Research.LeutholdGroup

In early September, the co-founder of one of the largest U.S. private equity firms declared that predicting recessions is a “fool’s errand.” We couldn’t disagree more.

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Developments over the last four months leave us even more skeptical that the November yield-curve inversion will join 1966 as a “false positive.” The number one reason being the subsequent shift in the yield curve itself.

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For those disappointed that February’s employment report won’t be released until March 10th, we have something to consider in the meantime.

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Market veterans know there’s just one thing more probable than a recession after the yield curve inverts: Yield curve denial among a large group of sell-side economists and market strategists! Indeed, the earliest of those dismissals occurred last March—a month before the first of more than a dozen iterations of a yield curve inversion. 

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We’ve heard for eons that “Low bond yields justify high equity valuations.” Value-conscious investors might have described this conundrum another way: “Low future returns in one asset class justify low future returns in another.” (Mysteriously, only the first rendition became a CNBC catch-phrase.)

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Economists who believe a 2023 recession will be avoided, may not know it but they are “messing with perfection.” Since August, we’ve chronicled several developments that have, without fail, correctly forecasted past recessions, or confirmed that one was already underway. 

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We found the spread between the “Expectations” and “Present Situation” series (the “Confidence Gap”) has historically moved almost in lockstep with the yield curve. As the Confidence Gap plummeted throughout 2021, the implication was the yield curve would soon follow. After some initial resistance, it did. 

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Jay Powell’s speech on November 30th triggered a 1,000-point intraday reversal on the DJIA and left us wondering who might have slipped the Chairman a recent copy of the Green Book.

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We think the U.S. economy will slip into recession sometime in the next year, but the level of “excess savings” provided by pandemic aid renders the already difficult task of timing more elusive than ever.

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We cringe when we hear the Treasury Secretary or a regional Fed bank president dismiss the possibility of recession on the basis of “low unemployment and strong job gains.” Those measures are as “laggy” as any economic statistics the government publishes.

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The LEI’s 3.6% six-month annualized loss through September 2006 was the largest decline not followed almost immediately by a recession. This year, the LEI contracted by 3.7% over the six months through June—if a recession is avoided in the current experience, it would be the most misleading signal in the history of the LEI as currently constructed.

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Key indicators are indeed trending in “pre-recessionary” fashion. Among them is the ISM New Orders Index, which dipped into contraction territory in June while inventories increased. Others are the JOLTS that shows a strong (but weakening) labor market, and unemployment claims—which have ticked up.

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No one wants to be this cycle’s Chuck Prince. In June 2007, the Citigroup CEO said, “As long as the music’s playing, you’ve got to get up and dance.” (Fifteen years later, when one Googles his name, “music playing” is what auto-fills.)

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In a simple test of 15 yield-curve variants, we found that the 2s10s spread ranks second to last, based on its correlation with one-year-forward real-GDP growth since 1978. The three best measures employed the 3-month bill as the “short” rate. The spread between the 5-year note and 3-month bill showed the strongest correlation with subsequent economic growth.

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It would be a mistake to ignore (as most pundits will) this important forecasting tool until the next time it threatens to invert. The level and direction of the yield curve provide helpful information throughout the entire economic cycle.

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As Yogi Berra might have quipped, it’s not just the leading indicators that are lagging… the lagging ones are, too.

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The consensus among market pundits is that a U.S. recession will be averted and, as a consequence, domestic stocks remain the best game in town.

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A way to gain perspective on the present is by trying to view it from the future. Ask yourself, “What are the signs of impending decline, now ignored by investors, that will one day be memorialized by the same investors as the most obvious in retrospect?”   

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The pattern of sharp sell-offs followed by equally sharp rallies continued in June. Most risky assets recouped nearly all the losses suffered in May, and then some.

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