MW Inflation is slowing and we've dodged a recession. Stocks are set for a summer stunner.
By Ed Yardeni and Eric Wallerstein
Ed Yardeni: Ignore the inverted yield curve - this 'Roaring 2020s' market is alive and well
The U.S. economy continues to grow and the labor market remains robust.
Over the past two years, the economic hard-landers had innumerable theories and charts to explain why higher interest rates would undoubtedly plunge the U.S. economy into a recession. Now, the diehard hard-landers are again insisting that their long-held recession call will be proven correct soon. Others among them say we're already in a recession.
So far, these forecasts have been wrong. The U.S. economy continues to grow and the labor market remains robust. The S&P 500 SPX and Nasdaq COMP are both at all-time highs, despite the Federal Open Market Committee (FOMC) informing market participants that they should expect no more than one cut in the federal-funds rate this year.
Markets started the year anticipating up to seven rate cuts. The hard-landers argued that the Federal Reserve would have to engineer a recession to bring down inflation by tightening monetary policy. When inflation turned out to be more transitory than they expected, the hard-landers reversed course and argued that the Fed would have to ease aggressively to avoid a recession.
The common denominator underlying the gloomy forecasts of the hard-landers has been a reliance on what we call Technical Analysis of Macroeconomic Data (TAMED). Causal effects and correlations that occurred during previous Fed tightening cycles were flashing red, and therefore, a recession was inevitable.
The hard-landers correctly observed that previous Fed tightening cycles were followed by financial crises that turned into economywide credit crunches and recessions. But the U.S. and global economies are much different in the postpandemic world than they were before, rendering many recession indicators with high success in the past misleading now. Here's how the TAMED approach to forecasting missed the mark:
Leading vs. coincident economic indicators: The Conference Board's Leading Economic Index $(LEI)$ has plunged since it peaked during December 2021. It is down more than 14% since then through May of this year. The Index of Coincident Economic indicators $(CEI)$, meanwhile, rose to another record high in May. It has risen steadily for several years after returning to its prepandemic trend relatively quickly. The CEI has been hitting new records since July 2021, despite the downbeat forecasts of the LEI.
The CEI probably rose to a new record in May, given its close correlation with S&P 500 forward earnings, which rose to a record of $260.02 per share in the week ended June 13. Earnings expectations are nearing our year-end target of $270 per share.
Industrial vs. digital economy: The LEI, on the other hand, could easily continue to sink. One reason the index's recession forecast has failed is because five of its 10 components are manufacturing and construction related. As a result, the LEI very highly correlated with the national manufacturing purchasing managers' index (M-PMI). LEI was a much better predictor of economic downturns when the U.S. economy was more industrial and a greater share of workers produced goods. Employment in manufacturing, mining and construction is now just 10% of total payrolls, down from a third in the early 1950s. Today's U.S. economy is more oriented toward services and technology-related industries.
China exporting deflation: Most hard-landers asserted a recession would be required to bring inflation down. They missed that a property-led recession in China did the trick. In the U.S., the core goods consumer-price index fell 1.7% year over year in May, from a peak of 12.5% in February 2022. Contributing significantly to that decline was a 2% drop in import prices from China.
Inverted yield curve: One component of the LEI gets more attention than the others for its predictive power in previous cycles: the inverted yield curve. It accurately predicted U.S. recessions in the past, with only a couple of false positives. But the LEI has become increasingly misleading as the economy becomes less industrial and more digital.
Buying bonds: The 2-year U.S. Treasury yield BX:TMUBMUSD02Y has been above the 10-year Treasury yield BX:TMUBMUSD10Y since November 2022, and yet no recession has ensued. In the past, the yield curve typically inverted as the Fed hiked short-term rates to combat inflation, while investors piled into long-term bonds. Investors anticipated something breaking in the financial system, which would spark a credit crunch and result in a full-blown recession. Thus, investors opted to lock in higher long-term rates before the Fed had to cut the federal-funds rate swiftly to revive the economy out of a recession.
Crisis contained: While the U.S. financial system did suffer a crisis during the current tightening cycle, the regional-banking crisis of March 2023 was quickly contained by the Fed. Many investors are still happy to clip more than 4% on the 10-year Treasury bond or more than 2% on inflation-adjusted Treasury Inflation-Protected Securities $(TIPS.UK)$. Though yields have come in slightly, they remain close to the highest rates offered on ultrasafe bonds in roughly two decades.
The 10-year Treasury yield will remain rangebound between 4% and 5% through the remainder of the year.
Rangebound rates: We expect the 10-year Treasury yield will remain rangebound between 4% and 5% through the remainder of the year. Expecting the TIPS yield to remain around 2% to 2.5%, plus long-term inflation at around 2% to 2.5%, gets us to this band. Furthermore, we expect the yield to remain below 4.5% more often than it is above, as inflation moderates toward the Fed's 2% target. Ten-year breakeven inflation - the difference between the 10-year nominal and TIPS yields - has largely remained between 2% and 2.5% for the past two years.
Yield-curve normalization? So, with little reason for the yield curve to normalize without the Fed cutting the federal-funds rate significantly, the yield curve will continue to weigh on the overall LEI. Could the yield curve uninvert without the Fed cutting the federal-funds rate? It's possible, but long-term yields would have to surge. Last fall, we saw what happened when the 10-year yield reached 5% - U.S. Treasury Secretary Janet Yellen drastically shifted the government's debt-issuance plans to mostly short-term Treasury bills, to avoid outstripping the relatively weaker demand for long-end notes and bonds.
The Sahm Rule
A relatively new recession model developed by former Fed economist Claudia Sahm is now widely followed. The eponymous Sahm Rule suggests that a recession is either already here or on the way if the three-month average unemployment rate rises 0.5 percentage point above the low-water mark of the last 12 months. As of May, the Sahm Rule is at 0.4 percentage point, just 0.1 point away from flashing red.
We have a few issues with the Sahm Rule:
Timing matters: We don't believe that simple moving averages are a good way to make economic forecasts - it's important to consider the idiosyncrasies of the macro environment in each cycle.
Momentum: All the Sahm Rule tells us is that when U.S. unemployment spiked in the past, it was preceded by an initial rise. In our opinion, that's fairly obvious. There are also several occasions where the Sahm Rule came dangerously close to being triggered, or in fact was triggered - like in August 2003 - but no recession materialized.
It's important to consider the underlying cause of the uptick in unemployment. In May, much of the unemployment increase to 4% stemmed from younger Americans, many of whom are still in college and are off for the summer. Perhaps students aren't too worried about their financial situation considering all the student-loan debt that's been forgiven. Meanwhile, the unemployment rate for workers ages 25 to 54 (3.3%) and ages 55 and over (2.7%) remains well below the headline rate
Jobs aplenty: Lots of small businesses are struggling to fill jobs right now, and less than 14% of surveyed consumers say it's hard to get a job at the moment. Immigration could put additional pressure on the unemployment rate even as employed workers continue to see real wage gains.
Mind the pandemic: The Sahm Rule and other TAMED indicators are ignoring structural shifts in the economy from cycle to cycle. For instance, many hard-landers missed the demographic change after the pandemic, when many baby boomers retired early and left a swath of job openings for younger workers to fill.
Thanks to record asset prices, boomers hold $78.6 trillion of the $160.8 trillion in U.S. household net worth. The wealth effect has boosted consumption and boomers are spending mightily on healthcare, leisure and hospitality. Record consumption of these services has sent employment in these sectors to records as well.
Bottom line: Economists are likely to continue searching for easy rules to forecast whether a recession is nigh, considering the fame that comes with accurately predicting a recession that few foresee. We'll continue to look at the details behind the economic headlines. So far, that leads us to believe inflation will continue to moderate, the economy will continue to grow and the "Roaring 2020s" are alive and well.
Ed Yardeni is president of Yardeni Research Inc., a provider of global investment strategy and asset-allocation analyses and recommendations. Eric Wallerstein is Yardeni Research's chief markets strategist. This article is excerpted from Yardeni Research's "Deep Dive" for June 21, 2024. Individual investors can read Yardeni Research reports here. Follow Yardeni on LinkedIn and his blog.
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-Ed Yardeni -Eric Wallerstein
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June 25, 2024 07:15 ET (11:15 GMT)
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