Forecasting the Next Recession

Macroeconomic and Investment Research

Forecasting the Next Recession

Macroeconomic and Investment Research

Guggenheim’s Model Points to Recession in Late 2019 or 2020

Report Highlights § It is critical for investors to have a well-informed view on the timing of the

business cycle because of its importance as a driver of investment performance. § Our Recession Dashboard includes six leading indicators that exhibit consistent

cyclical behavior ahead of a recession—and can be tracked in real time. § Based on the dashboard and our proprietary Recession Probability Model,

which shows 24-, 12-, and six-month ahead recession probabilities, we believe the next recession will begin in late 2019 to mid-2020. § Risk assets tend to perform well two years out from a recession, but investors

should become increasingly defensive in the final year of an expansion.

Introduction The business cycle is one of the most important drivers of investment performance. As the nearby chart shows, recessions lead to outsized moves across asset markets. It is therefore critical for investors to have a well-informed view on the business cycle so portfolio allocations can be adjusted accordingly. At this stage, with the current U.S. expansion showing signs of aging, our focus is on projecting the timing of the next downturn.

Predicting recessions well in advance is notoriously difficult. Using history as a guide, however, we find that it may be possible to get an early read on when the next recession will begin by analyzing the late-cycle behavior of several key economic and market indicators. Together, they would have provided advance warnings of a downturn. Our analysis of these metrics suggests that the current expansion will end as soon as late 2019.

Investment Professionals Scott Minerd Chairman of Investments and Global Chief Investment Officer Brian Smedley Senior Managing Director, Head of Macroeconomic and Investment Research Matt Bush CFA, CBE Vice President

Recessions Lead to Outsized Market Moves Treasury Rally/S&P 500 Drawdown from Trailing 12-Month Low/High S&P 500ÂŽ Index 50%

10-Year U.S. Treasury Note Total Return Index

40% Average Trough-Peak Rally During Recessions = 20%

30% 20% 10% 0% -10% -20% -30%

Average Drawdown During Recessions = -27%

-40% -50% 1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2015

Source: Haver Analytics, U.S. Treasury Department, Guggenheim Investments. Data as of 10.20.2017.

Past performance does not guarantee future results.

Identifying Common Late-Cycle Symptoms Economists, including those at the Federal Reserve (Fed), are fond of saying that business cycles do not die of old age. Rather, they tend to point to policy mistakes, bursting asset bubbles, or other shocks as recession catalysts. We think this conventional wisdom misses an essential point, which is that as a business cycle ages it becomes increasingly vulnerable to these life-threatening conditions. Indeed, history shows that economic cycles exhibit fairly consistent symptoms leading up to a recession, starting with a labor market that evolves from cool to hot and a monetary policy stance that progresses from loose to tight in response. That is not to say the Fed deliberately causes recessions. Rather, an overheating labor market makes the Fed nervous about the inflation outlook, resulting in a degree of policy tightening that flattens the yield curve and begins to slow the economy. Softening growth in demand results in a decline in the pace of net job creation and a pullback in business investment and consumer spending. Credit conditions tighten and asset valuations drop, typically from cycle highs. This combination of events is often sufficient to tip an overextended economy into recession.

The last several expansions have shown similar patterns leading up to a recession.

The charts on the following pages help to tell this story by identifying six indicators that would have exhibited consistent cyclical behavior, and that can be tracked relatively well in real time. We compare these indicators during the last five cycles that are similar in length to the current one, overlaying the current cycle. Taken together, they suggest that the expansion still has room to run for approximately 24 months. At the end of this paper, we assemble the six indicators into our singlepage Recession Dashboard, which we will update regularly going forward.

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1. Labor Market Becomes Unsustainably Tight Unemployment Gap (Unemployment Rate – Natural Rate of Unemployment)

The first indicator is the unemployment gap, which is the

Current Cycle 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -48 -42

difference between the unemployment rate and the natural

Average of Prior Cycles

Range of Prior Cycles

rate of unemployment (formerly called NAIRU, for the nonaccelerating inflation rate of unemployment). A strong labor market prompts the Fed to tighten because an unemployment rate well below the natural rate is unsustainable by definition, and can lead to a spike in wage and price inflation. Looking at the current cycle, the labor market is in the early stages of overheating. We see unemployment heading to 3.5 percent, -36

-30 -24 -18 Months Before Recession

-12

-6

0

which would be consistent with the pre-recession behavior of the unemployment gap in past cycles.

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Natural rate is Laubach-Williams one-sided filtered estimate. Past performance does not guarantee future results.

2. Fed Raises Rates into Restrictive Territory The second chart shows the reaction function of the Fed.

Real Fed Funds Rate – Natural Rate of Interest (r*) Current Cycle 3% 2% 1% 0% -1% -2% -3% -4% -5% -6%

Average of Prior Cycles

Subtracting the natural rate of interest—which is the neutral

Range of Prior Cycles

fed funds rate, neither contractionary nor stimulative for the economy—from the real fed funds rate gives us a gauge of how loose or tight Fed policy is. Leading up to past recessions, the Fed has usually hiked rates beyond the natural rate to cool the labor market and get ahead of inflation, only to inadvertently push the economy into recession. Looking at -48

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

0

the current cycle, we expect quarterly rate hikes to resume in December. This will put Fed policy well into restrictive territory next year, barring a sharper increase in the natural

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Natural rate is Laubach-Williams one-sided filtered estimate. Past performance does not guarantee future results.

rate than we expect.

3. Treasury Yield Curve Flattens One of the most reliable and consistent predictors of recession

Three Month–10 Year Treasury Yield Curve (bps) Current Cycle

Average of Prior Cycles

has been the Treasury yield curve. Recessions are always

Range of Prior Cycles

400

preceded by a flat or inverted yield curve, usually occurring

300

about 12 months before the downturn begins. This occurs

200

with T-bill yields rising as Fed policy becomes restrictive while

100

10-year yields rise at a slower pace. Looking at the current

0

cycle, we expect that steady increases in the fed funds rate will

-100

continue to flatten the yield curve over the next 12–18 months.

-200 -48

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

0

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

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4. Leading Indicators Decline The Conference Board Leading Economic Index (LEI),

Leading Economic Index, Year-over-Year % Change Current Cycle

Average of Prior Cycles

which measures 10 key variables, is itself a recession

Range of Prior Cycles

12%

predictor, albeit a fallible one. It has been irreverently said

8%

that the LEI predicted 15 out of the last eight recessions.

Nevertheless, growth in the LEI always slows on a

4%

year-over-year basis heading into a recession, and turns

0%

negative about seven months out, on average. Looking

-4%

at the current cycle, LEI growth of 4 percent over the past

-8% -48

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

0

year has been on par with past cycles two years before a recession, and we will be watching for a deceleration over the course of the coming year.

Source: Bloomberg, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

5. Growth in Hours Worked Slows Other indicators of the real economy, including aggregate

Aggregate Weekly Hours Worked, Year-over-Year % Change Current Cycle

Average of Prior Cycles

weekly hours, decline in the months preceding a recession

Range of Prior Cycles

7% 6% 5% 4% 3% 2% 1% 0% -1%

as employers begin to reduce headcount and cut the length of the workweek. Looking at the current cycle, aggregate weekly hours growth has been steady, albeit at weaker than average levels, reflecting slower labor force growth as baby boomers retire. We expect growth in hours worked to hold up over the coming year before slowing more markedly in 2019.

-48

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

0

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

6. Consumer Spending Declines Real retail sales growth weakens significantly before

Real Retail Sales, Year-over-Year % Change Current Cycle

Average of Prior Cycles

a recession begins, with the inflection point typically

Range of Prior Cycles

8%

occurring about 12 months before the start of the recession.

6%

Consumers cut back on spending as they start to feel the

4%

impact of slowing real income growth. This shows up most

2%

noticeably in retail sales, which are made up of a higher

0%

share of discretionary purchases than other measures of

-2%

consumption. Looking at the current cycle, real retail sales

-4% -48

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

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growth has been steady at around 2 percent. This is weaker than the historical average, but is consistent with slowertrend gross domestic product (GDP) growth in this cycle.

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Model-Based Recession Probability In addition to creating our dashboard of recession indicators, we have also developed an integrated model that attempts to predict the probability of a recession over six-, 12-, and 24-month horizons. We developed the model using the unemployment gap, the stance of monetary policy, the yield curve, and the LEI, as well as the share of cyclical sectors of the economy (durable goods consumption, housing, and business investment in equipment and intellectual property) as a percent of GDP. The model shows that it would have successfully signaled each recession in advance going back to 1960. Of course, this is a new model; it has not been used to predict future recessions and its future accuracy cannot be guaranteed.

As the chart below illustrates, we believe the current likelihood of a recession in the next six or 12 months is low, at 4 percent and 9 percent, respectively, as of the third quarter of 2017. Within a two-year window, recession risk appears more meaningful at 22 percent. We also show forecasts for the model, which is based on a continuation of current trends for each of the indicators, and assumes the Fed resumes quarterly rate hikes starting in December. If these trends play out, the model indicates a high probability of a recession starting in late 2019–mid 2020.

Near-Term Recession Risk Is Low, but Longer-Term Risks Are Rising Model-Based Recession Probability Next 6 Months 100%

Next 12 Months

Next 24 Months

90%

Guggenheim Estimate

80% 70% 60% 50% 40% 30% 20% 10% 0% 1976

1980

1984

1988

1992

1996

2000

2004

2008

2012

2016

2020

Hypothetical Illustration. The Recession Probability Model is a new model with no prior history of forecasting recessions. Actual results may vary significantly from the results shown. Source: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Shaded areas represent periods of recession.

What about the tax cuts currently being debated in Congress? Fiscal stimulus poses a modest upside risk to GDP growth in 2018, but by late 2019 the fiscal impulse could be fading, which will be a drag on growth. Moreover, campaigning for the November 2020 general election will be underway, which will serve to increase policy uncertainty in a way that could undermine consumer and business confidence.

Additionally, our recession date coincides with a period where the balance sheets of the world’s major central banks will likely be shrinking in aggregate for the first

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time since the financial crisis, removing that form of global monetary stimulus just as U.S. fundamentals are weakening.

As we noted earlier, predicting downturns is a notoriously difficult endeavor, but the fact that a variety of approaches all point to the same timeframe for a recession gives us confidence in our view. Naturally, there are substantial risks that our recession date could be too early or too late. The expansion could last longer than we think for a number of reasons, including the possibility that there is more labor market slack than there currently appears, or that productivity growth could accelerate considerably. On the flipside, a recession could occur sooner than we anticipate due to a sudden spike in inflation, more hawkish Fed policy, or a geopolitical shock, such as a military conflict with North Korea or a trade dispute with China. And there are always the unknown unknowns.

Nevertheless, we believe that successful investing requires a roadmap, as with any other endeavor. Our investment team uses this roadmap to help guide our portfolio management decisions, in order to seek superior risk-adjusted performance over time and across cycles.

Investment Implications When faced with a recession looming on the horizon, investors first must recognize that preparing too early can be as harmful as reacting too late. Indeed, the best gains in stocks often occur in the latter stages of an expansion, when economic growth is accelerating, monetary policy is not overly restrictive, and optimism is high— as is currently the case. As the graph below demonstrates, in the last five comparable cycles the S&P 500 has rallied an average of 16.2 percent in the penultimate year of the expansion, before falling 3.8 percent in the final 12 months.

Stocks Rally Two Years Out from Recession Before Declining in Final Year Cumulative S&P 500 Index Total Return Starting 24 Months Before Recessions Average

Range

35% 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% -24

-21

-18

-15

-12 -9 -6 Months Before/After Recession

-3

0

3

Source: Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007.

Past performance does not guarantee future results.

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In credit markets, high-yield spreads tend to stay flattish in the penultimate year of the expansion before widening in the final year, on average. Rising defaults and increasing credit and liquidity risk premiums drive a sharp pullback in the performance in high-yield bonds before and during recessions.

High-Yield Spreads Begin to Widen About One Year Out From Recession Cumulative Change in Basis Points Starting 24 Months Before Recessions Average of Prior Cycles

Range of Prior Cycles

800 700 600 500 400 300 200 100 0

-100 -200 -24

-21

-18

-15

-12 -9 -6 Months Before/After Recession

-3

0

3

Source: Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Includes cycles ending in 1990, 2001, and 2007.

Past performance does not guarantee future results.

If history is a guide, then by the final year of the expansion (2019), investors should turn defensive, positioning for widening credit spreads and falling equity valuations.

Treasury yields are likely to decline once the Fed stops hiking. As we noted in Stocks for the Long Run? Not Now, elevated stock valuations portend meager returns over the next decade, and one key reason is that a bear market is likely a couple of years away. Maintaining some dry powder in the final year of the expansion will allow equity and credit investors to take advantage of more attractive valuations, as some of the best investment opportunities present themselves during recessions.

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Guggenheim Investments’ Recession Dashboard Current Cycle Average of Prior Cycles Range of Prior Cycles 2.0% 1.5% 1.0% Unemployment Gap (Unemployment Rate – Natural Rate of Unemployment) 0.5% 2.0% 0.0% -0.5% 1.5% -1.0% 1.0% -1.5% 0.5% -2.0% 0.0% -2.5% -0.5%-48 -1.0%

Real Fed Funds Rate – Natural Rate of Interest (r*)

3% 2% 1% 0% -1%

-42

-36

-30 -24 -18 Months Before Recession

-12

-6

0

-2% -3%

-1.5%

-4%

-2.0%

-5%

-2.5% -48

-6% -42

-36

-30

-24

-18

-12

-6

0

-48

-42

-36

Months Before Recession

-30

-24

-18

-12

-6

0

-12

-6

0

-12

-6

0

Months Before Recession

Three Month–10 Year Treasury Yield Curve (Basis Points)

Leading Economic Index, YoY % Change

400

12%

300

8%

200

4%

100 0%

0

-4%

-100 -200 -48

-42

-36

-30

-24

-18

-12

-6

0

-8% -48

-42

-36

-30

-24

-18

Months Before Recession

Months Before Recession

Aggregate Weekly Hours Worked, YoY % Change

Real Retail Sales, YoY % Change

7%

8%

6%

6%

5%

4%

4% 3%

2%

2%

0%

1%

-2%

0% -1%

-4% -48

-42

-36

-30

-24

-18

Months Before Recession

-12

-6

0

-48

-42

-36

-30

-24

-18

Months Before Recession

Source all charts: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007.

Past performance does not guarantee future results.

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Important Notices and Disclosures Investing involves risk, including the possible loss of principal.

This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion.

Always consult a financial, tax and/or legal professional regarding your specific situation.

This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written permission of Guggenheim Partners, LLC. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited and Guggenheim Partners India Management. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses.

1. Guggenheim Investments total asset figure is as of 9.30.2017. The assets include leverage of $11.6bn for assets under management and $0.4bn for assets for which we provide administrative services. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management.

2. Guggenheim Partners assets under management are as of 9.30.2017 and include consulting services for clients whose assets are valued at approximately $63bn.

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We disaggregated fixed-income investment management into four primary and independent functions—Macroeconomic Research, Sector Teams, Portfolio Construction, and Portfolio Management—that work together to deliver a predictable, scalable, and repeatable process. Our pursuit of compelling risk-adjusted return opportunities typically results in asset allocations that differ significantly from broadly followed benchmarks.

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