Before we get started today, I want to mention that I recently wrote an article for Model Investing discussing what “normal” volatility looks like in the stock market. The piece includes some interesting statistics on daily fluctuations, as well as corrections and bear markets, so if you’re interested, feel free to give it a read here.
Alright, let’s begin with a quick look at the S&P 500 to get our bearings and see what the technical landscape looks like. As you can see below, the S&P has been extremely volatile over the last few weeks but is trading with a relatively tight band – trapped between its 50-day and 200-day MAs.
Those moving averages also coincide with recent support and resistance levels – denoted with the red and green lines. This backing and filling is not too surprising considering the vicious headline environment we’ve been in. With both our Administration and the Chinese toggling tariffs on and off like a light switch, the relative value of stocks continues to fluctuate wildly.
I should point out, however, that the S&P does remain in an uptrend. This year’s price action has been marked by higher-highs and higher-lows, and it’s important to give the benefit of the doubt to the inherent trend. A drop below 2,744 would be the first indication that the bullish trend is faltering.
Moving on, the main idea I want to talk about today is the notion that our economy will continue to expand (no recession) as long as consumer spending remains healthy and continues to grow. This is the primary case being made by those who are watching business spending deteriorate, but who don’t believe we’ll enter a recession. I made a similar case as recently as last week.
But, since I like to continuously argue with myself (it’s great for mental health, right?), I’d like to present the opposite case today – that even IF consumer spending holds up just fine, we could find ourselves in a recession at some point in the next year or two.
The primary data on which this argument lies is, lo and behold – consumer spending itself. In the chart below, we can see the year-over-year growth rate in consumer spending going all the way back to the 1960s. It should be plainly evident that consumer spending was growing steadily heading into each and every recession (gray shaded bars) over the last six decades.
In fact, the only time consumer spending actually contracted was during the financial crisis, and this occurred as a result of the recession, not as a precursor. Consumer spending was growing in excess of 4% (nominal terms) when the recession began, and had actually seen a surge higher right before the recession took off.
So based on this data alone, I think it’s fair to say that consumer spending cannot, and will not, prevent us from entering a recession. But of course there are always counterarguments …
Those continuing to stand by this line of thinking will point out that over the years, the share of our economy that is driven by consumer spending has risen. Well, that’s true. But it hasn’t risen all that much.
In this next chart, we can see personal consumption expenditures (consumer spending) as a share of GDP. Over the last six decades, consumer spending has risen from about 58% to 68% of our economy – certainly an increase, but not a dramatic one. Not only that, consumer spending as a percent of GDP has been somewhat stable in recent decades, and was near these levels during the past two recessions.
So if a contraction in consumer spending rarely, if ever, leads us into recession, what’s the primary culprit? Business spending, of course.
The chart below shows the year-over-year growth rate in gross private domestic investment (business spending), and as you can see, growth tends to go negative prior to (or near the start of) each recession. A contraction in business spending doesn’t always precede an economic recession, but it does have a strong correlation.
A look at the right side of this chart (above) shows that while business spending has been slowing, it has not quite breached the zero line that denotes contraction. This is why all eyes have been on business spending lately.
To provide another angle on this, the following chart shows business spending as a percent of GDP. Notice that the relative contribution of business spending to the economy tends to fall in advance of each recession, and bottoms near the end of the each recession.
We saw a big drop in this metric during 2015 – 2016 (when we experienced an earnings recession and Dow Theory sell signal), but since then it has recovered – until recently. My takeaway from this chart and the one above is that business spending is not leading us into recession quite yet, but it could in the very near future. That’s why this trade war nonsense needs to stop.
Since we’re on the topic of business spending, I should point out that gross private domestic investment data is only released quarterly, as part of the GDP report. To get more timely updates on business spending, we need to monitor related datasets such as durable goods orders.
The latest DGO report was released yesterday, and came in above expectations. Durable goods orders rose 2.1% in July, for the second straight monthly gain.
Unfortunately, beneath the surface there was more apparent weakness. Much of the rise was attributed to orders of nondefense aircraft (from Boeing), while core durable goods orders were only up 0.4%. On a year-over-year basis, growth in durable goods orders is hovering right around zero.
As a final note, make sure to recognize that durable goods orders did contract during 2015 – 2016, when business spending contracted as a share of GDP, but that did not cause an official recession. It did, however, result in the market losing about 20% of its value – so we need to be ready for a potential downdraft if business spending does not stabilize and head higher.
Now let’s cover a few other leading indicators, which continue to provide a mixed picture of the economy. Last Thursday we saw the preliminary “flash” readings on manufacturing and services by IHS Markit, and the data was not good.
The manufacturing PMI came in at 49.9 – falling below 50 and signaling the first outright contraction in manufacturing since September 2009. On the services side, things weren’t much better, with a reading of 50.9. Services represent the bulk of our economy and we need to see continued growth there to avoid a manufacturing induced recession.
Combining both manufacturing and services data, the IHS Composite PMI registered 50.9, which again is precariously close to the 50 level that denotes expansion from contraction.
The two caveats I’ll point out here are that these are survey based measures (meaning there is some variability) and these are the preliminary readings, which will be revised. Let’s hope the revised figures come in a bit higher.
Moving on, the end of last week also provided us with an update from The Conference Board regarding their Leading Economic Index. Long-time readers know that I appreciate this index for both its simplicity and long lead time, and thankfully, the index resumed its ascent last month.
The LEI rose 0.5% in July, following back to back 0.1% declines in June and May. You can see the LEI reaching a new high in the chart below.
While we’re seeing some leading indicators flash yellow, or even red, this particular index, which is a composite of 10 leading indicators, continues to rise. If the LEI is able to anticipate the next recession in similar fashion as the last two recessions, it suggests that we likely still have more than a year of expansion ahead of us.
Another way to view the LEI data is to look at its six-month growth rate. Notice below that the six-month growth rate in the LEI turned negative well before the last two recessions. The fact that is has not turned negative recently (and just ticked higher) is a good sign.
Finally, the last item I’d like to point out is that credit spreads remain tight. Recall that we’re watching this as a clue for when investors begin to exit the bonds of less financially sound companies – which itself is a sign of impending economic malaise.
Overall, while yields have come down dramatically and the yield curve remains inverted across nearly all maturities, I think the jury is still out on whether a recession is imminent. These low rates are stimulative in nature, and that, combined with a Federal Reserve set to ease further, ongoing deficit spending, and a President who wants to be reelected (and therefore can’t allow the economy to fall into recession), suggests this is not a done deal.
The market is always climbing a wall of worry, and this one seems to have its pickaxes sunk in deep.
I’ll leave you with one last data point that could, unfortunately, be a harbinger of reduced consumer spending. For the last few years we saw home price appreciation in excess of 5%. During the past year, that growth rate has slowed to 2%.
Consumers tend to feel wealthy and have an increased propensity to spend when their homes are rising in value. If this trend continues, it will likely dent consumer spending moving forward, as homeowners tend to shy away from improvements when their homes are either treading water or falling in value.
In case you’re interested in the price changes in your local area, changes in each of the 20 cities included in the composite data are listed below.