The U.S. economy is growing. How much and how well is open to debate, particularly in Washington, but in the 10th year of expansion, the news continues to be largely positive.
But another recession is inevitable. Do any signs suggest that path? Only a few, for now.
ClearBridge Investments employs a 12-indicator proprietary Recession Risk Dashboard to track these possibilities, using traffic light signals (green for expansion; yellow for caution; red for recession) for each indicator. At present, 11 of the 12 indicators continue to flash green.
This suggests the likelihood of a recession in the next 12 months remains below average. To the contrary, it signals that the U.S. economy likely will continue to expand over the next year.
Our Recession Risk Dashboard has been steady, experiencing its first two changes in 2018 in August. Corporate profit margins are growing steadily as revenue growth, tax reform and firming oil prices take hold. This caused our profit margins indicator to improve from yellow to green.
By contrast, the money supply indicator moved down, from green to yellow. Many financial stress indicators tend to roll over ahead of market peaks and recessions. Money supply growth has been slowing for several months against the backdrop of tighter Federal Reserve policy and increased short-term debt issuance. This could reflect an economy potentially less capable of withstanding liquidity shocks. As liquidity declines, the financial system and economy are less able to weather stresses or shocks, elevating the risks of recession or crash.
Recent Fed actions to concurrently raise short-term rates, while reducing the size of its balance sheet, have resulted in less cash moving through the financial system. Increases in short-term rates slow money supply growth. As rates rise, the opportunity cost of holding money in non-interest-bearing accounts rises. Fed balance sheet unwinding attracts cash off the sidelines in search of higher yield. This also happens when the U.S. Treasury issues more debt (both to fund the larger budget and tax reform), as investors convert cash holdings into Treasury securities.
Slowing money supply growth ultimately should weigh on spending, and in turn depress overall economic activity. Historically, when consumers and businesses expect to increase spending, they tend to build up liquid assets in anticipation. Conversely, when spending expectations are declining, the private sector tends to move liquid assets towards higher interest alternatives.
Money supply growth has provided ample lead time ahead of past recessions, turning to red on average approximately 2½ years prior to past recessions. While one of the longer leading indicators within the ClearBridge Recession Risk Dashboard, it is also somewhat less consistent than others, resulting in a relatively smaller weight to the overall signal.
As for corporate profit margins, several dynamics are positively impacting them. When oil prices fell from more than $100 per barrel in late 2014 to a low of $26 in February 2016, the energy sector and broader U.S. economy felt the pain. Energy company margins collapsed, dragging down margins for the S&P 500. With the oil market in a much healthier place, in the $60 to $70 per barrel range, energy margins have begun to re-normalize — and our indicator is no longer yellow.
Other potential drivers of further margin upside are apparent. Revenue growth has accelerated in 2018, providing additional operational leverage (fixed costs can be spread out over additional sales) and resulting in improved margins. Unit labor cost (a measure of employee compensation relative to inflation-adjusted output) has remained subdued, meaning companies are receiving value for the raises they have given in the form of better productivity. Both should combine to push corporate profit margins even higher in the back half of 2018 and into next year.
The benefits from lower tax rates will also improve corporate margins, of course, although these benefits are more one-time in nature.
As these tax reform benefits continue to circulate through the U.S. economy, the overall signal of the ClearBridge Recession Risk Dashboard remains solidly green: Expansion continues. This suggests that chances of a recession should continue to remain low for 12 months or more.
Jeffrey Schulze is a director at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.