Preparing For A Recession

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Sam Lau

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Samuel Lau, portfolio manager, DoubleLine.

One question that’s been on the top of mind for investors is if we are in or if we are headed for an economic recession. And to help answer this, there are a few tried and true indicators that we look at at DoubleLine that offer some insight on if the economy will enter a period of expansion or contraction in the upcoming months. And that’s typically decided in, the actual recession is actually decided in hindsight by an agency called the National Bureau of Economic Research, which is the official book of record for recessions here in the U.S.

But in terms of these indicators that we look at at DoubleLine as a signal for recession, I’ll go through and just highlight three of my favourite ones. And for the short answer for whether or not the U.S. will be entering a recession in the next 10 months is that it does seem to be on the way based on these recession indicators that I’ll go over as they’ve historically had a very good track record of preceding economic contractions. Again, here in the U.S.

So the first one I’ll take a look at is the Leading Economic Index and that is an aggregated number of economic and market variables. And this goes back, with data, back to the 1960s. The LEI, as I mentioned before, has an excellent track record when it comes to looking at proceeding recessions. And the signal there is when the year-over-year index flips negative, and we’d like to see it at least stay negative for two consecutive months before we start to consider it as a signal. But with that as a basis, the LEI has signaled eight of the last nine recessions here in the U.S., missing only that first recession that occurred just shortly after the LEI launched. If memory serves, it was two months after the LEI officially began releasing its data.

So the lead time on that has also been pretty good. It’s generally somewhere in the neighborhood of six to eight months from when it first dips into those two consecutive months of being negative to the beginning of the recession. So between six to eight months before the signal strikes and we see the recession as it’s declared by the NBER. When we take a look at it from a lag time or how much lead time it’s had at the longest part of it, it’s been 12 months. So generally, it’s pretty good from a timing signal as well when you’re talking about inside of a year having that foresight into a slowing in the U.S. economy, eventually being declared a recession. So again, thus far a very good indicator.

But what’s troubling right now is when I take a look at the Leading Economic Index, and I should have said this in the beginning, but this index is managed and aggregated by the entity called the Conference Board. But what’s troubling right now is that the LEI has been in negative territory for the last seven months or so now, and based on the last eight recessions and on this measure alone, we could either be in or very near the beginning of an economic recession in the U.S. as that indicator has already been triggered. That’s certainly within that period of between the six to eight months that I was talking about before.

One other indicator that has also been reliable over the same timeframe, again going back to the sixties, is looking at the U.S. headline unemployment rate relative to its 12-month and its 36-month moving averages. Now, the current print on the headline unemployment rate, when that breaks above the moving averages there, that triggers the recession indicator. And today, March 17th, 2023, the unemployment rate is 3.6%. And when we look at it relative to the 12-month average, the 12-month average is also 3.6%.

The 36-month moving average is 5.7. So, based on those percentages, you can see that we’re on the precipice of triggering that 12-month indicator as it just stands right on top of a 12-month average. But again, it does need to break through for us to consider the signal. But when it does trigger, this historically leads recessions by, again, six to eight months. So similar to the Leading Economic Indicator in terms of the lead time using the 12-month moving average as the indicator.

When we look at it relative to the 36-month, it looks like we still have a ways to go, the 3.6 relative to the 5.7, but as we’ve seen in the past, once the unemployment rate begins to move higher, it can move rather sharply rather quickly. And I will note that the 36-month is a slightly better indicator in terms of it doesn’t have as many false positives, but it is a coincident indicator to recession, meaning that it tends to just fall right around the same time that the recession begins.

And then lastly, I like looking at the shape of the U.S. yield curve here, the treasury yield curve to be specific, as an indicator. And there, looking at the spread between the 10-year note yield and the 3-month T-bill yield as the point on the curve. And this can be useful as it’s based on real time market data rather than the aforementioned economic data prints, which themselves can be lagged anywhere from one to two months, typically. So having the daily real time data can be useful when we’re looking at these things. When the 3-month yield exceeds that of a 10-year yield, you get a negative spread, what we call an inversion in the yield curve there, at least within those two points. And when this yield curve becomes inverted, it has preceded eight of the last eight recessions. And this indicator, when we take a look at it again, the differential between the 3-month and the 10-year yield, that indicator triggered last October. So, as far as timing goes, the average lead time here is a bit longer. It’s about one year, and it has a range of anywhere from nine to 23 months lead time.

So when I take a look at all of these together, I offer up these indicators because again, historically ,they had been good predictors over time. They’re publicly available to listeners if they want to go through and stick through some of the data. And it’s relatively straightforward indicators as well. They’re easy to put together and make adjustments as needed.

The bad news is that all three of these indicators suggest that 2023 is on the table for a possible recession. I guess the question now just remains is one of timing, but it does seem to point to somewhere in the second half of 2023, perhaps the first quarter or the first half of 2024. But the good news here is these indicators give us a little bit of foresight and that allows investors to position accordingly, which there still seems to be time for.

If we look through the markets, the different sectors of a fixed income market, we can begin with the credit markets. And today, within the credit markets, we have a preference for non-traditional fixed income sectors where you can still get high single-digit yields and in some cases, depending on where you’re investing, you can get low double-digit yields while remaining in investment-grade rated securities. So, instead of just relying on U.S. investment grade corporates, which yield around 5%, you can get a bit of the yield pickup over IG corporates here in the U.S. So for that, we like to include and look at non-traditional sectors like asset-backed securities, which are bonds backed by consumer loans, non-government guaranteed commercial, as well as residential mortgage-backed securities. And then the CLOs and merging market debt. For investors who are willing to step outside of that investment-grade arena and into the low investment grade, yields can go up quite quickly from there. But I would say that while these yields can be tantalizing to look at based on the kind of teens type of yields that you can get in some of these areas, given where we are in this economic cycle, I would caution against loading up solely on credit and your fixed income portfolios. I think today, more important than ever, is that one would need some expertise in order to underwrite these securities, understand the risk and how it integrates within the rest of the portfolio.

Now the good news is that for a compliment to credit risk today, U.S. treasury securities also have yields that we haven’t seen in years. And in some cases, depending on where you are on the curve, there are yields that we haven’t seen in excess of a decade. When you take a look at yields from the 2-month T-bill out to the 2-year treasury note, they currently deliver a yield over 4%.

So that can be quite an attractive parking spot for those who are waiting to deploy cash, both for your at-home do-it-yourselfers and investment managers alike. It’s not that we like to sit on cash, but it doesn’t hurt as much today as it did just even last year or a few years ago. But as you move out the curve, yields from, let’s say here, the 5-year treasury on out to the long bond, the 30-year bond, you can still get yields that are in the mid to high threes today. Even after the rallying that we saw earlier here around mid-March. While you do give up some income by going into treasuries and then out the curve, you do get some insurance that can provide protection against adverse moves in riskier assets. Like the aforementioned credit sectors within the fixed income market that do offer some juicier yields.

But the treasury side of the portfolio can also offset other risk assets like the equities within your portfolio. So oftentimes people ask me, would I rather own credit today for yield pickup or would I rather own treasuries for the risk trade off? And I’d like to reply with, why not both? That way if you have both of those sides in your fixed income portfolio, you have offsetting risk and return profiles inside that broader fixed income portfolio. And today, given what we just discussed about yields, you’re able to do so with relatively attractive income stream from both your credit and the treasury side of the portfolios.

For those who are looking for something that’s more in line with a vanilla Bloomberg AG like reward to risk profile, take on a little bit less credit risk, then you can still within an actively managed portfolio that’s benchmarked against the AG, you can get a portfolio that yields somewhere in the mid-fives today. So you’re getting about a percent pick-up in yield over the AG.