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U.S. Business Cycle Barometer

Highlights

- Since our last report in early November, two out of 10 leading indicators of near-term economic growth turned neutral from positive, while another two turned negative from neutral--the first negative signals since the launch of our dashboard in mid-2017. Six indicators remained unchanged, with five positive and one neutral.

- Our quantitative assessment of a recession in the next year is now 21%, up from 16% three months ago. Our qualitative assessment combined with calculated odds puts the risk of a recession at 20%-25%, one notch above the 15%-20% prediction in early November.

- The ongoing flattening of the yield curve in particular has been a major driver of higher recession odds. Financial conditions have eased in recent weeks, stemming from a significantly more dovish communication by the Fed. If the easing persists, the quantitative assessment will likely decline in the coming months.

Feb. 19 2019 — Since S&P Global Economics' last Business Cycle Barometer (BCB) report, the 10 leading economic indicators in our dashboard are now showing crosscurrents in the U.S. While economic indicators continue to point to a sustained economic expansion, heightened investor concerns over global economic developments led to market volatility and disruptions late last year, leaving a mixed picture for the second oldest expansion in U.S. history. We now see a 20%-25% risk of recession over the next 12 months--up from 15%-20% in our last publication.

Four out of 10 leading indicators of near-term economic growth momentum in our dashboard weakened since our November BCB report. Two turned neutral from positive, while the other two turned negative from neutral--which are the first negative signals for our dashboard in the history of our report dating back to May 2017 (see table 1). The remaining six indicators remained unchanged in status, with five positive and one neutral.

Of the deteriorating group, three were indicators that reflect capital market expectations for near-term growth conditions. The term spread and credit spread both turned neutral from positive in November, while the stock market signal turned negative (from neutral) for near-term growth momentum. Market volatility has subsided somewhat since mid-January, helped by a more "patient" Fed, but not enough to move the needle back to positive territory for these indicators.

Outside of the capital markets, banks (according to the Federal Reserve's Senior Loan Officer Survey, which offers insight into the supply and demand for bank credit) expect tightening of lending standards and a decline in demand broadly across sectors, signaling weaker growth momentum (thus moving to negative now, from neutral in the last report). In contrast, the other indicator on financial stress, which incorporates a wide variety of financial variables, the Chicago Fed's Nonfinancial Corporate Index (NFCI) remains positive for growth momentum. Although the NFCI tightened a bit last quarter, it continues to signal that the U.S. financial system is operating at slightly below historical average levels of risk, credit, and leverage. Meanwhile, the leading indicators capturing activity in the real economy largely remain positive for near-term growth momentum.

In line with deterioration of conditions in the financial markets that lasted until mid-January, our econometric model suggests the odds of a recession in the coming 12 months are now 21%--a notch higher than 16% in November but well below the thresholds for the prior six recessions (see chart 7). Still, beyond our quantitative assessment, policy risks remain elevated, and, at the margin, add to our formally calculated chance of a recession. Thus, S&P Global Economics sees a 20%-25% risk of recession in the U.S. over the next 12 months--up from 15%-20% in our November publication.

Regardless of whether a recession arrives, in keeping with the cyclical view of markets, the growth pace of the world's largest economy will likely slow. We expect annual average real GDP growth to be 2.3% in 2019 and 1.8% in 2020, following an estimated 2.9% growth in 2018 (and compared with a 2.2% average for the current expansion).

Although the U.S. data have not been out of step with our expectations in any meaningful way, an easing of growth with increased downside risk is unfolding against an uncertain global backdrop and amid more sensitive financial market sentiments. The Fed will be more data-dependent--with an even higher burden of proof on the data--in order to become confident that downside risks emanating from the financial markets and global conditions are receding.

This supports our belief that a longer duration between Fed rate hikes as it shrinks monetary accommodation is more likely now. In the past, most notably in the mid-1990s and 1998, when the Fed back pedaled its rate hikes coinciding with temporary spikes in the probability of recession, it managed a gentle slowdown of the economy before the growth outlook picked up again, leading to resumption of rate hikes. (Of course, that led to the dot-com bubble, which finally ended the expansion, and that is the kind of short run/long run trade-off that policymakers often face at mature stages of a cycle.

With that in mind, it is premature to claim that the current Fed tightening cycle is now over, as financial prices currently indicate. We expect one more rate hike of 25 basis points (bps) later this year, and two hikes is not completely out of the picture. (In December, we had penciled in two more rate hikes in the current interest-rate normalization cycle). This stance is consistent with our current forecast for the U.S. economy and the Fed's "data-dependent" mantra.

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