December Rate Action Still In Play Despite Leading Indicators Under Pressure

While focus has been trained on the US Dollar’s rally in recent sessions as a result of increasingly hawkish signals, the real main event is the upcoming nonfarm payrolls report. Amid a downturn in certain fundamentals—namely the housing sector which has significantly underperformed analyst estimates for key metrics—the last glimmers of hope for any action on rates before year end hinge largely on upcoming labor data and inflation figures. The divided nature of the Federal Reserve indicates that more members are coming around to the idea that action must be taken imminently instead of further delaying tightening. However, the economic recovery in the US remains tenuous, with certain warning signs screaming trouble ahead and the potential for an unfolding recession in the coming quarters.

An Uneven Recovery

As recent data has clearly displayed, the pace of the US economic recovery remains uneven. Second quarter GDP decelerated to the slowest annualized pace of growth since 2013 amid rising concerns about the softness in manufacturing along with weakness in a number of housing indicators. Considering these are two of the most important indicators of economic health, any further deterioration may be consistent with an incoming recession. Manufacturing is a particularly important measure of economic health, with purchasing managers indices giving a window into the outlook for orders and general activity in the sector. Although the PMI is in expansionary territory, the trend is generally moving back towards May lows after peaking in 2014. Other fundamentals pertaining to the sector have been declining, notably on the employment front. The latest ADP figure showed losses of an additional 6000 manufacturing jobs during the month of September after 4000 erased during August.

Outside of manufacturing losses, there is growing unease about the US housing sector’s activity.According to reports in September, the S&P Case-Shiller Home Price Index slowed to 5.00% annualized expansion in prices from the 5.10% announced previously. However, this pace is not considered sustainable according to David Blitzer of S&P Dow Jones Indices. Furthermore, it has coincided with disappointing results from existing home sales, new home sales, building permits, and housing starts data released during September.The icing on the cake are the cracks appearing in the high end of real estate, which normally is a precursor to problems in other areas.In Manhattan specifically, apartment sales have plunged by -20.00% year over year in a sign that one of the most popular housing markets is cooling.These signs are troubling, as retreating prices may foreshadow a coming recession.

Abundant Leading Indicator Pessimism

Although economic indicators in the form of data might be helpful in foretelling a coming correction or end of the cycle, other leading indicators that are relevant include benchmark equity indices. Stocks are generally a useful predictor of economic activity because companies are valued based on forward-looking expectations. Should companies and investors have a more pessimistic outlook, valuations will likely reflect this sentiment, causing share prices to fall. Although US benchmarks such as the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite remain not far off from record highs, narrowing volatility combined with smaller trading volumes are suggestive of an approaching breakout move or potential correction.In the event that the top is in, a correction to the downside would likely be swift in nature and be accompanied by a rebound in volatility and volume, the likes of which have been largely absent from recent price action.

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The S&P 500 in particular is currently undergoing a symmetrical triangle consolidation, a pattern typically resulting in a directional breakout. However, helping the thesis of a correction is the reduced volume and volatility that classically accompanies a reversal.Should the prevailing upward trend line be broken to the downside alongside faltering fundamentals, it could spell a recession ahead.However, there are a number of factors that could force a breakout. For one, should the Federal Reserve hike rates, it may force investors globally to reallocate their assets as yields rise thanks to climbing rates.As borrowing costs rise, the ripple effect may be felt across asset classes and also in the real economy, with manufacturing crumbling as a stronger dollar reduces export competitiveness and creates less attractive mortgage borrowing conditions. However, even without the Federal Reserve, the business cycle approaching a peak could result in a similar impact.

Looking Ahead

The upcoming payroll figures are highly relevant to the outlook for the US economy as they will give useful hints about the time horizon for further policy normalization. Another metric to keep an eye on is inflation, which alongside employment is an essential factor behind any Central Bank decision to adjust rates.However, leading indicators of economic activity like manufacturing, housing, and equity valuations should not be ignored. Considering the challenges that lie ahead for manufacturing activity and housing prices, two of the most prominent indicators could conceivably become warning signs over the coming months if they continue to retreat. Furthermore, if equity benchmarks should experience a correction, it might be confirmation that a recession is imminent. Although the case for a December rate hike remains strong, there is still room for data to derail normalization efforts between now and then.