Is the US heading for recession? President Trump thinks not, and most economists agree: a recent survey by the Philadelphia Fed found that the average forecaster expects only a very modest slowdown over the next 12 months, and that unemployment will actually continue to fall.
But this is not as comforting as we’d like. The IMF’s Prakash Loungani has pointed out that economic forecasters around the world have consistently failed to foresee downturns – their failure to predict the 2008 crisis merely continued a longstanding pattern. The fact that economists don’t expect a recession therefore tells us little about the chances of one.
Instead, John Williams – now a member of the rate-setting Federal Open Market Committee (FOMC) – has pointed out that a better forecaster of recession is the shape of the yield curve. With 10-year Treasury yields well below shorter-dated ones, this now points to a significant risk of recession. The New York Federal Reserve Bank estimates that the curve points to an almost one in three chance of one within the next 12 months. There’s a simple reason for this. An inverted yield curve is a sign that investors expect interest rates to fall, which means they expect a weak economy – and these expectations have often been correct.
The yield curve, however, is not the only troubling indicator. Another is the ratio of retail sales to the S&P 500. In July, this hit its lowest level since retail sales data began in 1947.
Common sense says this should worry us. Consumer spending is at least in part forward-looking – if we fear losing our job or getting a pay cut we’ll spend less than if we expect good times. And there is often wisdom in crowds. Of course, any individual consumer will be wrongly or irrationally overly pessimistic or overly optimistic. But across tens of millions of people such errors should to a large extent cancel out.
Low consumer spending should, therefore, be a warning sign of hard times to come.
And history confirms this common sense. Since 1947 there has been a statistically significant correlation between the ratio of retail sales to share prices and subsequent three- or five-year changes in industrial production: the correlation has been even stronger since 1980. Low ratios in the early 1970s, late 1990s and 2007, for example, led to recessions – while high ratios in the 1950s, early 1980s and 2009 led to expansions.
There’s also a correlation between this ratio and subsequent changes in the S&P 500. Adjusting for inflation, this has been 0.3 for three-year changes and 0.41 for five-year changes.
All this is consistent with UK evidence that consumer spending can predict equity returns and economic fluctuations as well as with research by Martin Lettau at the University of California Berkeley and Sydney Ludvigson at New York University. They have shown that deviations of consumer spending from what would be predicted by income and wealth can predict equity returns.
So, it’s not just the yield curve that’s telling us to be cautious of the US’s economic prospects. The wisdom of another crowd – consumers – is sending the same message.
What, then, could be wrong with this message?
One possibility – suggested by other work by Professors Lettau and Ludvigson – is that the rise in the S&P in recent years has been driven by a shift in incomes from wages to profits. We’d expect this to reduce retail sales relative to share prices, especially if workers expect the shift to persist.
This, however, will only maintain or increase share prices if the shift helps to support the economic expansion. Whether this is the case revives an old question in political economy, of whether pro-capital or pro-labour policies are best at promoting growth.
A rising profit share can support growth if companies plough enough of those higher profits back into capital spending. Unfortunately, this might have ceased to be the case – non-residential capital spending actually fell in the second quarter.
This could matter. Capital spending should in theory be forward-looking just like consumer spending: declines in it therefore should betoken increased corporate caution about future demand.
Which suggests we have not one or two but three different groups of people who are pessimistic about the economy: bond investors, consumers and company bosses. Personally, I would trust their judgment more than that of the President or of economic forecasters.
