Walks Like a Duck, Quacks Like a Duck
In recent weeks, due in large part to a market rally that kicked off the year, the idea of a “soft landing” has grown in popularity. We are at a point in this situation where any outcome is still possible and nothing has been confirmed. But in my opinion, a good old fashioned “pros and cons” list is very telling.
We will all know how this unfolds in time. For the time being we remain in this purgatory state between optimism and pessimism — the only thing that seems to be definitively on the rise is the level of bitterness between market participants who oppose one another.
It’s no secret that I’ve been on the cautious side of the field. I warned about the signals that, at the very least, point toward an economic downturn — and a more broad-based classic recession at most. I recognize that a few things remain in the “pros” column — perhaps the most talked about being the labor market — but I think it’s important to be real about the undeniable truths that sit in the cons column.
Undeniable Truth #1
There are leading, lagging, and coincident indicators. One of the most comprehensive leading indicators is called exactly that: the Leading Economic Index (LEI). Rather than looking at it for the absolute index level, the rate of change and direction of the trend is more telling.
Specifically, the 6-month annualized change in this index is -8.2%. That measure has never fallen below -3% without a recession to follow. There’s a first time for everything of course, but the historical pattern doesn’t bode well. As we sit here without confirmation one way or another, I’d argue the leading indicators are the most important to watch.
Undeniable Truth #2
One of the components that affects the LEI is the manufacturing side of the economy, and a way we measure that is with the ISM Manufacturing PMI survey. Since our economy is now more dependent on services than ever before, we luckily also have an ISM Services PMI survey to watch.
The way these work is any reading above 50 indicates economic expansion, and anything below indicates contraction. There are components of these indexes that would be considered “leading” (i.e., new orders), components that would be more “coincident” (i.e., production), and some that may even be “lagging” (i.e., backlog orders).
The composite indices, however, serve as a leading or coincident indicator for recessions, and both the manufacturing and services PMI indexes have fallen into contraction territory. Services in particular just saw its first reading below 50 since the Covid lows. In the prior three recessions, the recession start date ended up being just before the Services PMI fell below 50.
The next read on Services PMI is coming on Feb 3rd and I’ll be watching very closely.
Undeniable Truth #3
Labor market strength continues to be the sharpest weapon in the optimist’s toolbelt, and for good reason. Initial jobless claims remain contained, payroll numbers show persistent jobs added, and job openings remain high. But the labor market is not a leading indicator. It’s decidedly lagging, and it’s very possible (if not probable) that we just haven’t seen reality come through in the headline data yet.
There is some data that can foreshadow what might be on the horizon. Namely, the trend in temporary help. This measure has been falling since August 2022 and doesn’t show any signs of turning around.
Intuitively, employers will cut temporary or contract workers before having to cut full-time employees, so this serves as a decent leading indicator of where the broader labor market could be headed. The Richmond Fed has even penned a report stating that the change in temporary help tends to lead the overall employment market by about six months. That would suggest that unemployment data could be set to weaken starting with January or February readings.
Undeniable Truths #4 and #5
I’m running out of space so these last points need to be consolidated. Some of the other items in the cons column that serve as undeniable truths of rough air to come are those of the stock and bond markets.
Markets are irrefutably leading indicators, but this is where it gets murky. Many would stop me here and say, “stocks are rallying, the lows are in.” That may end up being true, but I would offer the counterpoint that stocks remain in a longer-term downtrend and still cannot seem to break above the resistance levels. Furthermore, during the shorter-term rallies we’ve seen, the parts of the market that have been hit the hardest are the parts that rally the most. That’s characteristically bear market behavior. We’re not out of it yet.
The yield curve is telling a more clear story. Curve inversions at the 2-Yr/10-Yr, 3-Mo/10-Yr, and the near-term forward spread are numbers we cannot ignore. These are no longer brief nor shallow inversions. And although there have been inversions (typically of the brief and shallow variety) without recessions to follow, there has never been a recession without inversions that come first.
Swims Like a Duck
From my vantage point, I see a duck. That said, I’ve been wrong before and I could be wrong again. Maybe it’s a very small swan. Or a baby ostrich imitating a duck. I’m pretty sure we can rule out flamingo, but stranger things have happened.
In any event, the best we can do is work with the information we have. My information says stay cautious, the economy is fragile.
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