Thursday, December 29, 2022
Not a Pessimist, Just a Realist
As of November, the Conference Board’s Leading Economic Index (LEI) continues to decline, signaling an impending recession. However, the current state of the economy is somewhat solid as firms add to their payrolls and consumers spend on both goods and services, despite high inflation. Consumer debt ratios are lower than previous periods of weakness and suggest that a bloated stock of savings and high nominal wage growth continues to buffer the consumer from high prices. But the outlook is gray as the LEI illustrates. So what do we make of the current situation?
Tracking the Three D’s of Recessions
The National Bureau of Economic Research (NBER) is the official arbiter for the U.S. business cycle and this group will most likely declare the economy will dip into a recession in 2023. When determining the state of the economy, the NBER looks at three factors–the three D’s–which are depth, diffusion, and duration. The Conference Board’s Leading Economic Index (LEI) is often a favorite metric for two of the three D’s. The six-month percent change of the LEI shows depth and duration. As of November, the six-month percent change is -3.7%, indicating rising recession risks. The six-month change has never been this low without a recession materializing soon thereafter. Falling building permits and rising unemployment insurance benefits claims were the main contributors to the decline in November.
An oft-overlooked component of the LEI can also shed light on the third D, the diffusion of an economic contraction. Diffusion is a measure of breadth. Earlier in 2022, the housing market was contracting but other areas of the economy were not, thus, economic weakness was not widespread. Since the economy was not experiencing a broad-based decline, the economy was not likely in recession.
The LEI is made up of 10 leading indicators and if a majority of indicators are declining, the diffusion of the LEI is below 50. As stated by the Conference Board, “the diffusion index of the LEI ranges from 0 to 100 and numbers below 50 indicate most of the components are weakening.”
Now that the economy is satisfying the 3 D’s of a recession, investors should anticipate the rising risks that the economy could fall into recession in 2023.
The U.S. is not currently in recession, given the strength of the consumer sector, but a recession looks increasingly likely in the New Year. The trajectory for growth looks weak. A deteriorating housing market, nagging inflation, and an aggressive Federal Reserve (Fed) puts the economy on unsure footing for 2023. The silver linings are markets have possibly priced in much of the near-term recession risks and the Fed will likely further downshift the pace of its future rate hikes.
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