The Economy

Could This Be the Recession That Wasn’t?

Even as key corporate financial indicators continue to fall, some hope may be emerging that forecasts of an impending recession will prove inaccurate.
David McCannMarch 1, 2019
Could This Be the Recession That Wasn’t?

CFOs may be preparing for a recession in the near future — but will one actually happen?

While most observers had believed that a recession in 2019 or 2020 was inevitable, signals have very recently grown more mixed, notes Charles Mulford, accounting professor at Georgia Tech’s Scheller College of Business and director of the school’s Financial Analysis Lab.

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It’s a relatively subtle shift that has emerged in just the past few weeks. Less than a month ago, the lab noted some disturbing trends in its quarterly report on cash-flow trends, which analyzed third-quarter 2018 financial data for 2,627 U.S. non-financial public companies with assets of at least $100 million:

  • Median free cash margin — free cash flow as a percentage of revenue — declined for a sixth consecutive quarter, to 4.01%.
  • Median revenue for companies in the sample weighed in at $1.238 billion, the fourth straight quarterly decline since the record high established in the fourth quarter of 2017.
  • The median level of capital expenditures as a percentage of revenue fell yet again, to 3.58%, marking the ninth consecutive quarter of declining or flat capex.

Mulford says he’s been surprised companies haven’t invested more of their cash windfall from the steep cut in the corporate income tax rate featured in the December 2017 Tax Cuts and Jobs Act. Instead, companies have (1) fattened up cash holdings and short-term investments, and (2) returned significant cash to shareholders through higher dividends and more and bigger stock buybacks.

“A premise of tax reform was that the money would be invested in capital assets, resulting in more economic growth,” Mulford notes.

That was intended to cure a long-term problem. Capital spending levels declined significantly during the last recession, enabling companies to continue generating cash and stay afloat. There was a bounce-back after the recession ended, but capital spending never rose above pre-recession levels — “it just sort of treaded water,” Mulford says.

The capex falloff over the past two years is likely a response to uncertainty associated with not only the softening economy reflected in the above numbers, but also with tariffs and trade wars, as well as the length of time since the last recession, Mulford observes.

The kicker, in terms of recession fears, has been a narrowing of the spread between the short-term and long-term interest rates of government securities — a scenario that’s long been associated with a worsening economy.

Many financial analysts calculate this yield spread as the difference in rates between 2-year and 10-year Treasury bills. The dreaded “inverted yield curve” happens when the 2-year rate exceeds the 10-year rate.

Mulford takes a much wider view of the yield spread, comparing the shortest-term federal securities, 3-month T-bills, with the longest-term ones, 30-year T-bonds. Only 6 times in the past 47 years has that yield curve inverted — and each such occurrence heralded a recession. Further, there has never been a recession during that time without an inversion.

At the end of the first week of February, the spread as Mulford calculates it stood at a perilous 55 basis points. That was the lowest since August 2007, when an inverted curve appeared just as the previous recession was getting underway.

By Thursday, Feb. 28, the spread had inched back up to 65 basis points, still a historically low figure — but Mulford sees it as an encouraging sign in the face of declining free cash margin and capex.

“It may not sound like a big increase, but the spread is widening again after shrinking for weeks,” he says. “It’s a conflicting signal.”

And it’s not the only one. For example, the Federal Reserve’s Federal Open Market Committee seems to have backed away from further raising the target federal funds rate, as it did multiple times in 2018. The FOMC announced in late January that it “will be patient as it determines what future adjustments” to the rate are appropriate, “in light of global economic and financial developments and muted inflation pressures.”

Such a policy lessens economic uncertainty, Mulford points out. So does a recent abatement of government actions and rhetoric around tariff increases, he adds.

“It’s been a long time since the last recession, and the yield curve was really tightening, so it seems like we should be having one,” he says. “Yet it hasn’t happened. Now there’s less talk of a trade war, and if that percolates through to where it affects thinking, we could see companies start to invest, almost as if we’ve actually had a recession and now here we go.”

He concludes, “I probably shouldn’t say this, but I’m going to: It’s possible now that we won’t ultimately have a recession.”

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