2% Chance - Unemployment Indicator Shows No Recession
There is only a 2% Chance that the economy is currently in a recession. One common recession indicator is the bottom in the unemployment rate. It’s not a terrible concept, but it’s unrefined. It was recently proven to be a misleading indicator. Some bears got excited by the 4 month period where the unemployment rate was above the 3.7% temporary bottom in November 2018.
If people enter the labor force and boost the unemployment rate, it’s not a bad thing. Furthermore, if the rate dips sharply for one month, that doesn’t mean there’s a trend higher. The BLS labor report can vacillate wildly on a month to month basis.
The chart below shows an improvement on that calculation. As you can see, it shows the 3 month average relative to the prior 12 month low. If the 3 month average is slightly higher than the prior 12 month low, it’s meaningless. The 3 month average needs to be 0.4% above the 12 month low for it to matter.
That gets rid of a lot of noise in the data.
2 % Chance - Since we’re at the cycle low in the unemployment rate, the indicator isn’t showing the economy is in a recession. It’s possible there will be revisions to the unemployment rate, but it’s highly unlikely there will be a 0.4% increase in each of the past two months along with an increase next month.
Perma bears are too skeptical of this expansion as usual. There’s a difference between a slowdown and a recession. This is a slowdown, not a recession. There is a 2% chance the economy is in a recession based on the current reading. For future reference, there is a 76% chance the economy is in a recession when the reading is between 0.4% and 0.49%; there is a 97% when it is 0.5% or greater.
Corporate Debt Market Isn’t That Bad
2% Chance - There are unwarranted fears about the corporate debt market because it is seen as the next bubble which will burst at the end of this cycle. There is a scary chart which shows the percentage of BBB debt has exceeded debt rated from A to AAA. From December 2010 to December 2017, total high yield debt is up 1.7X, total investment grade debt is up 1.9X, and the BBB portion of investment grade debt is up 2.4X. Despite this large increase in BBB debt, corporate credit quality doesn’t signal an impending disaster.
Corporate debt quality isn’t as bad as it seems because within the BBB category, there has been an increase in BBB+ rated debt. Specifically, from December 2010 to December 2017 BBB+ debt as a percentage of all corporate debt has increased from 11.5% to 18.2%.
BBB debt has increased from 14.2% to 16.1% and BBB- debt has increased from 10.9% to 13.4%. Therefore, 6.7% of the 11.1% increase was in BBB+ debt. I think when most people read the charts showing how large BBB debt has gotten, they don’t even consider the makeup of that category. It tells a completely different story.
Another aspect people don’t realize is a lot of BBB debt growth has come from the banks.
2% Chance - As you can see from the table below, 40% of the growth in BBB debt has come from the banks. 14% of the increase has come from Citi alone. The banks are lower rated than they were before the financial crisis. Their ratings were a big mistake heading into the financial crisis as the entire system almost cratered.
Now the rating agencies are much more cautious. Banks are well capitalized, so I don’t see a big issue this cycle. Key point here is that there isn’t a mass change in corporate debt quality. It’s specific to a few firms. If you are very worried, then you must be worried about Citi. Personally, I’m not worried about Citi. I’m not bullish on the bank stocks, but that’s a separate issue. They can underperform, while not having solvency issues.
Now let’s look at the 60% which isn’t from the banks. This growth is also concentrated in a few firms. Specifically, AT&T is 19% of the growth from December 2010 to December 2017. Its debt was downgraded from A in 2015 after it acquired DirectTV and Time Warner. If you think AT&T’s debt is an issue, you can worry about debt quality, but I won’t.
Similarly, Verizon’s debt was downgraded from A in 2013 after it bought Vodafone’s stake in Verizon Wireless. This doubled the firm’s debt and increased corporate BBB debt by 14%. On the opposite side, both GM and Ford were upgraded and contributed 7% each to the growth in BBB bonds. Ford was upgraded in 2012 and GM was upgraded in 2015. In total, 87% of the growth in BBB debt has come from these 4 firms and the banks.
2% Chance - Tariffs Imposed When Stocks Are High
Most investors are focused on how the tariffs effect the stock market, but few look at how the stock market effects tariffs. I have mentioned that Trump will be pressured to end the trade war if the stock market falls. However, I haven’t discussed how the tariffs have been announced when the market is up.
As you can see from the chart below, the first tariffs, the 10% tariff on $200 billion in Chinese goods, and the hike to 25% all occurred at market peaks. To be clear, the tariffs helped push the market lower, but the fact that they were enacted at such high levels implies Trump announces them when he has the most negotiating power. The 2nd chart shows the timing of escalation events.
The 3rd chart shows the de-escalating events. They occurred when the market was falling in December. The market now impacts monetary policy and trade policy. When the market goes up, you must worry about new tariffs and rate hikes. When the market goes down, trade war de-escalation and rate cuts can cushion the blow.
In other words, sell the rips and buy the dips. However, i the economy falls into a recession for cyclical reasons, neither monetary policy, nor trade policy can prevent a bear market.
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