More than a month ago I penned an article titled, “Economic Indicators Show Recession As Early As Next Month.” Since then more and more indicators have come out to further solidify that call while other indicators still remain above the recessionary threshold. While some indicators still suggest the U.S. economy is not yet in a recession, I believe there is enough evidence to suggest the U.S. actually slipped into a recession this month or will soon be in a recession as it appears one is inevitable given the bearish economic momentum.
Philadelphia Fed Coincident State Index Signaling Recession
The recession call I made earlier came from reviewing one of my favorite indicators, the Philadelphia Fed’s Coincident State Index, in particular their 1-Month Diffusion Index. Over the life of the indicator, the recessionary threshold appears to occur below 50, with the indicator falling below 50 on average 4-5 months prior to when recession begins. As highlighted in my earlier article, the index fell below 50 in May of this year which set the recessionary time clock in motion for one to begin in the Fall given its 4-5 month lead time. Since then the 1-Month Diffusion Index has plummeted further to a reading of 18 for August and its level is now low enough to suggest a recession may already be present.
Note: Recessions shaded by red bars
The reason why I like the Philadelphia Fed’s State Coincident Index data is that it is an economic breadth measure, meaning it reveals how pervasive economic strength is across the US, rather than giving an overall national level. Breadth measures are not only a key tool for any charting technician, but so too for economists and forecasters. For example, when more than 50% of the S&P 500 members are trading above their 200 day moving averages (200d MA) that would indicate a market in which more than half the stocks are in up trends. Tops in the market are associated with fewer and fewer stocks participating in an advance and this can be seen by a negative divergence of stocks trading above their 200d MA. The negative divergence is the first warning and when readings fall materially below the key 50% mark a bear market is usually in force.
Similarly, if more than half of states' respective economies are expanding, then the US national level is likely expanding. Like the 200d MA exercise for the S&P 500, if more and more states move into contraction territory to the point where less than half of the 50 states are expanding, a recession is likely ahead.
The figure below combines both of these ideas of breadth for the stock market and the economy. On the top panel is the S&P 500 and the percentage of stocks within the S&P 500 above their 200d MA. As you can see, only 18.8% of the 500 stocks within the S&P 500 are above their 200d MAs, with negative breadth like this last seen in late 2008 when the S&P 500 was deep into its last bear market. The bottom panel shows the Philadelphia Fed’s National Coincident Index in which a rising index indicates an expanding economy and a falling index indicates a contracting economy. As you can see, when the percentage of states that were expanding fell below 50% the U.S. was already in a recession and the National Coincident Index rolled over. Currently only 66% of states are expanding which indicates a weak economy and any further deterioration in the percentage of states expanding is likely enough to pull the national index down and lead to another recession.
The idea of looking at economic breadth can be used beyond the borders of the US and taken to a global scale to gauge the health of the global economy. Shown below is a figure created by Francois Trahan of Wolfe Trahan, which shows that the bulk of the globe’s manufacturing sector is in contraction territory (< 50 readings) with only three countries still expanding at a strong clip and a few near the threshold of slipping below 50.
Source: Wolfe Trahan, “Will Fat-Tail Risks Prevent A 4th Quarter Rally?” (09/21/2011)
A weak global economy will cut into one of the last strong areas of US GDP growth, which are exports. The export sub-index for the US ISM Manufacturing Report came in at 50.5 for August, dropping sharply from April’s 62 reading, and on the verge of moving into contraction territory. Given the global economic deterioration currently underway, we are likely to be treated to sub 50 readings in the export sub-index for September.
There are other numerous headwinds facing the US economy and some of the former economic stabilizers like state and local government employment are now turning into headwinds as the “austerity” buzz word going about in Europe is being witnessed state-side in local governments. Not since the early 1980s have state and local government payrolls been such a drag on the economy. August non-farm payrolls for the US showed ZERO job growth and September may show the first negative monthly jobs report since 2010.
All in all, the above factors suggest that the US economy is either in or slipping into another recession. Our firm’s own recessionary probability model is nearing the key 20% threshold mark in which a recession has occurred every time the 20% level is exceeded. Given we were at 19.5 for August, it appears a reading north of 20% is a given for September or October, which appears to be the month that the next recession will begin in the US.