Dollars and Sense

TD’s Leading Economic Index: It Was All Yellow

Beata Caranci, SVP & Chief Economist | 416-982-8067

James Orlando, CFA, Senior Economist | 416-413-3180

Date Published: September 3, 2019

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Highlights

  • External risks have deteriorated economic sentiment globally, with trade tensions and manufacturing weakness in Europe and Asia being most notable. 
  • Our TD Leading Economic Index is now flashing yellow in six of eight categories, demonstrating greater breadth of a slowing U.S. economy. This points to low growth of 1% to 2%, rather than a contraction (recession). 
  • Recession probability models that rely on the yield curve will always flash higher recession odds than those that rely on forward economic indicators. A key distinction is in the timing.  
  • Over August, a toxic combination has formed between heightened  ‘recession talk’  and yield curve inversion. We are at risk of what we have coined the “Beetlejuice Effect”. This is where recession talk can become self-fulfilling by playing into the psyche of businesses and investors. 
  • With no sign of improvement in global economic and political outcomes, we expect the Federal Reserve to cut policy rates two times in the coming months to keep a floor under the economy.  
Chart 1: Economic Leading Index Flashing Yellow

It was all yellow. We’re not talking about Coldplay’s hit song, but rather the observation that struck when we updated our Leading Economic Index (Chart 1). It shows six of eight indicators flashing yellow, marking more breadth than previous periods of market angst (Table 1). The last few months have brought forth a seismic shift in several areas of the outlook, supporting the view that the Federal Reserve has sufficient cause to follow through with two more cuts this year. If our economic index continues to deteriorate through year-end, more cuts may yet be on deck for 2020. 

Here’s a run-through of just some of the latest developments that suggest now is the time to err on the side of caution:

  1. Our global economic outlook has been downgraded to 2.9%. This thinning cushion to absorb political and economic shocks marks the slowest pace in a decade. The forecast disappointments have a high concentration within Europe, where the outlook remains tenuous for large economies, like Germany, Italy and the UK.
  2. The small green shoots that materialized on global trade over the spring looked to have been stepped on during the summer. Momentum was not sustained and trade escalation during August between China and the U.S. will not help matters. 
  3. This worrisome combination has prompted almost a universal shift to dovish comments or outright lower interest rates by central banks. Many are reading from the same playbook: rate cuts are largely to guard against unfavorable global trends and rising uncertainty.  
  4. In parallel with falling expectations for economic growth has been a downward swift in longer term bond yields. This has reinforced yield-inversion dynamics in countries like the U.S., while others have seen a large tranche of yields move into negative territory.

Against this backdrop, it’s not surprising that recession talk has returned to the front pages of the media and is top of mind among our clients. A deep dive shows that there is no evidence in the hard data that the U.S. is headed for a recession, but some warning flags indicate higher odds over the next 12-24 months.  

Dynamics at Play

Chart 1: Economic Leading Index Flashing Yellow

The incidence of ‘recession talk’ has shot up and sits higher today than prior periods of heightened market angst (i.e. stock market correction in December 2018 and the Chinese revaluation episode in 2015). As Chart 2 shows, the degree of concern is mirroring the period of 2011/12 when, in fact, Europe did tilt into a recession. The U.S. did not follow suit, as the financial and economic linkages tend to be stronger going in the other direction. However, the global economy was a restraint on the U.S. economy, which saw only 1.5% growth in 2011.

A key reason recession talk has increased is directly related to the inversion of the U.S. yield curve. Naturally this didn’t occur in 2011 because much of the dialogue was directed towards Europe. And, importantly, the mechanics were not easy to achieve, with U.S. short-term rates sitting near zero, versus 2.25% today. 

Any recession probability model that contains the yield curve as an explanatory variable will show high odds of a recession, typically within the 50-60% range. The NY Fed’s financial model is lower at 31% (as of July 31st), but relative to its history, this marks the highest odds since early-2007. As we’ve discussed in a previous report, this occurs because yield inversion is unquestionably a good signal of a recession. But, its history is not a perfect, and these days the signal may be obscured by unconventional central bank policies. In any event, models where it is the primary focus will always predict high odds once inversion occurs.

The most important piece of the puzzle comes into play when you switch the focus of recession probability models to those that monitor  economic indicators. Doing so causes the recession odds to fall measurably within the 20-30% range. 

What accounts for the difference? Timing. The signal from yield curve inversion has historically maintained a long lead time of 12-24 months, while those driven by economic indicators generally offer no more than a 3-6 month window. And herein lies a key piece of information. All models are telling us that a period of slower growth is on deck for 2020, particularly as the weight of tariff hikes this year come to fully bear on production and consumer costs. But, the signal has not yet arrived that negative financial market sentiment has bled deeply through the economic data. Nothing is written in stone yet: a recession may be in our future, but that risk is not imminent.

Two New Developments Of Concern

Last year, we published a paper coining the ‘Beetlejuice Effect’, in which recession concerns can become self-fulfilling by altering the hiring and investment behavior of firms. An area of concern in the past month is the potential for a toxic combination created by the high incidence of recession talk and the reinforcement of that sentiment within an inverted yield curve. Neither of these existed when we wrote that report in December. 

Chart 3: Hours Worked Have Been Softening

Within the economic data, here too there’s a new development afoot. Our Leading Economic Index shows six of eight indicators flashing a cautionary yellow. This is not a surprise for those indicators capturing business sentiment and output, as the deceleration in the ISM indicators and manufacturing cycle has been well telegraphed in the data for several months. What caught our eye over the summer was the deceleration in hours-worked (Chart 3). Is this a sign that businesses are responding to uncertainty by pursuing more cautionary hiring? Time will tell if the trend  deepens into red territory. If so, it would be harder for the mighty U.S. consumer to stand strong in the face of a compromised job market. 

In fact, the timing of the recent trade escalation couldn’t have been worse. We have been perpetual optimists that the U.S. consumer has strong underpinnings and present a key source of upside risk to our forecast. This became reinforced in recent data, showing a second quarter spending profile near 5%. And the third quarter looks like it will have a solid 3%-handle. However, as the full force of the tariffs comes to bear on production and market sentiment, we will be downgrading our U.S. outlook to somewhere in the 1.5% to 1.6% range for 2020. And, the near-term data on consumer spending may not be the best guide for next year. 

Consumers are likely to front-load purchases this fall to get ahead of tariff-related price hikes on some of the favorite items. This may make our Leading Economic Index prone to a false signal on the consumer side, requiring us to place more emphasis on what hours and job conditions are telling us, rather than consumer spending patterns. Don’t forget, we have likely not seen the peak in trade tensions, as the U.S. administration will be releasing a ruling on auto imports come November under their Section 232 investigation. Recently Japan has indicated they may have struck a trade deal with the U.S. to avoid a negative outcome, but Europe remains in the cross hairs and marks a larger trading partner with the U.S. than China. A collision of U.S. trade conflicts across two continents could be more than business sentiment is able to bear. 

This is why the economics community needs to be humble during this period of extreme political uncertainty. Economic models are not designed for political shocks, it requires a significant degree of judgement by forecasters. Lasting shocks to sentiment and income have larger impacts on the forecast than the direct effects on trade flows from movements in export prices. With the U.S. being the source of political uncertainty, it may lead to stronger feedback loops between the global economy and their domestic economy relative to that 2011 period when recession talk was heightened. 

Putting all the pieces together, it would be completely reasonable for the Federal Reserve to continue along the rate-cut course. Doing so now has a foundation that goes beyond simply taking out ‘insurance’. A case can be made that the fundamentals are showing some early evidence of fault lines.

Bottom Line

With external risks hitting both business and investor sentiment, we are closely watching for contagion to the broader U.S. and Canadian economies. According to the TD Leading Economic Index, we are not seeing red flags supporting outright contraction, but rather a broad-based weakening. So far, this pattern remains unique relative to what we’ve seen ahead of prior economic downturns, where specific sectors move deep into red territory based on prior excesses (i.e. corporate sector in 2000 and housing sector in 2007). 

Nevertheless, the economic backdrop has deteriorated sufficiently to prompt some backstop action by the Federal Reserve. We are calling for 50 bps in cuts by the end of 2019. This action will play through the confidence channel and hopefully provide the necessary support for the economy. Should we get further deceleration in our Leading Economic Index, then even more monetary stimulus will be warranted.

Tables

Table 1: Evolution of U.S. Leading Indicators
Date TDE Economic Index Consumer Variables Business Variables
2000s Recession (Recession Start: March 2001) 
Oct-00 -0.32 -0.12 0.00 -0.07 0.14 -0.12 0.02 -0.13 -0.05
Nov-00 -0.44 -0.11 -0.02 -0.19 0.12 -0.12 0.00 -0.08 -0.04
Dec-00 -1.03 -0.08 -0.08 -0.25 -0.06 -0.26 -0.04 -0.19 -0.08
Jan-01 -0.87 -0.06 -0.05 -0.19 0.12 -0.31 -0.07 -0.28 -0.03
Feb-01 -1.00 -0.06 -0.10 -0.28 0.01 -0.31 -0.11 -0.13 -0.03
Mar-01 -1.36 -0.07 -0.10 -0.42 -0.13 -0.28 -0.13 -0.20 -0.01
Financial Crisis (Recession Start: December 2007)
Jul-07 -0.23 -0.19 0.00 0.01 0.09 -0.03 0.02 0.05 -0.18
Aug-07 -0.35 -0.21 0.00 -0.03 0.03 -0.02 0.02 0.03 -0.18
Sep-07 -0.44 -0.22 0.03 0.00 -0.03 0.03 0.04 -0.09 -0.19
Oct-07 -0.43 -0.22 -0.01 -0.05 -0.01 0.00 0.02 0.03 -0.19
Nov-07 -0.40 -0.22 0.00 -0.05 0.05 -0.04 0.05 -0.04 -0.16
Dec-07 -0.73 -0.22 -0.02 -0.09 -0.08 -0.08 0.01 -0.01 -0.23
Current 
Feb-19 -0.17 -0.03 0.00 -0.02 -0.13 0.04 0.03 -0.02 -0.04
Mar-19 0.04 -0.03 0.04 0.03 -0.03 0.07 0.01 0.02 -0.08
Apr-19 -0.17 -0.01 -0.01 0.01 -0.02 0.00 -0.05 -0.03 -0.06
May-19 -0.14 0.02 -0.02 0.00 -0.05 -0.02 -0.02 -0.03 -0.03
Jun-19 -0.10 0.07 -0.02 -0.01 0.01 -0.03 -0.04 -0.02 -0.06
Jul-19 -0.19 -0.02 -0.05 0.00 0.04 -0.04 -0.07 -0.04 -0.01

Source: TD Economics

Interest Rate & Foreign Exchange Rate Outlook
    Spot Rate 2018 2019 2020
    Sep-03 Q1 Q2 Q3 Q4 Q1 Q2 Q3F Q4F Q1F Q2F Q3F Q4F
Interest Rates                            
Fed Funds Target Rate  2.25 1.75 2.00 2.25 2.50 2.50 2.50 2.00 1.75 1.75 1.75 1.75 1.75
3-mth T-Bill Rate  1.94 1.70 1.89 2.15 2.40 2.35 2.08 1.73 1.60 1.60 1.60 1.60 1.60
2-yr Govt. Bond Yield  1.51 2.27 2.52 2.81 2.48 2.27 1.75 1.50 1.50 1.55 1.60 1.70 1.80
5-yr Govt. Bond Yield  1.39 2.56 2.73 2.94 2.51 2.23 1.76 1.40 1.40 1.50 1.60 1.75 1.85
10-yr Govt. Bond Yield  1.50 2.74 2.85 3.05 2.69 2.41 2.00 1.55 1.55 1.65 1.75 1.90 2.00
30-yr Govt. Bond Yield  1.97 2.97 2.98 3.19 3.02 2.81 2.52 2.00 2.15 2.25 2.35 2.45 2.55
10-yr-2-yr Govt Spread -0.01 0.47 0.33 0.24 0.21 0.14 0.25 0.05 0.05 0.10 0.15 0.20 0.20
Exchange rate to U.S. dollar                          
 Chinese Yuan CNY per USD 7.18 6.27 6.62 6.87 6.88 6.71 6.87 7.20 7.25 7.25 7.25 7.25 7.25
 Japanese yen JPY per USD 106 106 111 113 110 111 108 106 105 104 103 103 102
 Euro USD per EUR 1.09 1.23 1.17 1.16 1.15 1.12 1.14 1.09 1.09 1.10 1.12 1.13 1.14
 U.K. pound USD per GBP 1.20 1.40 1.32 1.31 1.28 1.30 1.27 1.20 1.19 1.20 1.21 1.22 1.23
 Swiss franc CHF per USD 0.99 0.95 0.99 0.98 0.98 1.00 0.98 0.99 0.99 0.99 0.99 0.99 0.99
 Canadian dollar CAD per USD 1.34 1.29 1.31 1.29 1.36 1.34 1.31 1.33 1.33 1.32 1.31 1.30 1.30
 Australian dollar USD per AUD 0.67 0.77 0.74 0.72 0.71 0.71 0.70 0.68 0.68 0.69 0.70 0.70 0.70
 NZ dollar USD per NZD 0.63 0.72 0.68 0.66 0.67 0.68 0.67 0.63 0.64 0.65 0.67 0.68 0.69
Exchange rate to Euro                          
 U.S. dollar USD per EUR 1.09 1.23 1.17 1.16 1.15 1.12 1.14 1.09 1.09 1.10 1.12 1.13 1.14
 Japanese yen JPY per EUR 116 131 129 132 126 124 123 116 114 114 115 116 116
 U.K. pound GBP per EUR 0.91 0.88 0.89 0.89 0.90 0.86 0.90 0.91 0.92 0.92 0.93 0.93 0.93
 Swiss franc CHF per EUR 1.08 1.17 1.16 1.13 1.13 1.12 1.11 1.08 1.08 1.09 1.11 1.12 1.13
 Canadian dollar CAD per EUR 1.46 1.59 1.53 1.50 1.56 1.50 1.49 1.45 1.45 1.45 1.47 1.47 1.48
 Australian dollar AUD per EUR 1.63 1.60 1.58 1.61 1.63 1.58 1.62 1.60 1.60 1.59 1.60 1.61 1.63
 NZ dollar NZD per EUR 1.74 1.70 1.72 1.75 1.71 1.65 1.70 1.73 1.70 1.69 1.67 1.66 1.65
Exchange rate to Japanese yen                          
 U.S. dollar  JPY per USD 106 106 111 113 110 111 108 106 105 104 103 103 102
 Euro  JPY per EUR 116 131 129 132 126 124 123 116 114 114 115 116 116
 U.K. pound  JPY per GBP 128 149 146 148 140 144 137 127 125 125 125 125 125
 Swiss franc  JPY per CHF 107.4 111.4 111.6 116.3 111.6 111.1 110.5 107.1 106.1 105.1 104.0 103.5 103.0
 Canadian dollar  JPY per CAD 79.5 82.4 84.3 87.8 80.4 82.8 82.4 79.7 78.9 78.8 78.6 78.8 78.5
 Australian dollar  JPY per AUD 71.5 81.7 81.9 82.1 77.3 78.6 75.6 72.1 71.4 71.8 72.1 71.8 71.4
 NZ dollar  JPY per NZD 66.8 76.9 75.0 75.3 73.6 75.5 72.4 66.8 67.2 67.6 69.0 69.7 70.4
F: Forecast by TD Economics, September 2019; Forecasts are end-of-period. 
Source: Federal Reserve, Bloomberg.
Commodity Price Outlook
  Price 52-Week 52-Week 2018 2019 2020
  Sep-03 High Low Q1 Q2 Q3 Q4 Q1 Q2 Q3F Q4F Q1F Q2F Q3F Q4F
Crude Oil (WTI, $US/bbl) 55 76 42 63 68 70 59 55 60 55 56 57 58 59 59
Natural Gas ($US/MMBtu) 2.34 4.80 2.02 3.08 2.86 2.93 3.80 2.92 2.51 2.30 2.35 2.40 2.41 2.42 2.44
Gold ($US/troy oz.) 1535 1543 1183 1329 1306 1213 1229 1303 1307 1465 1470 1470 1450 1425 1425
Silver (US$/troy oz.) 18.70 18.70 14.00 16.74 16.56 15.02 14.58 15.58 14.91 16.60 17.25 17.50 17.50 17.50 17.50
Copper (cents/lb) 254 297 254 316 312 277 280 282 278 268 277 284 288 290 290
Nickel (US$/lb) 8.19 8.19 4.85 6.01 6.56 6.02 5.21 5.60 5.56 6.44 5.90 5.90 6.12 6.35 6.35
Aluminum (Cents/lb) 79 100 79 98 102 93 89 84 81 81 82 86 88 91 91
Wheat ($US/bu) 5.74 7.55 5.74 7.42 7.46 6.70 6.85 7.08 6.36 6.20 6.34 6.38 6.41 6.44 6.48
F: Forecast by TD Economics, September 2019; Forecast are period averages; E: Estimate. 
Source: Bloomberg, USDA (Haver).

International Interest Rates Outlook
  Spot Rate 2018 2019 2020
  Sep-03 Q1 Q2 Q3 Q4 Q1 Q2 Q3F Q4F Q1F Q2F Q3F Q4F
Germany                          
ECB Deposit Rate -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.40 -0.60 -0.60 -0.60 -0.60 -0.60 -0.60
3-mth T-Bill Rate  -0.72 -0.79 -0.65 -0.58 -0.84 -0.55 -0.60 -0.70 -0.70 -0.70 -0.70 -0.70 -0.70
2-yr Govt. Bond Yield  -0.92 -0.62 -0.67 -0.53 -0.62 -0.61 -0.76 -0.79 -0.76 -0.73 -0.68 -0.54 -0.43
5-yr Govt. Bond Yield  -0.93 -0.11 -0.30 -0.09 -0.32 -0.46 -0.67 -0.79 -0.73 -0.66 -0.59 -0.47 -0.37
10-yr Govt. Bond Yield  -0.71 0.49 0.30 0.47 0.24 -0.07 -0.33 -0.60 -0.50 -0.40 -0.30 -0.20 -0.10
30-yr Govt. Bond Yield  -0.20 1.15 1.02 1.08 0.87 0.57 0.26 -0.05 0.05 0.15 0.35 0.50 0.65
10-yr-2-yr Govt Spread 0.21 1.11 0.97 1.00 0.86 0.54 0.43 0.19 0.26 0.33 0.38 0.34 0.33
United Kingdom                      
Bank Rate 0.75 0.50 0.50 0.75 0.75 0.75 0.75 0.75 0.75 0.75 0.75 1.00 1.00
3-mth T-Bill Rate  0.76 0.51 0.59 0.75 0.70 0.75 0.75 0.75 0.75 0.75 0.88 1.00 1.13
2-yr Govt. Bond Yield  0.33 0.81 0.71 0.82 0.73 0.64 0.68 0.58 0.68 0.79 1.01 1.24 1.46
5-yr Govt. Bond Yield  0.26 1.11 1.03 1.17 0.90 0.69 0.61 0.54 0.64 0.77 0.96 1.14 1.33
10-yr Govt. Bond Yield  0.39 1.35 1.28 1.44 1.14 0.99 0.83 0.50 0.60 0.75 0.90 1.05 1.20
30-yr Govt. Bond Yield  0.90 1.71 1.74 1.91 1.82 1.55 1.47 1.00 1.20 1.35 1.45 1.55 1.65
10-yr-2-yr Govt Spread 0.07 0.54 0.56 0.62 0.42 0.36 0.15 -0.08 -0.08 -0.04 -0.11 -0.19 -0.26
F: Forecast by TD Economics, September 2019; Forecasts are end-of-period. 
Source: Bloomberg.
Global Stock Markets
  Price 30-Day YTD 52-Week 52-Week
  Sep-03 % Chg. % Chg.  High Low
S&P 500 2,926 -0.2 16.7 3,026 2,351
DAX 11,920 0.4 12.9 12,630 10,382
FTSE 100 7,259 -2.0 7.9 7,687 6,585
Nikkei 20,625 -2.2 3.0 24,271 19,156
MSCI AC World Index* 510 -0.8 12.0 532 436
*Weighted equity index including both developing and emerging markets.
 Source: Bloomberg, TD Economics.

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