The Four Horsemen of the Recession by Sébastien Page, Head of Global Multi-Asset and Chief Investment Officer at T. Rowe Price

I’m hearing hoofbeats, but a recession doesn’t seem imminent

Last week, I was preparing some notes for Bloomberg TV and CNBC appearances when I got stumped. Or maybe overwhelmed is the right word. I just couldn’t figure out how to summarize all the myriad economic headwinds into succinct but useful insights.

So many indicators are flashing red, and yet so many of them are distorted by the unwinding of COVID stimulus. I’ve been throwing up my hands and telling clients that “the macro data are wacky.”

(I’ll admit that’s an easy out for me because I’m not an expert in classical macroeconomics—just ask our economists Blerina Uruci and Nikolaj Schmidt how many Macro 310 or 410 questions they field from me in any given week. OK, and occasionally some 210 ones.)

Finding inspiration in how to boil down a complicated problem?

Then I happened to look down on my desk and see Peter Attia’s “Outlive: The Science and Art of Longevity” on my Kindle. Attia’s book was published less than a month ago, and it’s already a New York Times bestseller. I’m only about halfway through it, but I can see why. It’s a great book if you’re interested in health and longevity.?

Attia describes cancer, diabetes, heart disease, and Alzheimer’s as the “four horsemen” diseases that are most likely to kill you. Sure, there are many, many other things to worry about, but paying attention to and doing your best to avoid these four will get you a long way to a healthy life.

Attia’s four horsemen struck me as a useful way to boil down something very complicated—like our especially wacky economy. So, I asked myself, what are the four horsemen of the recession? Instead of looking at a few hundred economic indicators, most of which are flashing red, what are the top four that investors should worry about? I came up with the following list:?

1) An Inverted Yield Curve: This qualifies because an inverted yield curve represents monetary tightening, coupled with declining expectations for long-term growth and inflation. It’s not perfect—this signal has misfired, and the lags between yield curve inversions and recessions are all over the place. But there’s no perfect signal, and it’s one of the best we have.?

As of May 2023, the yield curve is significantly inverted, with three-month bills yielding about 5.2% compared with 3.4% for the 10-year note. There’s our first horseman.?

2) Cautious Purchasing Managers: The Institute for Supply Management’s Purchasing Managers Index (PMI) is another good leading indicator of a recession, and it’s widely followed by economists and investors. Importantly, it’s an indicator of the direction of growth rather than the level of growth. It represents the views of purchasing managers on whether the economy is improving or deteriorating.?

As of April 2023, the Manufacturing PMI is at 47.1, with any level below 50.0 indicating contraction. It has dropped 17 points since its peak. There’s our second horseman. (Caveat: The services index is still above 50.)1??

3) Rising Unemployment: To declare a recession, the National Bureau for Economic Research needs to see a rise in unemployment.??

Full stop—that isn’t happening. Yet. Despite 500 basis points in rate hikes from the Fed, the unemployment rate moved back down to a multidecade low of 3.4% in April. Despite 253,000 new hires, there remained about 1.6 open jobs per unemployed worker.2??

That said, unemployment claims and layoff announcements are gradually rising, and May’s data may paint a different story. Let’s say this horseman hasn’t arrived yet, but I’d be really surprised if he doesn’t show up eventually.?

4) Tightening Credit Conditions: Nearly half of all bank loan officers tightened lending to standard businesses in the first quarter. If you believe that history will repeat itself, the current level of credit tightening is a signal that a deep recession is unavoidable. Moreover, credit standards were already tightening before the first quarter (Q1), and Silicon Valley Bank’s collapse occurred as the quarter was winding down.

However, without saying “this time is different”—don’t ever say that in the polite company of money managers—the following analysis shows why I’m concerned by credit tightening but not yet ready to call a recession. Let’s say I’m only hearing the distant hoofbeats of this horseman.??

More on Our Fourth Horseman: The SLOOS?

For this month’s deep dive, I turned to some of my usual collaborators to analyze what the Federal Reserve’s most recent Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices, released on May 8, can and cannot tell us about a coming recession. The team this time included Cesare Buiatti, Grace Zheng, Rob Panariello, Will Durham, Charles Shriver, and Blerina Uruci, with quantitative investment analyst Cesare Buiatti taking the lead in assembling the data and running the analysis.

The April 2023 SLOOS shows that 46% of bank loan officers said they tightened lending standards to businesses in Q1. As shown below, we’ve breached the 46% level four times over the last 30 years, each time around a recession:

June 2020 (just after the COVID recession)?

March 2008 (early in the global financial crisis)?

December 2000 (just before the dot-com bubble recession)?

March 1990 (just before the recession that was sparked in part by the savings and loan crisis)??

We found that credit tightening, as expected is a negative harbinger for corporate profits, as show below.3?

Where’s the causality? Do credit conditions tighten because corporate profits fall, or do corporate profits fall because credit conditions tighten? It’s not an easy question. While credit conditions appear to lead corporate profits by about six months, I believe there’s a negative feedback loop involved.

In 1990 and 2000, credit conditions tightened before the recession. But in 2008 and 2020, the recession was already underway. If we take the COVID example, loan officers tightened credit because they worried about default risk due to the pandemic shutdowns. They didn’t have a crystal ball that predicted the pandemic, and they didn’t cause the short recession.

My perennial question: What does this tell us as asset allocators???

Only the event of 2020 was a BUY signal for stocks versus bonds, as shown below. The market had already sold off due to the pandemic, and the mother of all bazooka stimulus responses was on the way.?

In 2000 and 2008, the market had also already started selling off, but it continued to sell off after each event. As for small-caps versus large-caps, the evidence is mixed and not shown here.??

Are any of these past tightening cycles likely to serve as precedent for what is happening today? Unfortunately, given today’s wacky times, the short answer is no. The two most important differences between now and these prior credit tightening events are the following:?

First, default risk is much lower now. Our fixed income research team believes there is a 3% default rate over the next 12 months for the high yield universe, which is in line with historical averages.?

Second, COVID stimulus distortions persist. We’re still digesting over $700 billion in excess household savings, from the $2 trillion peak.??

The bears will say that it’s just a matter of time, but let’s remember that growth and liquidity are normalizing from very high COVID-reopening levels. In the current environment, year-over-year changes in the economic data series are misleading.

Also, demand for services, consumer spending, and corporate margins continue to flash green on the macro dashboard. Corporate earnings are much closer to a bottom than a peak, which historically has been a good time to buy stocks. And in a bad-news-is-good-news kind of way, credit tightening can do part of the Fed’s job, thus reducing the need for rate hikes.

In summary, feel free to pick your narrative, but I’m staying away from predicting a coming apocalypse. A recession may well be coming, but it’s not inevitable. Let’s just say that, while I’m hearing hoofbeats, I don’t think the four horsemen have assembled. Yet.

I believe our modest underweight to stocks and neutral portfolio risk positioning remain appropriate.??

?

References?

1 As of April 2023. Source: Institute for Supply Management/Haver Analytics.?

2 Source: Bureau of Labor Statistics.??

3 Note: Profits are lagging by 6 months but are measured over 12 months, which means that 6 months are “in sample,” and therefore the predictive “fit” is overstated.

? Small-caps outperformed coming out of the 2000 and 2008 recessions but underperformed after the 1990 and 2020 events. Notably, large-cap mega-techs dominated the COVID recovery era—until 2022, as we all know all too well.?

? As of March 2023. Excess household savings is defined as disposable personal income (SAAR, Bil.$) - personal outlays (SAAR, Bil.$). Source: Bureau of Economic Analysis/Haver Analytics.??

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