by Asset Allocation Committee

The recent employment report was very strong, with payroll growth rising more than forecast and the unemployment rate declining more than expected.  One uncertainty that develops when labor markets tighten is the point at which wage growth begins to lift inflation.

This chart shows yearly wage growth and the unemployment rate (inverted scale).  In the past three cycles, an unemployment rate at this level would have been consistent with wage growth in excess of 4.0%.  Although wages have been increasing, the growth rate remains below the 4.0% level.

The reason wage growth remains modest is complicated, but a contributing factor is that the labor force continues to increase.  A key function in that process has been that citizens who were not part of the labor force have been steadily finding jobs.  The chart below shows the 12-month rolling total of those who have been out of the labor force and found employment.  This number has been increasing in this expansion.

At the same time, the pace of these flows is beginning to slow.  If this source of new employees declines, in theory, it would tend to lift wages at an increasing pace until employment growth slows.  Nevertheless, for now, the labor market appears to be strong enough to attract new entrants into the labor force and employment, without excessive wage growth, which is a positive development for the economy.

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by Asset Allocation Committee

In 2017, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor to gauge market conditions.  The indicator is constructed using commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.  In this report, we will update the indicator with November data.

This chart shows the results of the indicator and the S&P 500 since 1995.  The updated chart shows that the upward momentum in the economy slowed last year but it does remain well above zero.  We have placed vertical lines at certain points when the indicator fell below zero.  It works fairly well as a signal that equities are turning lower, but there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, either the recession is imminent or we are already in a downturn and the equity markets have started their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at minus 1.0.  This provides an earlier bearish signal and also eliminates the false positives that the zero threshold generates.  Nevertheless, the fact that this variation of the indicator is below zero raises caution.

What does the indicator say now?  The economy has decelerated but is not yet at a point where investors should become overly defensive.  At the same time, the 18-month change in the indicator has fallen below zero; in 2016, this situation led to several months of sideways market activity.  If we continue to see the lower chart hover around zero, then the likelihood is greater that equities will flatten.  Thus, reducing equity risk by rebalancing for a more defensive equity sector exposure would be prudent.

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by Asset Allocation Committee

(NB: Due to the Thanksgiving holiday, the next report will be published on December 6.)

The health of the consumer is critical to the future path of economic growth.  For the most part, consumption is accounting for most of the growth in the economy.

This chart shows the four-quarter average of the contribution to real GDP from consumption compared to the net of the contribution from government, investment and net exports.  Over recent business cycles, the contribution outside of consumption has diminished.  The other sign from the data is that the risk of recession rises when consumption’s contribution declines below 2%.

Household debt plays a role in consumption.  The New York FRB has a data series on consumer debt that has just been recently updated.  The balance of household debt is now $13.95 trillion, a new record high.  However, on a per capita basis, we remain below the previous record.

From its peak of $53.0k in Q3 2008, this measure of debt declined to $44.5k in Q3 2013.  Since then, it has gradually increased.  However, it has not reached levels that would trigger significant concern.  In the last expansion, per capita debt growth was 10.9%; in this expansion the average growth is -0.4%.

As a percentage of the total, housing debt has been declining relative to auto and student loans.

In 2012, housing represented about 76.9% of outstanding household loans; it now stands at 70.5%.  Both student and auto loans have increased.  The median credit score for mortgages is a rather strong 763.

Auto loans is a bit lower, at 710, but credit quality has been improving, mostly a reflection of higher delinquencies.  Lenders appear to be increasing their caution.

Overall, the data suggests that the areas of greatest concern are auto and student loans; lenders do appear to be addressing the auto loan issue by becoming more selective in granting credit.  Student loans, which have a 90+-day delinquency rate of around 10% since 2012, are ultimately a public policy issue, but until this issue is resolved these loans will have an adverse impact on spending.  If there is going to be a financial crisis, this data would suggest it probably won’t come from the household sector.

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by Asset Allocation Committee

The yield curve has steepened since the FOMC started cutting rates, raising hope that a recession can be avoided.  In this report, we will examine whether these hopes make sense.

The above chart shows two recession indicators from two different regional Federal Reserve banks, Atlanta and New York.  The former is a GDP-based indicator and the latter is based on the yield curve.  The New York indicator is designed to signal economic activity a year into the future.  We like to combine the two indicators because the Atlanta indicator tends to give false positives.  However, in the past, when the New York indicator has moved above 30 followed by an Atlanta indicator rising above 40, a recession has been unavoidable.

Fed funds show us that easing doesn’t necessarily protect the economy from a downturn.  Even though the FOMC has usually cut rates as the New York FRB indicator penetrated 30, it was not enough to fend off a downturn.  Thus, even with the recent rate cuts, the risk of recession remains elevated.

The good news is that the Atlanta indicator is at a level where a recession isn’t imminent.  The bad news is that the New York indicator has signaled a downturn is coming.  Since the 1969-70 recession, the average lead time from the New York recession indicator has been 10 months, with a range of five to 15 months.  Thus, by next spring, we could see evidence of a downturn.  However, if we use the Atlanta indicator as a signal-confirming device, we should have a better idea of when a recession is actually underway.  So, for now, investors should not become overly cautious but, by the end of Q1, increased vigilance will likely be warranted.

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