A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.



Q/A on Economic Slowdown Taking Hold

Harlan Levy: How real and how significant are inflation and interest rate fears?

Lakshman Achuthan:
Coming on top of the realization that the world's central banks, net-net, plan to buy fewer bonds in 2018, the fresh news in recent weeks has been the tax cut and then the budget, both of which have brought deficit concerns to the fore. Given the implications for the international demand and supply of bonds, the surge in bond yields in recent weeks and months is justifiable.

However, those understandable interest rate fears are widely conflated with inflation danger. Please recall that our summer 2016 reflation call, when inflation expectations had plunged, and our spring 2017 on-target out-of-consensus forecast that inflation would undershoot, were based on ECRI's U.S. Future Inflation Gauge.Today, the USFIG sees no danger of a surprise surge in inflation anytime soon, even though massive budget deficits could result in higher inflation in the years to come. And, as we've explained, the latest jump in average hourly earnings growth is not inflationary, but rather confirms that an economic slowdown is taking hold.

H.L.: Is the U.S. economy's momentum dwindling, and if so what's ECRI's prediction for the next few years?

L.A.: The implications of rising rates are more worrisome than realized by most people who are missing ECRI's 2018 slowdown call. Please recall that our slowdown call is based on the same ECRI leading indexes on the basis of which we made a global growth upturn call before the 2016 election. And by early 2017 - when most were worried that the hard data wasn't confirming the soft data - ECRI declared the strongest global growth upturn since 2010.

Most people extrapolate trends. That often works, but at cycle turns, by definition, that's a mistake. ECRI's leading indexes are designed to signal when the risk of such a mistake is high, and of late they've been sending a warning signal loud and clear.

But what we find particularly interesting is a bond market metric that's really not affected by deficit concerns - the quality spread between yields on junk bonds and BAA corporate bonds. As we recently explained, that bond market quality spread is corroborating ECRI's slowdown call. Consistent with a greater rise in perceived default risk for lower-quality bonds during a slowdown, it's actually been widening since last spring, completely in line with ECRI's growth downturn call. In fact, it's now around its widest point since the fall of 2016.

H.L.: What effect on the economy and stocks do you expect from the Trump tax cuts?

L.A.: The general optimism on growth is being further fueled by tax cuts, and most estimates of the boost to growth amount to a fraction of 1 percent of GDP in 2018. But slowdowns - three of which we've seen since 2010 - tend to cut GDP growth by a couple of percentage points. So, as we've asserted, the tax-cut boost - while supportive of corporate profits - isn't enough to offset the near-term cyclical slowdown.

H.L.: Do you see a recession in the near future, and if so when and how significant would it be?

L.A.: While we do see a slowdown, we don't see a recession in the near future. The danger is that this slowdown could end in a "hard landing," so we remain on the lookout for such a signal from our leading indexes, which are designed to signal rising recession risk. Until we see such a recession flag, it would be premature to predict when such a recession would arrive and how severe it would be.

H.L.: Do you expect the Federal Reserve to raise rates two or three times this year, and if so, what's the possibility that that's too many and will be done too quickly?

L.A.: There is a real risk of the Fed hiking rates too fast in the face of an economic slowdown they don't see coming. Because that could bring on a "hard landing," we are keeping a close eye on our leading indexes that signal recession risk.


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