Economic Activity Seems Brisk, But…

Contrary to the situation in 2014-2015, economic indicators are currently far from signaling an imminent recession. We frequently discussed growing weakness in the manufacturing sector in 2015 (which is the largest sector of the economy in terms of gross output) – but even then, we always stressed that no clear recession signal was in sight yet.

US gross output (GO) growth year-on-year, and industrial production (IP) – note that GO continues to be published with a lag of two quarters. As the upper half of the illustration shows, growth in manufacturing output turned negative in 2014 – 2015, while y/y growth in “all industries” GO fell to zero by Q3 2015. The lower half shows the culprit: the mining sector, which includes upstream oil and gas production. While the sector is small, it is very volatile and accounted for an uncommonly large share of capex due to the shale oil/fracking boom. This was confirmed by the action in credit spreads during this time period as well, as junk bond spreads exploded mainly due to a relentless sell-off in energy company debt in the wake of plunging oil prices. Although happy times are here again following the oil price recovery, GO has begun to weaken slightly again in Q1 and Q2 2017 (note: the surge in IP since then does not tell us much, as GO leads IP).

There are a number of “sine qua non” indicators, such as real gross private domestic investment, the Philly Fed’s US leading index, the ISM/PMI indexes, initial unemployment claims, the yield curve (here in the form of the 10 year minus 2 year spread), and the National Financial Conditions Index, which routinely provide early warning signals ahead of economic downturns.

In 2015 no clear recession signal was evident from these indicators and they are now even further removed from giving such a signal. The yield curve is a potential exception – it has flattened significantly throughout last year, and its recent upturn may be the beginning of a trend change toward steepening (it is still too early to tell). A sustained trend change traditionally constitutes a recession warning.

The Citigroup economic surprise index has turned down this year after rising relentlessly in the second half of 2017. This indicates that economists have finally adjusted their expectations after a series of strong data releases, just as these data begin to weaken somewhat. If the current downtrend persists, it may become meaningful for stock and bond markets in the short to medium term (usually slightly negative for the former and positive for the latter).