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 that time, the average monthly gain in the LEI was 0.3%, which matches the average monthly gain in the LEI during the last three economic expansions (1982–1990, 1991–2001, 2001–2007). If the LEI averages 0.3% per month over the next 12 months, in June 2017, the year-over-year increase in the LEI would be 3.7%; this would suggest that the odds of a recession in the 12 months ending in June 2018 would be just 5%.
However, we believe the U.S. economy has the potential to pick up some steam in the coming quarter—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 6.7% year-over-year gain in the LEI in June 2017, which would put the odds of recession occurring by June 2018 at just 3%. The infographic (the third chart) also shows what the LEI would look like a year from now at 0.1% and 0.2% gains per month.
It is possible that the LEI doesn’t move at all, as perhaps the uncertainty around Brexit tightens U.S. financial conditions; or a sharply stronger dollar puts renewed downward pressure on oil prices, capital spending, and manufacturing; or a policy mistake at home or abroad dampens growth. In that case, no change in the LEI would put the odds of recession occurring between June 2017 and June 2018 at just 8%.
On balance, the LEI, even at just 0.7% year over year, says the risk of recession in the next 12 months is very low (7%), but not zero; and based on the level of the LEI relative to its prior peak, the current economic expansion may last at least another 4 years. 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 recoveries 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.
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 Canally is chief economic strategist for LPL Financial.