Schwab, LPL Investment Chiefs: Risk of Recession Is Low, but ‘Not Zero’

Recession risk is up based on recent economic indicators, but it's not high, according to experts from Charles Schwab and LPL Financial.

While the Conference Board's Leading Economic Index unexpectedly declined 0.2% in August, Liz Ann Sonders, Schwab's chief investment strategist, believes this has "yet to signal a definitive turn for the worse."

The Leading Economic Index, which Sonders calls the "most-widely followed set of leading indicators," is designed to signal peaks and troughs in the business cycle. The Leading Economic Index tracks 10 diverse economic indicators, including data on employment, manufacturing, housing, bond yields, the stock market, consumer expectations and housing permits.

(Sonders is speaking at the most heavily attended preconference session in the industry at Schwab Impact 2016 in San Diego on Oct.27)

Over the past 50 years and eight recessions, the Leading Economic Index peaked well in advance of the onsets of recessions—on average by more than 12 months, Sonders said.

"And in the case of the three most recent recessions, the LEI had 'round-tripped' (taken out its prior high) at least four years prior to the subsequent recessions," Sonders writes in her latest commentary. "So, if a recession is imminent today, it would be unprecedented for the LEI not to give sufficient warning."

Sonders wrote, "Yes, August's reading was negative and worse than expected, but as noted, there are usually months and months of deterioration before recessions ensue. August is also a month notoriously prone to economic data revisions—especially jobs-related data. So, the net is it's too soon to declare victory for the economic bears."

Burt White, chief investment officer for LPL, agrees that the Leading Economic Index is signaling the continuation of the economic expansion and bull market, according to his weekly market commentary.

White looks at the year-over-year change in the Leading Economic Index, which he calls the "best snapshot of the overall health of the economy," to determine if the economy is showing late-cycle warnings. LPL's analysis indicates that the year over year change in the Leading Economic Indicator has to turn negative to indicate a recession.

"When the year over year change has turned from positive to negative, a recession has followed in anywhere from 0–14 months with an average lead time of six months," White wrote.

However, the year over year change in the Leading Economic Index as of August 2016 was +1.1%, which White said suggests "a continuation of the economic expansion that began in 2009."

"The pace of annual increases has slowed, but that is due mostly to what we view as temporary factors," he wrote. "Should this indicator weaken further and the weakness persist, we would become more concerned."

According to White's colleague, John J. Canally, Jr., CFA Chief Economic Strategist at LPL, the Leading Economic Index shows the risk of recession is low—but it's also not zero.

"The [Leading Economic Index], even at just 1.1% year over year, says the risk of recession in the next 12 months is very low (7%), but not zero," Canally wrote. "Although the odds of a recession increase when looking out 18 months (11%) and 24 months (12%), they remain low—but again, not zero."

While the current recovery has been long, both Canally and Sonders pointed out the length of a recovery does not typically determine when it ends.

"Yes, this has been a historically-long recovery of over seven years, or 86 months—which compares to the post-war average of 58 months. But expansions don't typically die of old age, they die of excess," Sonders wrote. "The excess is often in the form of inflation, monetary policy, capital spending, capacity utilization, debt, etc. If there is one benefit to this recovery having been of the anemic variety is that it's kept this excess in check."

Canally wrote that, in the past, overbuilding in housing or commercial real estate, borrowing too much to pay for overbuilding and overspending, or even overconfidence by businesses and consumers have all led to overheating and recession.

"The current recovery has been relatively lackluster by historical standards, and the excesses that have triggered recessions in the past are not present," Canally wrote.

According to Canally, the recent weakness in the Leading Economic Index reflects the lingering impact of the stronger dollar, the fall in oil prices and resulting decline in oil-related capital spending, and the general weakness in the manufacturing sector that has beset the U.S. economy since oil prices peaked in mid-2014.

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