Macroeconomic and Investment Research

Forecasting
the Next Recession
Macroeconomic and Investment Research

Guggenheim’s Model Points to Recession

in Late 2019 or 2020

Report Highlights Investment Professionals

§ It is critical for investors to have a well-informed view on the timing of the

Scott Minerd
business cycle because of its importance as a driver of investment performance.
Chairman of Investments and
§ Our Recession Dashboard includes six leading indicators that exhibit consistent Global Chief Investment Officer
cyclical behavior ahead of a recession—and can be tracked in real time.
Brian Smedley
§ Based on the dashboard and our proprietary Recession Probability Model,
Senior Managing Director,
which shows 24-, 12-, and six-month ahead recession probabilities, we believe Head of Macroeconomic and
the next recession will begin in late 2019 to mid-2020. Investment Research

§ Risk assets tend to perform well two years out from a recession, but investors
Matt Bush CFA, CBE
should become increasingly defensive in the final year of an expansion.
Vice President

Introduction
The business cycle is one of the most important drivers of investment
performance. As the nearby chart shows, recessions lead to outsized moves across
asset markets. It is therefore critical for investors to have a well-informed view on
the business cycle so portfolio allocations can be adjusted accordingly. At this stage,
with the current U.S. expansion showing signs of aging, our focus is on projecting
the timing of the next downturn.

Predicting recessions well in advance is notoriously difficult. Using history as

a guide, however, we find that it may be possible to get an early read on when
the next recession will begin by analyzing the late-cycle behavior of several key
economic and market indicators. Together, they would have provided advance
warnings of a downturn. Our analysis of these metrics suggests that the current
expansion will end as soon as late 2019.
 Recessions Lead to Outsized Market Moves
Treasury Rally/S&P 500 Drawdown from Trailing 12-Month Low/High

S&P 500® Index 10-Year U.S. Treasury Note Total Return Index
50%

40%
Average Trough-Peak Rally
30% During Recessions = 20%
20%

10%

0%

-10%

-20%

-30%
Average Drawdown During
-40% Recessions = -27%

-50%
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Source: Haver Analytics, U.S. Treasury Department, Guggenheim Investments. Data as of 10.20.2017.
Past performance does not guarantee future results.

Identifying Common Late-Cycle Symptoms

Economists, including those at the Federal Reserve (Fed), are fond of saying
that business cycles do not die of old age. Rather, they tend to point to policy
mistakes, bursting asset bubbles, or other shocks as recession catalysts. We think
this conventional wisdom misses an essential point, which is that as a business
cycle ages it becomes increasingly vulnerable to these life-threatening conditions.
Indeed, history shows that economic cycles exhibit fairly consistent symptoms
leading up to a recession, starting with a labor market that evolves from cool to hot
and a monetary policy stance that progresses from loose to tight in response. That
is not to say the Fed deliberately causes recessions. Rather, an overheating labor
market makes the Fed nervous about the inflation outlook, resulting in a degree
of policy tightening that flattens the yield curve and begins to slow the economy.
Softening growth in demand results in a decline in the pace of net job creation
and a pullback in business investment and consumer spending. Credit conditions
tighten and asset valuations drop, typically from cycle highs. This combination of
events is often sufficient to tip an overextended economy into recession.

The last several expansions have shown similar patterns leading up to a recession.
The charts on the following pages help to tell this story by identifying six indicators
that would have exhibited consistent cyclical behavior, and that can be tracked
relatively well in real time. We compare these indicators during the last five cycles
that are similar in length to the current one, overlaying the current cycle. Taken
together, they suggest that the expansion still has room to run for approximately
24 months. At the end of this paper, we assemble the six indicators into our single-
page Recession Dashboard, which we will update regularly going forward.

Guggenheim Investments November 2017 1

1. Labor Market Becomes Unsustainably Tight
Unemployment Gap (Unemployment Rate – Natural Rate of Unemployment) The first indicator is the unemployment gap, which is the
Current Cycle Average of Prior Cycles Range of Prior Cycles difference between the unemployment rate and the natural
2.0% rate of unemployment (formerly called NAIRU, for the non-
1.5%
1.0% accelerating inflation rate of unemployment). A strong labor
0.5% market prompts the Fed to tighten because an unemployment
0.0%
-0.5%
rate well below the natural rate is unsustainable by definition,
-1.0% and can lead to a spike in wage and price inflation. Looking
-1.5%
at the current cycle, the labor market is in the early stages of
-2.0%
-2.5% overheating. We see unemployment heading to 3.5 percent,
-48 -42 -36 -30 -24 -18 -12 -6 0
which would be consistent with the pre-recession behavior of
Months Before Recession
the unemployment gap in past cycles.
Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles
ending in 1970, 1980, 1990, 2001, and 2007. Natural rate is Laubach-Williams one-sided filtered
estimate. Past performance does not guarantee future results.

2. Fed Raises Rates into Restrictive Territory

Real Fed Funds Rate – Natural Rate of Interest (r*) The second chart shows the reaction function of the Fed.
Current Cycle Average of Prior Cycles Range of Prior Cycles Subtracting the natural rate of interest—which is the neutral
3% fed funds rate, neither contractionary nor stimulative for
2%
1% the economy—from the real fed funds rate gives us a gauge
0% of how loose or tight Fed policy is. Leading up to past
-1%
-2% recessions, the Fed has usually hiked rates beyond the natural
-3% rate to cool the labor market and get ahead of inflation, only
-4%
-5%
to inadvertently push the economy into recession. Looking
-6% at the current cycle, we expect quarterly rate hikes to resume
-48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession
in December. This will put Fed policy well into restrictive
territory next year, barring a sharper increase in the natural
Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles
ending in 1970, 1980, 1990, 2001, and 2007. Natural rate is Laubach-Williams one-sided filtered rate than we expect.
estimate. Past performance does not guarantee future results.

3. Treasury Yield Curve Flattens

Three Month–10 Year Treasury Yield Curve (bps) One of the most reliable and consistent predictors of recession
Current Cycle Average of Prior Cycles Range of Prior Cycles has been the Treasury yield curve. Recessions are always
400 preceded by a flat or inverted yield curve, usually occurring
300 about 12 months before the downturn begins. This occurs
200 with T-bill yields rising as Fed policy becomes restrictive while
100 10-year yields rise at a slower pace. Looking at the current
0 cycle, we expect that steady increases in the fed funds rate will
-100 continue to flatten the yield curve over the next 12–18 months.
-200
-48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending
in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

2 November 2017 Guggenheim Investments

4. Leading Indicators Decline
Leading Economic Index, Year-over-Year % Change The Conference Board Leading Economic Index (LEI),
Current Cycle Average of Prior Cycles Range of Prior Cycles which measures 10 key variables, is itself a recession
12% predictor, albeit a fallible one. It has been irreverently said

8%
that the LEI predicted 15 out of the last eight recessions.
Nevertheless, growth in the LEI always slows on a
4%
year-over-year basis heading into a recession, and turns
0%
negative about seven months out, on average. Looking
-4% at the current cycle, LEI growth of 4 percent over the past
-8% year has been on par with past cycles two years before a
-48 -42 -36 -30 -24 -18 -12 -6 0
recession, and we will be watching for a deceleration over
Months Before Recession
the course of the coming year.
Source: Bloomberg, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in
1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

5. Growth in Hours Worked Slows

Aggregate Weekly Hours Worked, Year-over-Year % Change Other indicators of the real economy, including aggregate
Current Cycle Average of Prior Cycles Range of Prior Cycles weekly hours, decline in the months preceding a recession
7%
as employers begin to reduce headcount and cut the length
6%
5%
of the workweek. Looking at the current cycle, aggregate
4% weekly hours growth has been steady, albeit at weaker than
3% average levels, reflecting slower labor force growth as baby
2%
boomers retire. We expect growth in hours worked to hold up
1%
0% over the coming year before slowing more markedly in 2019.
-1%
-48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession

Source: Haver Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending
in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee future results.

6. Consumer Spending Declines

Real Retail Sales, Year-over-Year % Change Real retail sales growth weakens significantly before
Current Cycle Average of Prior Cycles Range of Prior Cycles a recession begins, with the inflection point typically
8% occurring about 12 months before the start of the recession.
6% Consumers cut back on spending as they start to feel the
4% impact of slowing real income growth. This shows up most
2% noticeably in retail sales, which are made up of a higher
0% share of discretionary purchases than other measures of
-2% consumption. Looking at the current cycle, real retail sales
-4% growth has been steady at around 2 percent. This is weaker
-48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession
than the historical average, but is consistent with slower-
trend gross domestic product (GDP) growth in this cycle.
Source: Haver Analytics Analytics, Guggenheim Investments. Data as of 10.31.2017. Includes
cycles ending in 1970, 1980, 1990, 2001, and 2007. Past performance does not guarantee
future results.

Guggenheim Investments November 2017 3

 Model-Based Recession Probability
In addition to creating our dashboard of recession indicators, we have also
developed an integrated model that is designed to predict the probability of a
recession over six-, 12-, and 24-month horizons. The model uses the unemployment
gap, the stance of monetary policy, the yield curve, and the LEI, as well as the share
of cyclical sectors of the economy (durable goods consumption, housing, and
business investment in equipment and intellectual property) as a percent of GDP.
Applying our model using historical data shows that it would have successfully
signaled each recession in advance going back to 1960.

As the chart below illustrates, we believe the current likelihood of a recession

in the next six or 12 months is low, at 4 percent and 9 percent, respectively, as of
the third quarter of 2017. Within a two-year window, recession risk appears more
meaningful at 22 percent. We also show projections for the model, which is based
on a continuation of current trends for each of the indicators, and assumes the Fed
resumes quarterly rate hikes starting in December. If these trends play out, the
model indicates a high probability of a recession starting in late 2019–mid 2020.

Near-Term Recession Risk Is Low, but Longer-Term Risks Are Rising

Model-Based Recession Probability

Next 6 Months Next 12 Months Next 24 Months

100%
90% Guggenheim
80% Projection
70%
60%
50%
40%
30%
20%
10%
0%
1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

Hypothetical illustration based on a back-test. Hypothetical, back-tested model results have inherent limitations, such as: the model is designed with the benefit of hindsight, based on historical data,
and does not reflect the impact that certain economic and market factors might have had on the the rule-making process. Please see “Important Notices and Disclosures” for more information on the
limitations of back-tested model results. Source: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Shaded areas represent periods of recession.

What about the tax cuts currently being debated in Congress? Fiscal stimulus poses
a modest upside risk to GDP growth in 2018, but by late 2019 the fiscal impulse could
be fading, which will be a drag on growth. Moreover, campaigning for the November
2020 general election will be underway, which will serve to increase policy
uncertainty in a way that could undermine consumer and business confidence.

Additionally, our recession date coincides with a period where the balance sheets
of the world’s major central banks will likely be shrinking in aggregate for the first
time since the financial crisis, removing that form of global monetary stimulus just
as U.S. fundamentals are weakening.

4 November 2017 Guggenheim Investments

 As we noted earlier, predicting downturns is a notoriously difficult endeavor, but
the fact that a variety of approaches all point to the same timeframe for a recession
gives us confidence in our view. Naturally, there are substantial risks that our
recession date could be too early or too late. The expansion could last longer than
we think for a number of reasons, including the possibility that there is more
labor market slack than there currently appears, or that productivity growth could
accelerate considerably. On the flipside, a recession could occur sooner than
we anticipate due to a sudden spike in inflation, more hawkish Fed policy, or a
geopolitical shock, such as a military conflict with North Korea or a trade dispute
with China. And there are always the unknown unknowns.

Nevertheless, we believe that successful investing requires a roadmap, as with any

other endeavor. Our investment team uses this roadmap to help guide our portfolio
management decisions, in order to seek superior risk-adjusted performance over
time and across cycles.

Investment Implications
When faced with a recession looming on the horizon, investors first must recognize
that preparing too early can be as harmful as reacting too late. Indeed, the best gains
in stocks often occur in the latter stages of an expansion, when economic growth
is accelerating, monetary policy is not overly restrictive, and optimism is high—as
is currently the case. As the graph below demonstrates, in the last five comparable
cycles the S&P 500 has rallied an average of 16.2 percent in the penultimate year of
the expansion, before falling 3.8 percent in the final 12 months.

Stocks Rally Two Years Out from Recession Before Declining in Final Year
Cumulative S&P 500 Index Total Return Starting 24 Months Before Recessions
Average Range
35%
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
-24 -21 -18 -15 -12 -9 -6 -3 0 3
Months Before/After Recession

Source: Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007.
Past performance does not guarantee future results.

Guggenheim Investments November 2017 5

 In credit markets, high-yield spreads tend to stay flattish in the penultimate year
of the expansion before widening in the final year, on average. Rising defaults
and increasing credit and liquidity risk premiums drive a sharp pullback in the
performance in high-yield bonds before and during recessions.

High-Yield Spreads Begin to Widen About One Year Out From Recession
Cumulative Change in Basis Points Starting 24 Months Before Recessions

Average of Prior Cycles Range of Prior Cycles

800
700
600
500
400
300
200
100
0

-100
-200
-24 -21 -18 -15 -12 -9 -6 -3 0 3
Months Before/After Recession

Source: Bloomberg, Guggenheim Investments. Data as of 9.30.2017. Includes cycles ending in 1990, 2001, and 2007.
Past performance does not guarantee future results.

If history is a guide, then by the final year of the expansion (2019), investors should
turn defensive, positioning for widening credit spreads and falling equity valuations.
Treasury yields are likely to decline once the Fed stops hiking. As we noted in Stocks
for the Long Run? Not Now, elevated stock valuations portend meager returns over
the next decade, and one key reason is that a bear market is likely a couple of years
away. Maintaining some dry powder in the final year of the expansion will allow
equity and credit investors to take advantage of more attractive valuations, as some
of the best investment opportunities present themselves during recessions.

6 November 2017 Guggenheim Investments

Guggenheim Investments’ Recession Dashboard

Current Cycle Average of Prior Cycles Range of Prior Cycles

2.0%
1.5%
1.0%
Unemployment Gap (Unemployment Rate – Natural Rate of Unemployment) Real Fed Funds Rate – Natural Rate of Interest (r*)
0.5%
2.0%
0.0% 3%
-0.5%
1.5% 2%
-1.0%
1.0% 1%
-1.5%
0.5% 0%
-2.0%
0.0% -1%
-2.5%
-0.5%-48 -42 -36 -30 -24 -18 -12 -6 0 -2%
-1.0% Months Before Recession -3%
-1.5% -4%
-2.0% -5%
-2.5% -6%
-48 -42 -36 -30 -24 -18 -12 -6 0 -48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession Months Before Recession

Three Month–10 Year Treasury Yield Curve (Basis Points) Leading Economic Index, YoY % Change

400 12%

300 8%
200
4%
100
0%
0
-4%
-100

-200 -8%
-48 -42 -36 -30 -24 -18 -12 -6 0 -48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession Months Before Recession

Aggregate Weekly Hours Worked, YoY % Change Real Retail Sales, YoY % Change

7% 8%
6%
6%
5%
4%
4%
3% 2%
2%
0%
1%
-2%
0%
-1% -4%
-48 -42 -36 -30 -24 -18 -12 -6 0 -48 -42 -36 -30 -24 -18 -12 -6 0
Months Before Recession Months Before Recession

Source all charts: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 10.31.2017. Includes cycles ending in 1970, 1980, 1990, 2001, and 2007.
Past performance does not guarantee future results.

7 November 2017 Guggenheim Investments

Important Notices and Disclosures
Investing involves risk, including the possible loss of principal.
This material is distributed or presented for informational or educational purposes only and should not be considered a recommendation of any particular security, strategy or investment
product, or as investing advice of any kind. This material is not provided in a fiduciary capacity, may not be relied upon for or in connection with the making of investment decisions, and does
not constitute a solicitation of an offer to buy or sell securities. The content contained herein is not intended to be and should not be construed as legal or tax advice and/or a legal opinion.
Always consult a financial, tax and/or legal professional regarding your specific situation.
This material contains opinions of the author or speaker, but not necessarily those of Guggenheim Partners, LLC or its subsidiaries. The opinions contained herein are subject to change without
notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained
herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is not indicative of future results. There is neither representation nor
warranty as to the current accuracy of, nor liability for, decisions based on such information. No part of this material may be reproduced or referred to in any form, without express written
permission of Guggenheim Partners, LLC.
Hypothetical, back-tested or simulated model results have many inherent limitations only some of which are described as follows: the model is designed with the benefit of hindsight,
based on historical data, and does not reflect the impact that certain economic and market factors might have had on the rule-making process. No hypothetical, back-tested or simulated results
can completely account for the impact of financial risk in actual performance. Therefore, it will invariably show positive results. The information is based, in part, on hypothetical assumptions
made for modeling purposes that may not be realized in the actual results. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions
used in achieving the results have been stated or fully considered. Assumption changes may have a material impact on the results presented. There are frequently material differences between
hypothetical, back-tested or simulated results and actual results of the model. Unlike actual results, hypothetical, back-tested or simulated results are achieved by means of the retroactive
application of a back-tested model itself designed with the benefit of hindsight. The back-tested results differ from actual results because the rules may be adjusted at any time, for any reason
and can continue to be changed until desired or better results are achieved. In fact, there are frequently sharp differences between hypothetical, back-tested and simulated model results and
the actual results subsequently achieved.
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Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe
Limited and Guggenheim Partners India Management. This material is intended to inform you of services available through Guggenheim Investments’ affiliate businesses.
1. Guggenheim Investments total asset figure is as of 9.30.2017. The assets include leverage of $11.6bn for assets under management and $0.4bn for assets for which we provide administrative
services. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC,
Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners
Europe Limited, and Guggenheim Partners India Management.
2. Guggenheim Partners assets under management are as of 9.30.2017 and include consulting services for clients whose assets are valued at approximately $63bn.
©2017, Guggenheim Partners, LLC. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners,
LLC. GPIM 31201

Guggenheim Investments November 2017 8

Guggenheim’s Investment Process
Guggenheim’s fixed-income portfolios are managed by a systematic, disciplined
investment process designed to mitigate behavioral biases and lead to better decision-
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We disaggregated fixed-income investment management into four primary and
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