What is the LEI suggesting for what’s ahead?
So, what happens next? Perhaps the LEI—past and present—can help answer that question. The deceleration in the LEI in mid-2014 coincided with the rise in the dollar, the drop in oil prices, and the subsequent decline in oil-related capital expenditures and manufacturing. Since then, the average monthly gain in the LEI was 0.2%, which is just below the average monthly gain in the LEI (0.3%) during the last three economic expansions (1982–1990, 1991–2001, 2001–2007). If the LEI averages a 0.2% increase per month over the next 12 months, in August 2017, the year-over-year increase in the LEI would be 2.4%; this would suggest that the odds of a recession in the 12 months ending in August 2018 would be just 6%. If the LEI averaged 0.3% per month in the next year—matching what it averaged during the prior three economic expansions—in August 2017, the year-over-year increase in the LEI would stand at 3.6%, putting the odds of a recession in the 12 months ending in August 2018 at just 5%.
However, we believe the U.S. economy has the potential to pick up some steam in the coming quarters—not by much, but some—and could match the recovery to date gross domestic product (GDP) growth rate of 2.0–2.5%. During that time (mid-2009 through today), the average monthly gain in the LEI was 0.4%. If sustained over a full year, the 0.4% gain would translate into a robust 4.8% year-over-year gain in the LEI in August 2017, which would put the odds of recession occurring by August 2018 at just 3%. The infographic (the second chart) also shows what the LEI would look like a year from now if it averaged 0.1% per month, a pattern that would accompany very stagnant economic growth.
It is possible that the LEI may not move at all. Perhaps the uncertainty around the U.S. election outcome or the negotiations around Brexit—which are slated to start in early 2017—may impact growth; or a sharply stronger dollar could put renewed downward pressure on oil prices, capital spending, and manufacturing; or a policy mistake at home or abroad, including a misstep by China in its handling of its bad debt problem, may negatively impact the U.S. economy. In that case, no change in the LEI would put the odds of recession occurring between August 2017 and August 2018 at just 8%.
On balance, the LEI, 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. Although the odds of a recession increase when looking out 18 months (11%) and 24 months (12%), they remain low—but again, not zero. We note that economic expansions do not generally die of old age, but end due to excesses building up in one or more sectors of the economy. 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.
Conclusion
The current recovery has been relatively lackluster by historical standards, and the excesses that have triggered recessions in the past are not present. Still, a dramatic deterioration of the financial or economic situation abroad, a fiscal or monetary policy mistake here in the U.S. or abroad, or an exogenous event (a major terror attack, natural disaster, etc.), among other events, may cause us to change our view.
John J. Canally Jr., CFA, is the chief economic strategist at LPL Financial.