The Globe and Mail - 30.07.2019

TUESDAY,JULY30,2019 | THEGLOBEANDMAIL O B7

GLOBEINVESTOR

REPORTONBUSINESS|

O

ne specific index would
have allowed investors to
near-perfectly time equity
markets over the past 14 months
and it points to one indicator –
U.S. corporate bond spreads – as
the most important to follow in
the weeks ahead.
Central bank monetary policy
has been a central driver of equity
market performance since
mid-2018. The monetary tighten-
ing by the U.S. Federal Reserve
and Bank of Canada in 2018 led to
extremely weak equity markets
in the second half of last year. The
trend was reversed on Christmas
Eve with the Fed’s pivot to a more
accommodative, stock-friendly
policy, and equities have been ral-
lying since.
The importance of financial
conditions – the ease of credit
conditions and monetary policy –
is apparent in the top accompa-

nying chart. The S&P 500 (and the

S&P/TSX Composite Index to a

significant degree, although it’s

not shown) has closely tracked

the Goldman Sachs U.S. Financial

Conditions Index. The Goldman

index is plotted inversely to bet-

ter show the trend, so a rising pur-

ple line indicates lower rates and

easier credit conditions.

The Financial Conditions In-

dex has five components. The 10-

year U.S. Treasury yield has the

largest weighting, followed by

BBB-rated corporate bond

spreads (the amount BBB bonds

yield above comparable U.S. Trea-

sury bonds), the trade-weighted

U.S. Dollar Index, the Federal Re-

serve policy rate and a small (5

per cent) weighting in the S&P

500 itself.

Of the four non-S&P 500 index

components, correlation analysis

points to BBB spreads as by far

the biggest contributor to the

similarity between the path of fi-

nancial conditions and the U.S.

equity market. This close rela-

tionship between the volatility of

bond spreads and equities can be

seen in the second accompanying

chart.

BBB-rated corporate bonds

hold a very important position in

global markets in the current en-

vironment. In a late May report,

Standard & Poor’s noted that BBB

bonds represents 53 per cent of all

U.S. investment-grade bonds and

the market capitalization of the

category is more than 250 per

cent larger than high yield, spec-

ulative bonds.

Importantly, BBB is the lowest-

tier investment-grade rating –

anything lower is considered high

yield or junk. Many investment

funds are prohibited from invest-

ing in junk bonds and this means

that a BBB bond that gets down-

graded must be sold from all of

their portfolios.

The tightening monetary con-

ditions of late 2018 put enough fi-

nancial pressure on BBB-rated

bond issuers that downgrades to

junk status became more likely.

This pushed bond spreads higher

• investors demanded more com-
  pensation for the added risk in
  the form of higher coupon pay-
  ments – which put even more
  pressure on these companies.
  The Fed’s about-face on tight-
  ening has allowed the BBB corpo-
  rate bond sector to perform well
  in 2019. Even so, the sheer scale of
  the sector and the severe penalty
  for downgrades makes it an im-
  portant one to follow as a mea-
  sure of balance sheet health for
  U.S. and global companies.
  For more than a year, investors
  have been confronted with equi-
  ties markets driven primarily by
  changes in central bank policy
  and monetary conditions. Until
  that changes, BBB-rated corpo-
  rate bond spreads, as the most
  volatile component of financial
  conditions, will be an important
  indicator to gauge where stocks
  will head next. They can be
  tracked at the Federal Reserve Ec-
  onomic Data website.

KeepaneyeonU.S.corporatebondspreads

Untilequitiesmarkets

arenolongerdriven

primarilybycentral

bankpolicy,BBB-rated

corporatebondswill

remainakeyindicator

BONDSPREADSANDEQUITIES:GAUGINGWHAT’SNEXT

JOHN SOPINSKI/THEGLOBE ANDMAIL

SOURCE:SCOTTBARLOW;BLOOMBERG; FEDERALRESERVEECONOMICDATA

98.5

99. 
    

99.5

100. 0

100 .5

2,25 0 10 1. 0

J

2018 2019

A SOND JFMA MJ J

J

2018 2019

A SOND JFMA MJJ

2,35 0

2,45 0

2,55 0

2,65 0

2,75 0

2,85 0

2,95 0

3, 050

3,15 0

SIP 5 00 Goldman Sachs U.S. FinancialConditions Index (inveSted)

1.25

1.35

1.45

1.55

1.65

1.75

1.85

1.95

2. 05
   2,25 0 2.15

2,35 0

2,45 0

2,55 0

2,65 0

2,75 0

2,85 0

2,95 0

3, 050

3,15 0

SIP 5 00

MeSSill Lynch U.S.CoSpoSateBBB

Option-Adjusted SpSead (inveSted, %)

SCOTT
BARLOW

OPINION

INSIDETHEMARKET

B

usiness economists in the

U.S. expect economic

growth to slow this year, and

a rising proportion of them think

corporate sales and profits will de-

cline.

The National Association for

Business Economics said Monday

that its quarterly survey of busi-

ness conditions found that the

Trump administration’s tariffs on

goods from China, Europe and

other countries have disrupted

the businesses of about a quarter

of its members. Still, the survey al-

so found that the NABE’s member

economists generally expect the

economy to keep growing, albeit

only gradually, and to avoid a re-

cession in the next 12 months. Just

less than half say they think the

economy will expand 2 per cent or

more over the next year – sharply

lower than the two-thirds who

predicted so in January.

Over all, the survey suggested

that the economists, who work

mainly for corporations and trade

associations, expect the economy

to cool in part because of the high-

er costs imposed on imported ma-

terials by the U.S. tariffs. (The

NABE says 119 of its members re-

sponded to the survey.)

The results echo the message

from thegovernment’s report Fri-

day on economic growth in the

April-June quarter. Thegovern-

ment estimated that growth

slowed to a 2.1-per-cent annual

rate from a 3.1-per-cent rate in the

January-March quarter. Business-

es cut back on their investment

spending for the first time in three

years, which most analysts attri-

buted to a more cautionary strate-

gy resulting from the trade war.

Over all, 28 per cent of respon-

dents said they thought the tariffs

have had a negative impact on

their business. That figure was

much higher among manufactur-

ers: Three-quarters felt the tariffs

had hurt business. Factories have

been hit hard by the administra-

tion’s expanded taxes on import-

ed steel and aluminum.

The survey also suggested the

job market may be cooling slight-

ly. One-third of respondents said

they had hired during the April-

June quarter, down from 44 per

cent who had said so a year earlier.

There were some bright spots

in the results: Nearly half the re-

spondents expect business in-

vestment spending in buildings,

equipment and software to in-

crease in the July-September

quarter. That’s the highest pro-

portion to say so in a year.

ASSOCIATEDPRESS

U.S.business

economists

foreseeslower

growth:survey

CHRISTOPHERRUGABER

L

ast week’s report on second-quarter
gross domestic product showed
that the economy slowed last
spring. It also came exactly 10 years
since the Great Recession ended, making
this officially the longest expansion in
American history. (Well, probably. More on
that in a second.) So perhaps it’s no sur-
prise that forecasters, investors and ordi-
nary people are increasingly asking when
the next downturn will arrive.
Economists often say that “expansions
don’t die of old age.” That is, recessions are
like coin flips – just because you get heads
five times in a row doesn’t mean your next
flip is more likely to come up tails.
Still, another recession will come even-
tually. Fortunately, economic expansions,
unlike coin-flip streaks, usually provide
some hints about when they are nearing
their end – if you know where to look. Be-
low is a guide to some of the indicators that
have historically done the best job of
sounding the alarm.

INDICATOR1:THEUNEMPLOYMENTRATE

The unemployment rate is near a 50-year
low, but that isn’t what matters for reces-
sion forecasting. What matters is the
change: When the unemployment rate ris-
es quickly, a recession is almost certainly
on its way or has arrived.
Even small increases are significant.
Claudia Sahm, an economist at the U.S.
Federal Reserve, recently developed a rule
of thumb that compares the current unem-
ployment rate with its low point over the
previous 12 months. (Both are measured
using a three-month average, to smooth
out short-term blips.) When that gap hits
0.3 percentage points, the risks of a reces-
sion are elevated. At half a percentage
point, the downturn has probably begun.
Unemployment is considered a “lag-
ging” indicator, and it is unlikely to be the
first place to pick up on signs of trouble. But
what it lacks in timeliness, it makes up for
in reliability: The unemployment rate pret-
ty much always spikes in a recession, and it
rarely rises much without one.
That is why right now the unemploy-
ment rate should be a source of comfort:
Not only is it low, it’s trending down. When
that has been the case, historically, there
has been less than a one-in-10 chance of a
recession within a year, according to a
Brookings Institution analysis that worked
off Ms. Sahm’s measure.

INDICATOR2:THEYIELDCURVE

The yield curve is less intuitive than the un-
employment rate, but it has historically
been among the best predictors of reces-
sions.
The fundamentals are straightforward:
The curve essentially shows the difference
between the interest rate on short-term
and long-termgovernment bonds. When
long-term interest rates fall below short-
term ones, the yield curve is said to have
“inverted.”
Think of the yield curve as a measure of
how confident investors are in the econo-
my. In normal times, they demand higher
interest rates in return for tying up their

money for longer periods. When they get

nervous, they’re willing to accept lower

rates in return for the unrivalled safety

bonds offer. (That’s the simplified version.)

The Federal Reserve Bank of New York

has developed a handy metric that trans-

lates fluctuations in the yield curve into re-

cession probabilities. Right now, it puts the

chance of a recession starting in the next

year at about one in three – up sharply from

a year ago, and not far from where it was on

the eve of the Great Recession.

Don’t panic yet, though. Many econo-

mists argue that the yield curve means less

than it used to, partly because the Fed was

until recently raising short-

term interest rates, even as

the huge holdings of bonds

that it accumulated during

the recession are putting

downward pressure on long-

term rates. Taken together,

those actions could be skew-

ing the shape of the yield

curve. And, in any case, it has

taken as long as two years for

a recession to follow a yield-

curve inversion in the past.

INDICATOR3:THEISM

MANUFACTURINGINDEX

Every month, the Institute

for Supply Management sur-

veys purchasing managers at

major manufacturers about

their companies’ orders, in-

ventories, hiring and other activity. It then

aggregates those responses into an index:

Readings above 50 indicate that the manu-

facturing sector is expanding; below 50, it is

contracting. (The institute also releases a

measure of activity in the service sector,

but that index doesn’t go back as far.)

The manufacturing index has some sig-

nificant advantages. It is released early, of-

ten on the first day of the subsequent

month, and unlike lots of economic data, it

doesn’t get revised. Most importantly, the

index is a true leading indicator: It has his-

torically shown signs of trouble before the

broader economy hit the skids.

On the other hand, manufacturing no

longer drives the U.S. economy, which

means a contraction in the sector doesn’t

guarantee a recession. The ISM index fell

below 50 for several months in 2015 and

2016, for example, signalling an “industrial

recession” that never turned into the real

thing. But steep downturns in manufactur-

ing tend to be signs of trouble – it is rare for

the index to fall much below 45 or so with-

out a recession hitting.

Right now, American manufacturers are

being battered by a global slowdown and

by trade tensions. As of June, the index is

still in expansion territory, but barely.

Many economists think it will fall below 50

in the coming months but don’t expect a

steeper drop.

INDICATOR 4: CONSUMER

SENTIMENT

Consumers drive the econo-

my, now more than ever. It is

pretty much impossible for

the economy to keep grow-

ing if Americans decide to

keep their wallets closed.

The trouble is, by the time

spending slows, a recession is

probably under way. Mea-

sures of consumer confi-

dence, such as the long-run-

ning indexes from the Con-

ference Board and the Uni-

versity of Michigan, provide

insight into how consumers

will spend in the future.

Confidence indexes are

volatile from month to month, and they

sometimes drop sharply as consumers re-

act (and overreact) to the stock market, po-

litical developments and other events.

Those declines often don’t translate into

real changes in spending.

But sustained declines are another mat-

ter. Economists at Morgan Stanley recently

found that a 15-per-cent year-over-year

drop in the Conference Board’s index is a

reliable predictor of a recession.

By that metric, the economy isn’t in

trouble. Consumer confidence is basically

flat compared with a year ago, but it has

fallen since late last year.

NEWYORKTIMESNEWSSERVICE

Whenthenextrecessioncomes,

here’swhereyou’llseethefirstsignsofit

TheInstituteforSupplyManagementmanufacturingindexhashistoricallyshownsignsof

troublebeforethebroadereconomyhittheskids.TIMAEPPEL/REUTERS

BENCASSELMAN

Unemployment is

considered a

‘lagging’ indicator,

and it is unlikely to

be the first place to

pick up on signs of

trouble.But what it

lacks in timeliness, it

makes up for in

reliability: The

unemployment rate

pretty much always

spikes in a recession,

and it rarely rises

much without one.