Economic Update - February, 2020
posted on Fri, Feb 28, 2020
The Coronavirus is on the forefront of everyone’s mind right now. The unknown right now is how much it will impact the economy in the short and long term. The goal with this newsletter is to focus on the macro level data and adapt our portfolios as the data changes. I am not saying we ignore the news reports on the Coronavirus, but we should exercise a little patience as this plays out. A well constructed portfolio has already taken into account your risk tolerance, goals and where we are in the current market cycle.
I am from the mindset that we should invest having a long-term and goal oriented approach. Daily news reports should not dictate how our money is invested. With
that in mind we should always have an eye on what the economy is doing on a macro level. Since 1955, the U.S. has experienced nine recessions. My goal with this report is to help identify the next recession so that we can make adjustments to your investment strategy accordingly.
Analyzing the economy is far from an exact science and with of all the data now available at our fingertips it is easy to run around in circles without coming to any real conclusions. I have found that by focusing our attention on three macro level reports we can get a general idea of where the U.S. economy is currently and make investment decisions accordingly.
1) Inverted Yield Curve
An inverted yield curve is when the 2 year U.S. treasury rate falls below the 10 year U.S. treasury rate for a 30 day period. The last 9 times this happened (since 1955), the U.S. economy entered a recession within the next 16 months (on average).
As of February 28, 2020 the 10 year Treasury rate is 1.168% and the 2 year Treasury rate is 0.931%. That is a positive difference of 0.237%. We had a slight inversion of the yield curve from August 26, 2019 - August 30, 2019. Since then it has reverted back to a normal yield curve and the spread has been slowly separating. As a stand alone statistic, it is hard to tell if this quick inversion was a false positive or a signal for a future recession.
2) FRED Smoothed Recession Probability
This is a model which attempts to predict the probability of a recession based on non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales. Historically, three consecutive months of smoothed probabilities above 80% has been a reliable signal of the start of a new recession.
The data for this model is usually a couple months in arrears and as of February 1, 2020 the probability for a recession is 2.00%.
3) Economic PI Baseline
By plotting 19 key economic indicators, the BaR Analysis Grid© clarifies current economic conditions and signals how near the economy is to a recession. The mean of coordinates (MoC) is the average of all plotted points. It indicates the overall health of the economy.
There is a lot of data illustrated on the chart. As of February 28, 2020 the MoC is still not in the zone which would signify the start of a recession. That being said, a lot of the data points are moving closer to the horizontal baseline and it is worth monitoring.
As a reference point, here is the same chart from 13 months ago. You will see that a lot of the data points have pushed significantly closer to the horizontal baseline over that period. As a positive you are seeing slightly more data points shift back into the expansion quadrant.
There are 4 major stages to an economic cycle:
1) Early Recession - Consumer expectations are at their worst, industrial production is falling, interest rates are at their highest and the yield curve is flat or even inverted.
2) Full Recession - GDP has been retracting quarter over quarter, interest rates are falling, consumer expectations have bottomed and the yield curve is normal.
3) Early Recovery - Consumer expectations are rising, industrial production is growing, interest rates have bottomed and the yield curve is beginning to get steeper.
4) Late Recovery - Interest rates can be rising rapidly, with a flattening yield curve. Consumer expectations are beginning to decline and industrial production is flat.
Based on the data from this report, as of February 28, 2020 it appears that we are still in the late recovery phase. The best guess would be that we could approach the next phase (early recession) in approximately 12 months.
Please feel free to contact me anytime to discuss in more detail.