By: Michael W Arone, CFA, Matthew J Bartolini, CFA, CAIA, Anqi Dong, CFA, CAIA
The threat of recession has loomed over investors for more than a year, ignited by the inversion of the yield curve, which typically predates a recession by six to 24 months.1 That relationship has held since 1955, with just one false signal over a nearly 70-year period.
After first inverting in April 2022, the yield curve has been persistently inverted since July. That puts us roughly in the middle of the recession window. So, will the “yield curve as predictor of recession” relationship hold?
If you’re an optimist, you might believe the economy will face only a protracted slowdown, buoyed by the resilient consumer and a strong jobs market. But pessimists are more likely to brace for recession, pointing to multiple leading economic indicators skewed to the downside.
These divergent viewpoints and potential outcomes make portfolio diversification even more vital now. To pursue current cyclical opportunities without giving up potential downturn protection, consider a mix of the following:
- Cyclical industries, especially the consumer-centric Homebuilders and Transportation
- Gold, whether growth only slows or a technical recession occurs
- Non-cyclical stocks, to combat volatility and position for recession
To better understand the dual-nature of this economic backdrop, let’s dive a little deeper.
Leading Indicators Signal Recession Risks
Among the many indicators pointing to economic weakness, readings on year-over-year (YoY) changes of the Conference Board US Leading Ten Economic Indicators Index (LEI) have been negative and declining for the past nine months.
Negative readings have coincided with every US recession except in 1960. Only the recessions of 1975 and 2009 were preceded by more consecutive months of negative YoY changes.2
So, while the LEI’s current change of -7.8% is not as weak as historical cycles (all recessions except for 1970 had deeper declines), the duration of negative readings is significant. Also backing the view that recession is coming, 75% of the indicators that make up the LEI are in decline right now.3
But not everything is in decline.
Strong Labor Boosts Consumer Spending, Outlook for Cyclicals
The labor market remains strong, with the employment-population ratio for those aged 25-54 rising to 80.8% — its highest level since 2001.4 And while tech and banking have had layoffs, other industries are increasing pay to attract workers. In fact, average hourly earnings are up 4.4% from a year ago.5
Unlike the lack of breadth in the economy, job growth is broad-based. Despite some softening, the Bureau of Labor Statistics’ diffusion index still sits above 50,6 underscoring the resilience of labor demand amid elevated interest rates and sluggish macro trends.
Higher wages have increased disposable incomes. Inflation-adjusted disposable income, the main support for consumer activity, increased 0.3% recently.7 This pushed the savings rate to 5.1%, the highest since the end of 2021, indicating healthy consumer balance sheets.8 And credit card delinquencies are still below average, despite record credit card debt.9
These gains in labor and wages are supporting consumer spending — the largest portion of economy — and keeping growth positive. In the Q1 GDP report, the consumer was the main driver of growth, expanding by 3.7% compared to the 1.1% headline figure.10
In fact, inflation-adjusted final sales to private domestic purchasers, a key gauge of underlying demand, rose 3.2% on the quarter, the most since Q2 2021.11 Forward-looking consumer sentiment indicators have been improving as well, climbing off the bottom from mid-2022.12
Homebuilders Benefits from Stable Earnings, Constructive Valuations
With Homebuilders reporting better-than-anticipated new home sales and higher traffic of prospective buyers, the National Association of Home Builders (NAHB) Confidence Index has climbed every month this year.13
A slight decline in mortgage rates from the cyclical peak in 202214 has also contributed to improved confidence. And if the Fed does lower policy rates, mortgage rates that are still elevated relative to historical averages could fall further.15
The earnings outlook for Homebuilders has stabilized against this backdrop. The number of earnings downgrades decreased heading into the spring and remains at its lowest level in a year.16 Thanks to easing supply chain pressures and disinflationary trends in goods, prices of building materials have declined on an year-over-year basis for three straight months to the level of April 2021.17
With that tailwind, Homebuilders reported strong Q1 2023 earnings (25% above estimate versus the 6% for the S&P 500 Index) and sales surprises (8% above estimates versus 3% for S&P 500 Index).18 Importantly, this recent strength hasn’t extended valuations.
After falling by 30% in 2022, the industry still has plenty of room to make up. Both on a price-to-earnings (P/E) and price-to-book (P/B) basis, Homebuilders is trading at a larger than normal discount to the S&P 500 Index, as shown in the following chart.19
Overall, housing supply remains tight while demand remains strong — boosted by the strong labor markets and healthy household balance sheets. Alongside improving earnings trends and constructive valuations, this may lead to a more optimistic outlook for this consumer-oriented industry.
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Footnotes
1 Michael D. Bauer and Thomas M. Mertens, “Economic Forecasts with the Yield Curve,” Federal Reserve Bank of San Francisco.
2 Bloomberg Finance, L.P., National Bureau of Economic Research (NBER), State Street Global Advisors as of 05/10/2023.
3 Bloomberg Finance, L.P., as of April 30, 2023 based on the LEI Diffusion Index reading of 25.
4 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Labor Statistics data.
5 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Labor Statistics data.
6 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Labor Statistics data. Bureau of Labor Statistics Employment. Diffusion Nonfarm Payrolls +3 Month SA Index is 61.2.
7 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Economic Analysis data.
8 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Economic Analysis data.
9 Bloomberg Finance, L.P., as of April 30, 2023.
10 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Economic Analysis data.
11 Bloomberg Finance, L.P., as of April 30, 2023 based on Bureau of Economic Analysis data.
12 Bloomberg Finance, L.P., as of April 30, 2023 based on the University of Michigan Consumer Sentiment Index which is now at 63.50, a 27% increase from June 2022.
13 Bloomberg Finance, L.P., as of April 30, 2023 based on National Association of Home Builders Market Index.
14 Bloomberg Finance, L.P., as of April 30, 2023 based on Mortgage Bankers Associate data.
15 Bloomberg Finance, L.P., as of April 30, 2023 based on Mortgage Bankers Associate data.
16 FactSet, as of 5/10/2023. The industry is represented by the S&P Homebuilders Select Industry Index.
17 US Bureau of Labor Statistics, PPI by Industry: Building Material and Supplies Dealers, as of 3/31/2023.
18 FactSet as of April 30, 2023.
19 Bloomberg Finance, L.P., as of 05/10/2023 based on the S&P Homebuilders Select Industry Index and the S&P 500 Index.
20 The International Air Transport Association (IATA).
21 IATA – Airlines Cut Losses in 2022; Return to Profit in 2023.
22 Bloomberg Finance, L.P., as of 05/10/2023 based on the return of the S&P Transportation Select Industry Index in 2022.
23 Bloomberg Finance, L.P., as of 05/10/2023 based on the S&P Transportation Select Industry.
24 Bloomberg Finance, L.P., as of 05/10/2023 based on the S&P Transportation Select Industry.
25 Bloomberg Finance, L.P., as of 05/10/2023 based on the Philadelphia Federal Reserve Partisan Conflict Index.
26 House Republicans pass U.S. debt bill, pushing Biden on spending | PBS NewsHour.
27 Bloomberg Finance, L.P., as of 5/15/2023 based on historical monthly returns for the MSCI USA Minimum Volatility Index and the Russell 1000 Index from 1995-2023.
28 Bloomberg Finance, L.P., as of 5/15/2023 based on historical monthly returns for the MSCI USA Minimum Volatility Index and the Russell 1000 Index from 1995-2023.
Glossary
Leading Economic Index (LEI)
The Composite Index of Leading Indicators, otherwise known as the Leading Economic Index (LEI), is an index published monthly by The Conference Board. It is used to predict the direction of global economic movements in future months. The index is composed of 10 economic components whose changes tend to precede changes in the overall economy. Businesses and investors can use the index to help plan their activities around the expected performance of the economy and protect themselves from economic downturns.
Recession
A period of temporary economic decline during which trade and industrial activity are reduced
Philadelphia Federal Reserve Partisan Conflict Index
Tracks the degree of political disagreement among U.S. politicians at the federal level.
NAHB Housing Market Index (HMI)
The Housing Market Index (HMI) checks the pulse of the single-family housing market, according to a monthly survey of NAHB members.
S&P Transportation Select Industry Index
S&P Select Industry Indices are designed to measure the performance of narrow GICS® sub-industries. The Index comprises stocks in the S&P Total Market Index that are classified in the GICS transportation sub-industry.
Price-to-Book
The price-to-book (P/B) ratio considers how a stock is priced relative to the book value of its assets
Price-to-Earnings
The price-to-earnings (P/E) ratio relates a company’s share price to its earnings per share.
Percentile Ranking
A system of ranking scores that shows the percentage of results that are lower than the benchmark or fund in question for the most recent three-year period. Every year, each score is updated with the most recent year’s percentiles.
Sector Investing
An investor or portfolio that invests assets into one or more sector of the economy such as financials, energy, or health care.
S&P 500® Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Valuation
The process of determining the current worth of an asset or a company.
Low Volatility
A lower volatility means that a security’s value does not fluctuate dramatically, and tends to be more steady and has less systematic risk.
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Originally Posted June 5, 2023 – Diversify Recession Risks with Cyclicals and Defensives
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Homebuilding companies can be significantly affected by the national, regional and local real estate markets. This industry is also sensitive to interest rate fluctuations which can cause changes in the availability of mortgage capital and directly affect the purchasing power of potential homebuyers. The building industry can be significantly affected by changes in government spending, consumer confidence, demographic patterns and the level of new and existing home sales.
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