specific job to do), and it should encompass all of the potentially leading areas of a “six-cycle map” of the economy.
In my experience and in backtests, these principles lead to better Business Cycle forecasts (capitalizing to avoid confusion with the component cycles) than the more conventional approach of pouring a giant bag of indicators into a giant pot and statistically blending them.
I’ll put the principles to use in just a moment, but first I’ll repeat the diagrams included in the intro article that help demonstrate how the approach works. The first diagram is a map combining key pieces of each component cycle:
The second diagram collapses the map into a stylized template for tracking the economy:
The last diagram uses the template to show the economy’s descent into recession from 2006 to 2009:
Is a U.S. Recession Imminent? (Part 1)
I included the diagrams because they can help you “picture” the six-cycle approach, but they’re not especially predictive without refinements, and that’s where the aforementioned checklist comes in. My primary checklist, designed to screen for recession risks, consists of ten assessments—two for the core business cycle, one for every other component cycle and one each for the foreign sector, fiscal policy and monetary policy. For each of the ten, my assessments take one of only three readings—“risk-on,” “risk-off” or “neutral.” Checklist items that are risk-on are booming, those that are risk-off are weak enough to help push the economy into recession, while a neutral reading means that the particular item signals neither acceleration nor deceleration from the economy’s long-term trend.
As I argued in the intro article and in greater depth in my book, checklisting can provide the discipline we need to carefully weigh the economy’s positive and negative forces. Although sometimes written off by the pretentious as not sophisticated enough, checklist-based methods are time-tested and easy to understand. In a macro world bulging with madcap mathematical theories and short-lived econometric models (they habitually “blow up”), longevity and simplicity are nice features to have.
So without further review, here are my checklist assessments for the U.S. economy, which I’ll keep short by glossing over the more detailed analysis. I’ll then use the assessments to gauge the risk of an imminent recession.
- Core business cycle (business earnings): Neutral. Although the perpetually revised national accounts data show five years of falling corporate earnings on a pre-tax operating basis, and Factset shows S&P 500 earnings declining on a year-over-year basis in Q1 and possibly also Q2, the more transparent GAAP earnings grew strongly through Q1 and also Q2 with the reporting season just more than halfway over. For most purposes, I prefer GAAP, but in this case I’ll be conservative and call it a stalemate.
- Core business cycle (household earnings): Neutral. Household earnings growth is a bright spot, but it isn’t quite strong enough as of this writing to record a risk-on reading.
- Business credit cycle: Neutral. Business credit demand is weaker than usual, but lending standards haven’t significantly changed in either direction, while bank balance sheets are expanding at a moderate pace.
- Household credit cycle: Neutral. Household credit demand is also weaker than usual, but once again lending standards haven’t significantly changed and banks continue to expand.
- Stock price cycle: Neutral. Although the 12-month change in real stock prices is strong, my research suggests that market levels haven’t climbed above last year’s highs by enough to merit a risk-on reading.
- House price cycle: Neutral. Although house price growth is decelerating, it’s still slightly above the CPI inflation rate. It would have to drop another 3% or so, depending on changes in consumer inflation, before I would call it a risk-off reading.
- Home building cycle: Neutral. The home building cycle is weakening, although the rate of change is glacial and the effects on GDP almost imperceptible. It remains to be seen if the flat-to-downward trend will continue at the same pace or develop into something more jarring.
- Foreign sector: Neutral but on watch for a possible downgrade. Although slowing exports have weighed slightly on GDP, imports have dropped as a percentage of GDP (a measure of import penetration) in the first half of 2019. On balance, data fail to support a risk-off assessment, although that could change with either a steeper drop in exports or a rising propensity to import.
- Fiscal policy: Neutral. Government spending is growing at a decent clip in 2019, while taxes and net transfer receipts dropped to a new six-year low as a percentage of GDP in the first half of the year, which can only help household and business spending power. So fiscal policy continues to support growth, although it falls short of a risk-on assessment. Also, the mini–fiscal cliff that many forecast for late 2019 and 2020 now looks as though it might be more like a mogul, if anything at all, thanks to this week’s free-spending, drop-it-on-the-kids debt ceiling deal.
- Monetary policy: Risk-off. The (mostly) inverted yield curve suggests that monetary policy is restrictive.
*For all four credit and asset price cycles, I also rely on a measure of “thin-air” spending power, which my indicator-update subscribers know as “TSP.” See “TSP Indicator Update: Criss-Cross, Flip-Flop and Remembering 1966.”
Overall, the checklist assessments are unusually, well, neutral. And neutral isn’t especially good—the checklist looks worse than it has since early 2012 at the depths of the European debt crisis. The first quarter of 2012 was the last time that risk-off assessments outnumbered risk-on assessments, and the absence of any risk-on assessments in the current checklist is also a rarity. So the economy comes through my checkup looking far from vibrant, which you might have expected considering recent buzz about a potential global recession.
All that said, the paragraph above is the gloomiest one I’ll write, because my checkup falls short of a recession prediction for two reasons. First, recessions normally follow a few quarters with four or more risk-off assessments, which would tell us that vicious loops are cutting across component cycles and threatening to overwhelm the economy’s positive forces. Second, recessions normally begin with significantly more risk-off than risk-on assessments, which would also tell us that negative forces are beginning to prevail. Using a mechanistic version of the checklist and calculating a composite indicator as the number of risk-ons minus the number of risk-offs, here are the readings at the last nine Business Cycle peaks: -1, -3, -6, -5, -8, -8, -5, -2 and -5. And here are the readings one quarter before the last nine BC peaks: -3, -1, -6, -3, -6, -6, -2, -4 and -1. (For reference, the economy peaked in Q3 1957, Q2 1960, Q4 1969, Q4 1973, Q1 1980, Q3 1981, Q3 1990, Q1 2001 and Q4 2007.)
But that’s enough numbers, because the approach is easier to grasp in pictures. Here’s a template that shades risk-on and risk-off assessments, first for the current checklist and then for the checklist readings before past recessions:
The charts approximate the economy’s balance of positive and negative forces at a point in time, helping to expose impending recessions. They map the contours of each recessionary process, which can then be compared to the present, demonstrating the ease, discipline and balance of the six-cycle approach. They can also help to manage any debate—if you disagree with this or that assessment, you can substitute your own view without building a whole new “model.” And as far as the debate goes, in a future chartbook I’ll expand both the historical analysis and the rationale behind my current assessments. For now, though, let’s take a deeper look at today’s outlook and get subjective.
Is a U.S. Recession Imminent? (Part 2)
Here are three points to consider about the current expansion, building once again on the six-cycle map and checklist but subjectively this time, meaning without the composite indicator’s arithmetic.
First, the expansion continues to draw strength from rising after-tax real incomes, steady bank credit growth and record (or near-record) asset prices, and those three forces usually boss the Business Cycle. In fact, over the last 65 years the economy has never fallen into a recession with all of the following circumstances in place: (A) after-tax real incomes rising for households and businesses, (B) bank credit growing at a decent pace and (C) risky asset prices also growing or at least flat. Since A, B and C feed into spending capacity, that historical fact only says that spending is unlikely to fall (as it would in a recession) if spending capacity is growing.
In other words, neither households nor businesses will slash spending without having a good reason to do so, and historically that reason is that they’re either earning less money or they have less access to money via bank credit or asset sales. So history aligns perfectly with how you might expect households and businesses to decide how much to spend. And as of this writing, I’m not sure what would cause spending to fall today, since A, B and C are all true according to my analysis, as shown by the first six checklist items being neutral.
Of course, not everyone looks at it in the same way, and some might say the risk of a spending contraction lies in a fear of the unknown, such as the uncertain effects of a tariff war. But if fear alone drags spending lower, I would expect to see it in bank behavior and risky asset prices before we see it in the broad economy, and that brings me right back to waiting for a false reading from A, B or C.
Second, and notwithstanding my point above, another argument holds that some combination of the housing, foreign and government (think fiscal policy) sectors could combine with the lagged effects of monetary tightening and push the economy into recession. With at least some reasons for concern in each of the three sectors mentioned, this seems a valid risk to watch for, but I don’t see it in the data. In fact, the last few quarters of national accounts data show that the government sector is still growth supportive, as noted above, and the housing sector is hard to get excited about one way or the other—it hasn’t boomed during the current expansion nor does recent weakness qualify as a bust.
Third, the checklist is relatively sanguine in comparison to other popular indicators that have stalled or pointed downwards in recent months, such as the yield curve, PMIs, industrial production, construction, small business hiring and new home and car sales. If these indicators have convinced you the end is nigh, you’ve probably already stopped reading and may have jumped straight to the comment section of whatever site you’re on to tell everyone what a dunce I am. That’s fine, conflicting views are what makes a market, and you might be proven right. I’ll just point out that many of the weakest indicators are coincident or lagging indicators that tend toward mini-cycles of strength and weakness within the overall Business Cycle, which makes them unreliable as recession signals. The biggest exceptions are probably the housing sector and the yield curve, but you’ve already heard my thoughts on housing, and as alarming as the recent curve inversion might seem, historical correlations suggest that other indicators might be more effective. (For example, scroll near the end of this chartbook for a comparison to TSP.)
All things considered, the economy’s positive forces appear strong enough to keep the negative forces in check through probably the rest of the year, so the expansion should continue into 2020. But the balance of forces has weakened in recent months, and that weakening trend could continue, so stay tuned.
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Tags: asset price cycles, bank credit, business cycle, business earnings, checklists, coincident indicators, component cycles, CPI, credit cycles, econometrics, economic forecasting, fiscal policy, foreign sector, GDP, home building cycle, household earnings, lagging indicators, leading indicators, monetary policy, recessions, S&P 500, six-cycle map, thin-air spending power, vicious loops, virtuous loops, yield curve