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Reality Check: The Risks Are Rising

Written by Brad McMillan, CFA®, CFP® | Jun 6, 2019 7:04:28 PM

I do a semiannual update of my economic and market outlook every year, usually in several versions over a one- to two-month period. In the past couple of years, that strategy has worked. Fundamental conditions didn't change much over that period, even though headlines often did.

This year, things are looking quite different. At the end of last year, the economy was growing, hiring and confidence were strong, and business continued to want to expand. There really wasn’t much to worry about. Here in the middle of the year, that's still the case—but much less so. Growth is weaker, hiring is showing signs of slowing, and confidence has dipped and risen again. Conditions remain favorable, but they look shakier. Those factors provided the context of the first version of my update.

As I work on a more recent version, though, I now have more data (worse data) to consider. In the past month, we have seen the yield curve invert for a period of weeks, which gets us very close to starting the clock on a recession watch. The ADP job number came in much weaker than expected, consistent with weakening industry surveys of hiring intentions. This unexpected weakness raises the stakes considerably on tomorrow’s jobs report. Trade worries have spiked again, as a China deal remains elusive and an entirely new round of potential tariffs with Mexico is now in play. The risks are rising by the day.

Not all bad news

Consumer confidence has bounced back and remains at high levels. Consumer spending has also rebounded. And, at more than two-thirds of the economy, spending is important. Hiring has also remained solid, and the damage from the tariffs hasn’t shown up in any material way. For all the headlines, the actual numbers are still in positive territory. I keep those numbers in mind when I make forecasts.

What lies beneath?

When you look under the surface, though, the risks are certainly rising. Job growth may be at risk. If that softens, so will everything else. Consumer confidence is high, but there is a real gap between how people feel today and how they expect to feel in six months. This type of gap has historically been a sign of trouble ahead. Business confidence is still positive, but it is down significantly—reflecting real concerns about future demand. And while the yield curve has been inverted only for a short time, as I said above, we are getting very close to a trigger point.

Red flags to watch for

The question here is not whether a recession is imminent—it isn’t. The better question is how much slack we have before a recession becomes a real danger in the next couple of quarters. We are getting dangerously close to that point. Jobs will be a key indicator here. Watch tomorrow’s report closely, as a weak report could indicate business confidence is eroding even faster than the surveys show. If the yield curve stays inverted for another couple of weeks, that will also be a red flag.

Markets are reacting to the headlines right now, but they remain supported by the fundamentals. If the fundamentals continue to erode, expect more damage.

As I prepare my next set of outlooks, this is the problem I face. Although the base case remains continued growth, for the economy and markets, the downside risks have increased substantially in the past month. They may or may not rise even further over the next couple of weeks.

Remember, too, that here we have discussed only economic risks. We also have to consider the ongoing political risks around trade and the U.S. debt. Most notably, the pending debt ceiling confrontation has the potential to erode confidence even further, for both the consumer and business. Confidence is the foundation of growth. As such, any erosion would be another unneeded headwind for both the economy and markets.

How confident am I?

These risks are what I am turning over in my mind right now. How confident am I now—and how confident do I expect to be in six months or so? I don’t know, and neither do the markets. While I still expect things to remain positive, increasingly, it could go either way.