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Evaluating the Increasing Threat of U.S. Recession
Central banks have been working to slow demand, which we think increases the chance of mild recession. Head of Portfolio Solutions for Global Fixed Income Tim Johnson evaluates what the market and economic indicators are saying.
The Federal Reserve and other central banks likely welcome the corrections this year in the equity and bond markets. Intent on containing inflation, central banks have been working to slow demand by tightening financial conditions. As a consequence, we think US indicators show an increasing threat of a mild recession.
Let's take a closer look. A useful metric to evaluate the influence of US monetary policy is the Treasury Department's OFR financial stress index, which tracks financial conditions for credit, equity evaluation, funding, safe haven assets, and volatility. The index is positive when stress levels are above average and negative when stress levels are below average.
This year the index has risen from -1.3 to positive 0.8 reflecting the Federal Reserve's effort to guide inflation back to its 2% target from about 8% now. In the bond market, the yield curve has inverted again, and high yield credit spreads have well surpassed 450 basis points both developments have historically indicated a high chance of recession.
Economic indicators also show signs of a possible recession. Real gross domestic product, which is adjusted for inflation, fell 1.6% in the first quarter of this year from growth of 6.2% the previous quarter. If the economy shrinks in the second quarter, the US technically will enter a recession.
Further, the Conference Board's Index of Leading Economic Indicators fell from six in January to three in May. The decline through 0 has been a reliable precursor to recession during the following two years. With these ominous signals, we remain cautious about the possibility of a US recession, though, we don't think it will occur.
The closer look at the market and economy reveals four encouraging observations. First, tighter financial conditions have slowed demand, [CUT OUT] may tone down the Fed's aggressiveness to help reduce market volatility. Longer maturity treasury yields have already begun to stabilize around 3%.
Second, core inflation measures have peaked and begun a gradual declined. Third, an increase of a half in the three month average unemployment rate often foreshadows a recession. This indicator has declined this year and stabilized at 3.6% suggesting a supportive labor market.
Fourth, some fixed income valuations now reflect the recession but a brief and mild one. For example, at the current yield of roughly 9% for high yield bonds, an investor could realize a return of 5% or more assuming average defaults of 1.5% and 2.5% long-term inflation. In the coming quarter, we'll be watching for continued inflation moderation while focusing our investments on bond issuers we believe are equipped to weather the profit margin compression typically seen during mild recessions.