Key Points
-
Surging leading economic indicators, coupled with fiscal policy, suggests a higher and longer trajectory for economic growth.
-
But accompanying higher inflation and tighter financial conditions point to an era of higher market volatility.
-
Volatility spikes are to be expected, but don’t historically signal impending doom for either stocks or the economy.
Every month in the immediate aftermath of the release of The Conference Board Leading Economic Index (LEI) I put together a small deck together for Schwab’s Operating Committee highlighting the overall data and some of the key takeaways. The latest report—out last week—was notable in its strength; and in stark contrast to the worries expressed by some clients lately about the risk of a recession in the near term.
LEI in record territory
The chart below has multiple components, which I’ll explain, but its key element is the overall LEI itself, shown in the line. The LEI rose 1.0% month-over-month in January to a new record high. Over the past three months it’s up nearly 10% at an annual rate. Historically, that’s been consistent with 4% real gross domestic product (GDP) growth.
LEI in record territory
Source: FactSet, The Conference Board, as of January 31, 2018.
On the chart above you will also see horizontal dotted and solid lines. The former represent “round trips” in the LEI—from the pre-recession cycle high through the trough and back to the prior high. The solid lines represent how long a span there was between the round trip being complete and the subsequent recession. As you can see, for the past three cycles (with the early-1980s double-dip recession considered as one) the span was between four and eight years. We are currently less than a year since the LEI took out its pre-recession high (it took the LEI more than 11 years to make a new high). That suggests we still have a decent runway ahead before recession risk begins to accelerate.
The table below looks at the component parts of the LEI; of which one is the stock market. Not only was there no deterioration in any of these components in the January report, as you can see there is no red on the page—either in terms of the current level or trend of these indicators.
Source: FactSet, The Conference Board, as of January 31, 2018.
The LEI has been in record-high territory for the past 11 months; while during the past five economic expansions, the LEI remained in record territory for 38 months on average—ranging between seven months and 89 months (source: Yardeni Research).
No recession in sight … yet
There are myriad recession forecasting models on which I keep an eye. One is a pattern-recognition algorithm based on the observed dynamics of U.S. real GDP growth put out by the Federal Reserve Bank of Atlanta. As you can see in the chart below, not only is the current reading very low based on history, the latest trend has been down, not up. Although most of the largest spikes in history have come after recessions had already begun, there was a notable turn-up in the index in advance of those recessions.
Recession risk low and falling
Source: Federal Reserve Bank of Atlanta calculations. Recession Indicator Index (thru 3Q17) is a pattern-recognition algorithm that assigns dates to when recessions begin and end based on the observed dynamics of U.S. real GDP growth.
But not all is rosy
While we’re cheering the acceleration in growth inferred by the LEI, we need to be mindful of the associated risks. BCA Research calculates that the influence of the recently-passed tax cut bill—coupled with the Senate deal on government spending—has turned the “fiscal impulse” positive by 0.8% of GDP; with next year’s impulse even larger at 1.3%. As such, fiscal stimulus may expand the length of the expansion, but it could bring with it higher inflation, tighter monetary policy and perhaps a steeper next recession.
Higher inflation and tighter monetary policy tends to signal late-cycle conditions; and tends to be accompanied by higher equity market volatility. This is precisely what we posited in our 2018 outlook, which had the theme of “It’s Getting Late.” One indication of this theme is financial conditions, which have begun to tighten after a long period of decline.
As you can see in the chart below, financial conditions were generally loosening over the past two years. This was in spite of the Federal Reserve’s five rate hikes starting in late-2015 (the red dots represent points when the Fed raised the fed funds rate). But it appears we have hit an inflection point in those conditions—initially triggered by the spike in equity market volatility earlier in February.
Financial conditions finally tightening
Source: Bloomberg, as of February 22, 2018.
Inflation expectations have ticked up and the January inflation reports have also contributed to rising expectations of tighter monetary policy. As BCA opined, the new Federal Open Market Committee (FOMC), under the tutelage of new Chairman Jerome Powell, will likely be more tolerant of equity corrections and tighter financial conditions than in the past.
Higher volatility era is here
A trigger for this expected higher volatility—and more frequent pullbacks/corrections—could be tied to coming liquidity “squeezes” courtesy of a more hawkish Fed this year, tighter monetary policy by global central banks, more stimulative fiscal policy, and even higher oil prices. Volatility spikes don’t tend to signal finales to expansions; but they do tend to signal late-cycle conditions.
The BCA-sourced table below shows episodes when the CBOE Volatility Index (VIX) rose by more than 10% in a 13-week period (going back to the VIX’s inception in 1993).
Source: BCA Research, Inc. *Episodes when VIX rose by more than 10% in a 13-week period. Recession periods excluded. **Thru February 22, 2018.
As you can see, spikes in volatility have not historically signaled the end of business cycles; however, 60% of the spikes outside of recessions occurred during the late stages of the cycle. On average, economic expansions lasted for an additional 41 months after the noted spikes; and one year later the stock market was higher in eight of nine episodes. Finally, the average interval between the spikes and the end of the bull market was 45 months.
In sum
I’ll end where we did in our 2018 outlook with a recommendation for investors around discipline. Although we see a relatively long runway between now and the next recession, with higher volatility expected—and already witnessed—more frequent rebalancing of portfolios around strategic targets is warranted, as well as a keen eye on diversification (both among and within asset classes).
Important Disclosures:
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
©2018 Charles Schwab & Co., Inc. All rights reserved. Member SIPC.
© Charles Schwab
Read more commentaries by Charles Schwab
