A Note on the Economy
A Note on the Economy
From Dr. Uric Dufrene, Indiana University South East
Not a day goes by that you won’t hear or read about the possibility of the economy entering a recession. Indeed, several indicators do continue to point in the direction of a recession. While the economy does face significant risks, slower growth is likely, but not to the extent that it will trigger an officially dated recession.
One indicator flashing a recession signal is Consumer Sentiment, the statistical indicator which is largely based on consumer perception of household finances. Consumer sentiment, as measured by the University of Michigan Consumer Sentiment Survey, has been on a downward trend since the post Covid recession peak in April 2021. The last reading of 68.2 is the lowest since the Great Recession, and the lowest prior to the Great Recession was in the first recession of the early 80s. A 68.2 reading is lower than the levels of consumer sentiment that appeared in 9 recessions dating back to the 1950s. There were only two recessions with consumer sentiment readings lower than the current: the Great Recession and the early 1980s. From this indicator alone, one would conclude that a recession is pending.
Another widely cited consumer mood statistic is the Conference Board’s Consumer Confidence Index. Where the Michigan survey is derived from consumer perceptions about finances, the Consumer Confidence Index is based more on consumer attitudes regarding labor market conditions. With the Consumer Confidence Index, the outlook regarding the economy is somewhat different than the Michigan Sentiment number. The latest reading is down from the post pandemic recession high of June 2021 but is still higher than all levels that existed between 2010 and 2017. The tight labor market and historically low unemployment rates prior to the pandemic resulted in consumer confidence numbers that were higher than the current reading, but the only other period where the consumer confidence numbers were noticeably higher than the current reading was in the late 1990s. Unlike the consumer sentiment number, consumer confidence is not signaling a recession. When we observe data such as record-breaking job quits, one of the conclusions we can draw is that workers are very confident.
So why is there such disagreement between sentiment and confidence? There is one word, and it is inflation. Consumers do not like inflation, and this is the first time that a large percentage of the buying public has ever experienced rising prices of this magnitude. And if consumers face higher prices, they certainly expect shelves to be stocked and goods to be delivered in a reasonable amount of time. The supply chain situation, along with the highest inflation in 40 years, combine to produce the very dismal consumer sentiment numbers. In fact, there is a negative correlation between sentiment and inflation. When inflation is up, sentiment is down, and vice versa.
When we examine actual household finances, we get a view of the consumer that is different from inferences we might draw from the Consumer Sentiment Survey. Overall, consumer finances are stronger now than coming into the pandemic. Household net worth is at the highest level on record. With the devastating Great Recession, it took 5 years before households could recover net worth lost. With the Covid recession, it only took about one quarter to recover losses. Since March 2020, net worth has been climbing, and the gains since then are the largest since going back to the 1940s, perhaps the largest gains in history. Think of this net worth as a cushion.
Consumers also used excess savings and stimulus to pay down debt. Household debt as a percent of income is considerably lower than the high rates that existed at the start of the Great Recession. At that time, household debt as a percent of personal income was higher than 100%, about 124%. Today, the number is in the upper 80s, considerably lower than the excessive debt number associated with the Great Recession. Delinquency rates for credit cards and consumer loans are at historical lows, at least the lowest in the past 30 years. There has been a small uptick since the middle of 2021, but rates remain under those that existed coming into the Covid recession and far lower than delinquency rates associated with the Great Recession.
Home equity loans are at the lowest level since 2000. Home equity loans outstanding peaked with the real estate binge of the Great Recession but has been on a downward trajectory since. With the decline in household debt as a percent of income and lower consumer delinquency rates, the household is positioned to take on more debt, providing potential support to consumer spending. Think of this unused debt capacity as additional stimulus for growth. Will consumers tap into this is a question.
Another signal pointing to a recession is the yield curve, which is a plot of Treasury yields at various maturities. Normally, an upward sloping yield curve points to a growing economy; longer term bonds have higher yields than shorter term instruments. One of the signals to monitor from the yield curve is the difference between the 10-year Treasury and the 2-year. An expanding spread usually points to growth, and a declining spread points to potential slower growth. An inversion occurs when the yield on the 2-year exceeds the yield on a 10-year bond. The curve is about to show inversion, pointing to an upcoming recession. The issue is the timeliness of the prediction. An inverted yield curve does not point to when a recession will occur, only that it will occur. The 10-2 spread narrowed about 3 years prior to the recession of 2001, and about the same for the Great Recession. The spread narrowed prior to the Covid recession, but that was even before we knew anything about Covid. Another measure derived from the yield curve is the difference between 3-month T-Bills and the 10-year Treasury. Unlike the 10-2, this gap has been widening, pointing to stronger growth.
Record openings and a labor force that is now showing expansion will support payroll growth for the rest of 2022. New claims for unemployment are at record low levels. In addition to a solid labor market, industry data and macro trends continue to point to growth in manufacturing. Very lean inventory to sales and customer inventories suggest that manufacturers still have a lot of production in the pipeline. Higher prices at the pump and inflation in general will impose additional costs on households. In addition, declining consumer sentiment along with signals that we are getting from the yield curve, point to slower growth. However, we are not ready to declare that a recession will take hold this year.
The U.S. economy saw record increases in consumer spending over the past two years. Government stimulus and a shift away from services to goods spending resulted in record gains to retail sales. This amount of spending cannot be sustained, and we will see a deceleration in this consumption. This will allow supply chains to “catch up”. Improvements to the supply chain, along with an expanding labor force, will result in a moderation of the price increases. The five-year break-even rates, an implied rate of inflation due to bond pricing, have moved up about 7/10ths of a percent since the beginning of the year, but remain under 4%.
To sum up, we will see slower growth this year, but not ready to declare that we will see a recession. If one wants to observe a measure of consumer resilience, just try going to your favorite restaurant on a weekend evening. Without a reservation, be prepared for a long wait.
Data source: FactSet