It’s a bad news – bad news situation. The first bad news? Inflation is sticking around for longer than anyone would like. The other bad news? That prediction is predicated on the prediction of recession. But keep reading for a gold nugget at the end of this blog!
The Federal Reserve Bank of Cleveland (also known as the Cleveland Fed) has modeled out expected inflation for CORE PCE (prices of core personal consumer expenditures, excluding food and energy prices). Their methodology included three components that align with those noted by Chair Powell in his press conference on December 14, 2022: housing, core goods, and core-services-less-housing.
The Cleveland Fed’s model projects inflation slowing to just 2.75 percent by the end of 2025. Inflation, initially deemed transitory is now here to stay. And it would take a deep recession to achieve this predicted inflation path. Ergo, a recession appears to be imminent.
What we’re seeing right now is a divergence between the economic reality and the financial markets. Stocks are overvalued. The Feds have made their stance on future rates pretty clear.
They are hawkish and will do whatever it takes to tame inflation. The market is now fully pricing in rate hikes of 25 basis points at each of the next three Federal Open Market Committee (FOMC) meetings.
If the economy further deteriorates, will the Feds take their foot off the pedal? As they continue to raise rates, the economy will slow down accordingly and financial markets will also experience a downturn.
To further support our theory, we’ve compiled some recent readings of the leading economic indicators to see what they’re telling us.
10-2 Year Treasury Yield Spread: The 10-2 Treasury Yield Spread is the difference between the 10-year treasury rate and the 2-year treasury rate. A 10-2 treasury spread that approaches zero signifies a “flattening” yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period. A negative 10-2 spread has predicted every single recession from 1955 to 2018. This is a far-leading indicator that typically shows up somewhere between 6 months and 2 years prior to the onset of the recession. The most current reading of -.83% just came out on February 24th and it implies we are in a recession.
Philadelphia Fed Manufacturing Survey: Formally known as the Business Outlook Survey (BOS), this monthly survey produced by the Federal Reserve Bank of Philadelphia (AKA Philadelphia Fed) questions manufacturers in the Third Federal Reserve District on general business conditions. The February report released earlier this month took an unexpected plunge. The expected decline of -7.8 turned out to be an actual drop of -24.3.
This was the sixth consecutive negative reading and the lowest one since May 2020. This survey indicates the direction of change in overall business activity and accurately reflects the pace of growth in manufacturing nationally. It has been a reliable leading indicator in predicting recessions. In the 8 previous times when the reading was as low as it is now, the economy was either already in a recession or about to enter one within four months.
Conference Boards Leading Economic Index: This index looks at 10 different components that The Conference Board believes are predictive, or “leading”, with respect to the direction of the US economy. The Leading Economic Index (LEI) fell by -0.3% in January, following a decline of -0.8% in December. The most recent six-month period had a steeper rate of decline compared to the previous six-month period. Therefore, the Conference Board is expecting high inflation and rising interest rates to continue as consumer spending contracts, tipping the US economy into recession this year.
Durable Goods Orders: The January report came in at 4.5% lower month over month, the lowest on record going back to April 2020. This implies that the consumer is not spending on big-ticket items and this is simply not a good sign for the overall health of the economy.
Where does all of this bad news and more bad news leave those of us who are carefully watching the financial markets? Technology, manufacturing, and energy sectors typically struggle in a recessive environment. But, at last, some good news! Healthcare and consumer staples are recession-proof industries and generally perform well. Commodities, the US dollar, and gold should also do well in the near term.
See? We told you there was a gold nugget at the end!
