When Will The Party End?…

By almost any measure, the U.S. economy is in great shape.  At 3.9%, the U.S. unemployment rate is at historic lows. Inflation remains at reasonably low levels and economic growth, as measured by GDP, just hit its highest quarterly rate since 2014. But economies have a nasty tendency to go through boom and bust cycles and the current expansion is definitely long in the tooth. At 110 months, it is the second longest boom on record and almost 3 times longer than the 39 month average expansion.

Understandably, most investors are wondering when the party will end. Many of the traditional statistics that economists track suggest that we have no reason to worry but a few other indicators with strong predictive track records bear watching.

The Treasury Yield Curve: Mention the yield curve and most people’s eyes start to glaze over. The data contained in the graph below, however, has an impressive record of accurately predicting economic downturns. Historically, investors have demanded more compensation for holding longer dated bonds. The yield curve measures this “liquidity premium,” or the spread between the yield offered on 10-year Treasuries compared to 2-year Treasuries. In the past, this spread has narrowed as the Federal Reserve, in an effort to cool off an overheating economy, raised rates. But monetary policy is a blunt tool at best and often overly aggressive Fed action has pushed the economy into recession. History shows that once the spread goes negative (i.e., 2-year Treasuries yield more than 10-year Treasuries), recessions soon follow. The yield curve has not gone negative yet but today stands at a decade low 0.15%.

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Housing Starts: Residential housing contributes only about 3%-5% of U.S. GDP. However, factor in related spending on things like remodeling and utilities - - and housing as a whole contributes as much as 16%. Housing starts are a particularly good leading indicator of overall economic confidence; builders are reluctant to embark on new construction projects and consumers are reluctant to make such a large purchase if they are uncertain about the future.

Unfortunately, after several years of recovery (see chart above) housing starts have flat-lined around the 1.2 million mark.  So far, strong job and wage growth appears to be offsetting the negative impact of higher interest rates and housing costs, but this metric bears watching.

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The Unemployment Rate: Historically, the U.S. unemployment rate has troughed just before a recession. This outcome most likely reflects the fact that rising demand for labor during periods of strong economic growth tends to ignite wage inflation which in turns spurs aggressive Fed tightening. Where are we today? The unemployment rate has recently been oscillating between 3.8% and 4.0%. It is hard to imagine the rate going too much lower from here although, encouragingly, wage gains have remained relatively subdued.

Interestingly, while the three metrics discussed here have a pretty good track record of predicting recessions, the economists who track them do not. According to Ned Davis research, “economists, as a consensus, called exactly none of the seven recessions since 1970.”

If economists can’t predict the next recession, what is the average investor supposed to do? Remember that even if you can’t predict the business cycle, you can control your own behavior. Be sure your investment strategy accurately reflects your own risk tolerance and return objectives. An ample supply of cash too will help you ride out the economic storm when it comes and prevent you from having to liquidate holdings in a down market.