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Cam Harvey: Forecasting Recessions
00:39:19
Campbell Harvey, a professor of finance at Duke University, director of research at Research Affiliates, and author of "DeFi and the Future of Finance," is best known for identifying the link between an inverted yield curve and impending...
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- [00:00]
Mike Wahlberg
Get ready for cfa Institute Live 2025 with free power packed webinars designed to inspire and inform. Led by industry experts, these concise sessions tackle game changing topics like how AI is transforming investment strategies in emerging markets. Don't just show up, show up Ready. Gain the insights you need to drive meaningful conversations this May in Chicago. Claim your spot now@cfainstitute.org Foreign welcome to the Enterprising Investor, the flagship investment podcast for CFA Institute. I'm Mike Wahlberg and I'm joined today by finance royalty of sorts. Many of you will recognize the name Dr. Cam Harvey as he is credited as the economist who first identified the link between an inverted yield curve and a coming recession, a relationship that has become gospel among practitioners over the last nearly 40 years. Cam is a professor of Finance at Duke University and Director of Research at Research Affiliates, the asset management firm founded by Rob Arnott in publishing. Extensively throughout his career, Cam has collected nine Graham and Dodd Awards from the CFA Institute for Excellence in Financial Writing in the Financial Analyst Journal and the Journal of Portfolio Management chose his submissions as Best Article of the year four times in the last 10 years. Cam also recently published a book called Defi and the Future of Finance. It has been an unusually volatile summer as the market has been racing to interpret the latest economic data and what the Fed will or should do. I look forward to hearing Cam's thoughts on all of this. Welcome to the show, Cam.
- [01:38]
Dr. Cam Harvey
Thank you for inviting me.
- [01:40]
Mike Wahlberg
And before we get to the mania in the markets right now, Cam, I'd love to start with the recession indicator you're most famous for. Can you explain simply for those that don't know simply what it is and and then talk a bit about how the original work came together as well as how it's performed since.
- [01:55]
Dr. Cam Harvey
Sure. So the indicator is really a simple indicator. It just looks at the slope of the term structure and what I mean by that is the difference between a long term rate and a short term rate. And usually it's the case that for example you go to a bank and get a certificate of deposit or something like that, the rate is higher if you lock your money in for a longer period of time. So a normal term structure, the longer term rate is higher than the short term rate. However in certain unusual situations that flips and you get a so called inverted yield curve, which means the short rate is higher than the long rate. That doesn't last for very long. But it is bad news in terms of what happens in the future in terms of economic activity. So where Did I get the idea? It is an interesting story. At least interesting for me. I was a master's student in an internship in Toronto and the internship was in corporate development at a company called Falcon Bridge Copper. A company no longer exists in that name.
- [03:14]
Mike Wahlberg
I remember Falkenberg.
- [03:15]
Dr. Cam Harvey
Yeah. And I got this job. I was excited about it and they gave me a task and that was to develop a model to forecast US real GDP growth. And I thought, oh, wow, this is super exciting. This will be a great project for me in the summer. Little did I realize at the time how crazy that was. If you think about a copper mining firm, the single most important input for planning is some expectation of what's going to happen to gdp. So they called Copper doctor Copper for a good reason. Because copper price moves with the economy. So key planning decisions like opening mines, closing mines, how much you're spending on exploration, it's all linked to this number. And they delegate this job to an intern. So again, at the time I had no idea. So I started to work on this and I realized almost immediately that I was severely disadvantaged because there were a number of companies at that time that specialized in economic forecasting. And they had extensive computing resources, great data, dozens of PhDs in econometrics and statistics. And you would pay them a fee, let's say a quarter million dollars a year, and they would deliver these forecasts. So there's no way that I could assemble a team, collect the data and do anything like what they were doing. So I had to do something different. It had to be innovated, had to be simple. And in my first year I read a few papers by this person, Eugene Fama, at the University of Chicago, and he was making a very intuitive argument that stock prices should reflect expectations of future economic growth. And the idea is that earnings are correlated with the strength of the economy and the stock price is the present value of all the cash flows from the firm. So that stock price should reveal expectations of future economic growth. And again, very intuitive. But it didn't work. So his research showed that the stock price is just all over the place and produced many false signals. But that paper gave me the idea of, well, maybe he's looking at the wrong asset. Why not look at something less risky? Bonds and bonds have like number of advantages over stocks. So if you look at the government bond, it's relatively risk free, it's got a fixed maturity. Stocks don't have fixed maturity. The dividends on a stock are discretionary, whereas on the bond the coupons are fixed. So you Put all that together. And it suggested that the same intuition about expectations of future economic growth could work for fixed income. And I started that work during my master's. It actually looked really good in many. You don't know the rest of the story that I was about to present to senior management. And I came into the office one day and was told that the entire corporate development group had been terminated, including me. And I'm out of a job before I get to present this idea to them. So with a few weeks left in the summer, there was no chance of another job. So I continued to pursue the idea because I was really excited about it. And then when I got back my second year, I showed the idea to one of my mentors, professor, and he said, this is very promising. Why don't you work on this as a term paper in my course over the next year. And I did that. And in the fall, I showed the final draft of my term paper to him. He read it, he circulated it to his colleagues, and he said, you need to apply for a PhD. And I did. I had no idea. I had not intended to apply for a PhD. I intended to get a job in business. So I didn't know much about it. I applied. There was one school I wanted to go to. I applied to a number of them, of course, but the school I wanted to go to was the University of Chicago because that one researcher, Eugene Fama, the idea of looking at asset prices and extracting information. So I was accepted there and then further developed the idea. It turned into my dissertation and. And that's where it all started. So it's. It's really unexpected. I had no idea that I was going to be an academic. My parents didn't understand what I was doing. They thought I should get like a real job. I was the first person in my family to get a bachelor's degree and I was kind of pushing my luck doing a master's. I remember my grandfather saying to me when I said, I'm doing a PhD. He said, Is that one more year? I said, no, granddad, it's not one year, if only. So it's kind of unexpected. But that. That's kind of my start. And at the time, deal curve indicator within my thesis from 1960s, it had correctly predicted four out of four recessions, and rightfully so. And of course, at the University of Chicago or anywhere, academics very skeptical. And I remember at least one member of my committee saying, well, it just could be lucky. Only four observations. And I kind of got through for a number of Reasons. One reason is that the economic theory behind this indicator is sound, that it's well understood that interest rates have a nominal component or an expected inflation component, a real component, which that real component is by theory linked to expected real economic growth. So that theory was sound. And also there's another member of my committee, Merton Miller, particularly liked the following that you have a choice to get a forecast. You could pay a quarter million dollars a year to a service, or you could use my forecast, which was as good or better than the quarter million dollar a year forecast. And at the time it would cost 25 cents, the price of a Wall Street Journal. So I got three.
- [10:23]
Mike Wahlberg
That's amazing. Falkabridge must be kicking themselves in hindsight. Hey, if they knew.
- [10:27]
Dr. Cam Harvey
Yeah, they're no longer in business, maybe for a good reason.
- [10:30]
Mike Wahlberg
Yeah, yeah, yeah. And so tell me about. So that was four observations to that point. And how has it done since? And I'm curious how you think about lead times, because some lead times are longer and shorter. And how do you decide when the lead time is, you know, long enough or too long before you count it as a predictor?
- [10:48]
Dr. Cam Harvey
Okay, so as I mentioned, I was 4 of a 4 in the backtest. Right. So again, this could have been lucky. And another thing that my committee liked was that the yield curve got the double dip recession in the early 1980s and none of these expensive services got that. So there was some interest in this indicator. And after I graduated, I published the paper and various spinoffs of the paper, and this is the way it usually works in science, that there are two scenarios when you go out of sample. The first scenario is the effect weakens and that's the good scenario. The bad scenario is the effect completely goes away and that's consistent with the initial finding just being a lucky finding. So neither of those scenarios played out for me. It turned out that in the next four inversions of the yield curve where the short rate went above the long rate, they were all followed by a recession. So at this point, the indicator from 1960s is 8 out of 8 without a false signal. And let me emphasize the importance of without a false signal, because you could have an indicator that says in every quarter there's going to be a recession. And that indicator would be eight out of eight, but it would have a massive number of false signals. So this indicator is 8 out of 8. You mentioned the lead time. Well, on social media, people criticize the model for having an inconsistent lead time. They criticize the model for not being very good at forecasting the depths of a recession. And my response is, you're asking way too much. This is a very simple indicator. Come on.
- [13:01]
Mike Wahlberg
I was going to say that's asking a lot.
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Dr. Cam Harvey
Give me a break. This is eight out of eight. It's reliable. Economy is still complex. It's remarkable that you could have something that does such a reliable job. But it is true that the lead time is inconsistent. So over the eight episodes the range of lead time is six months to 23 months. So the longest we had to wait was the global financial crisis recession that began in December 2007, the yield curve recently in November 2022 inverted. And the yield curve that I look at is the 10 year treasury bond yield minus the three month. And the logic to that is that the 10 year is the most liquid treasury bond and I didn't want any noise induced by illiquidity. And the short term is the extremely liquid 90 day treasury bill. And I choose three months because that is the frequency of GDP. So GDP is measured on a quarterly basis. So that is the appropriate short term to look at. So the yield curve presently has been inverted for almost 20 months. So we're not quite at the situation of 2007, but we're close. And if you look at the clustering, there's some that are 18, 19, 23. So we're within, we're within the range.
- [14:39]
Mike Wahlberg
So that takes us to our current economic environment here. I'm sitting on that for, I think you said 22 months, watching for a potential recession to come down here and the markets have been more or less volatile over that time period. Right now here we're recording on the first week of August and they've been very volatile the last week and a half here. Fed's Last meeting was July 31st and the S&P 500 was down 6% that first week of August. I know you have strong views, I was going to say, I know you have strong views on the Fed's decision to keep its benchmark rate between five and a quarter and five and a half percent. And apparently the market is agreeing with you. Cam, can you talk me through that?
- [15:16]
Dr. Cam Harvey
Yes. So if you follow me on LinkedIn, over the last couple of years I've been very negative on the Fed policy. So to be clear, I was critical of the hikes going to five and a quarter percent in 2023. I thought, and I still believe that the Fed overshot and the logic that the Fed was giving had to do with inflation. And I believe that they have very poorly handled the reading of Inflation and actually twice. So let me explain. The way that inflation goes into GDP changed in 1982. And what was introduced is something called owner's equivalent rent. And it turns out that that operates with a lag. So this means that inflation, the CPI is highly predictable. And what you can do is you can look at real time rents, let's say, and have a very good idea how that will feel feed into the CPI over the next year to a year and a half. So in 2021 and actually late 2020, rents were surging, so they were double digit. And at the time what was going into the CPI in terms of the calculation was between 2 and 3% year over year for rent, yet the real time rents were over 10%. So it was obvious that that would make its way into the cpi. And I was saying that inflation is going to surge. The Fed was saying, oh well, this is not permanent thing, it's just a temporary thing, inflation's transitory, we don't need to do anything. So we're going to keep rates at zero. And to keep rates at zero, it just, it was baffling to me. So think of the economy is growing, unemployment very low, stock market at all time highs. Why do we need to keep the rates at zero? It's very distortionary. And finally in November they retired the word transitory and started to hike. And they had to hike very quickly to catch up, to undo their mistake. So over the last year the same mistake has been made. The sort of numbers that go into the cpi. And just let me emphasize that shelter is the most important component of CPI. 36% of the CPI is shelter. So again recently, if you look at real time rents, the rents are year over year, maybe 0%, maybe generously 1%. Yet the latest CPI print, what goes into The CPI is 5.2% year over year. So it's disconnected from reality. Actually the Zillow is negative 0.8%. So the gap between a real time rent and what goes into The CPI is 6 percentage points. And this means that we're printing CPI that says 3% but is actually far less. So what I like to do is to inject the real time inflation for shelter and recalculate the cpi. And it's a real time cpi. And if we, let's say assume that shelter inflation is running at 1%, that means the real time CPI is about 1.5%.
- [19:05]
Mike Wahlberg
So what do you use for that data? I know you mentioned Zillow there, like what could the Fed be using? That's different from this lagged indicator that they're using.
- [19:12]
Dr. Cam Harvey
Yeah, so they can use various different surveys. So Zillow's1apartmentless.com is another. There's, there's plenty of data out there whereby you can put a real time indicator together. So let me mention one subtle point, that the CPI actually does reflect the real time experiences of consumers. So I'll give you an example. So let's say December 31, the landlord sends out an email to all tenants saying rents next year are going to go up by 10%. So if your lease expires December 31, your rent goes up by 10%. But if your lease doesn't renew until the end of August, you don't feel that 10%, it's zero until the end of August, then it goes up 10%. So the CPI actually does reflect the real time experiences of consumers. However, this is really an important point that the Fed policy needs deal with real time data and expectations of the future. So what the Fed should be looking at are not the leases that expire whenever they should be looking at like new rentals. So in other words, the Fed policy has no ability to change the past. So whatever the Fed does doesn't affect that email that happened eight months ago saying rents are going up 10%. That's done. That's history. What the Fed can influence is stuff going forward and that's why they need to have a different measure of inflation that is real time based, that they can make policy based upon. So policy should be made upon data that is fresh, not stale.
- [21:16]
Mike Wahlberg
Yeah, another, another area you talked about is the retail sales that that's also distorted.
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Dr. Cam Harvey
So retail sales are really important if you think about gdp and we know it's like four components, consumer spending, investment, government and the trade sector. The consumer is 70% of GDP, so personal consumption expenditures. So this is like a very significant driver. And indeed in 2023, the reason that we had reasonable growth, so 2.1% real GDP growth, it was driven by the consumer and the consumer effectively drawing down Covid era savings. So there was extraordinary stimulus, both monetary and fiscal, that made its way into consumer savings. And consumers actually during COVID didn't really get out and spend to the same degree. So there was pent up spending and these savings that was kind of like drawn down. But retail sales are highly correlated with personal consumption expenditures. So I've done analysis on this and that's something that you can watch pretty well in real time, different categories. You need to be careful with retail sales because it's reported on a nominal basis. So almost everything else is reported on a real basis. So we look at real gdp, but retail sales are nominal and I track those very closely. And it turns out that over the last six months, and especially over the last three months, they're flat and flat nominal. So you need to take inflation out of that. So even my real time adjusted inflation would suggest that this is very weak. So you put a few things together. So you put that the consumer savings have now dropped pre Covid level. So that's consistent with the savings have been drawn down and that the drawing down of the savings has reached a limit and we shouldn't expect the same robust consumer spending that we had in 2023. Another piece of data that I track very carefully is consumer loans. So if you look at credit cards, if you look at auto loans, there's a clear trend and that is delinquencies are increasing. So on the cards, the Philadelphia Fed shows that the delinquency rate is an all time high from their data. So that to me indicates kind of a consistent signal that the savings have been drawn down. So why would you pay 20% plus interest on a credit card? Well, your savings have been drawn down. So again, you look at this and it suggests to me that consumer spending over the next year is going to be muted. So we will likely see this in the third quarter, in the fourth quarter. There's just not a lot of capacity right now in terms of consumer spending. Indeed, if you look at not just overall consumer spend, but look at different components and we've got great data on this where we can drill in on individual sectors. And when I see people not going out to restaurants or even cutting back on fast food, that's a red flag. That means that people are worried and the savings have been drawn down. So don't expect the consumer to be the robust leader of economic growth over the next year.
- [25:19]
Mike Wahlberg
So given that outlook, it sounds clearly cam like you're advocating for a cut sooner than later. I know you've done some really fascinating analysis comparing today to back in 2007 on that last big one that we, that big recession that we had on the back of the credit crisis. What are the similarities and differences Cam from now versus then and, and what's your outlook then? Do we, do we get, do we still get the soft landing? Everyone's hoping how, what do you see there?
- [25:44]
Dr. Cam Harvey
Yeah, I put this LinkedIn post up recently that was comparing 2007 and today and it's really striking. So in 2007 the Fed kept the fed funds rate at 5.25%. And that's like where it is today in the face of declining stock market and and an inverted yield curve that was inverted for 19 months. And then you fast forward to 7-31-2004. The Fed keeps the rate at 5.25% and the yield curve's been inverted for 19 months. So it's a near identical situation. The FOMC statement in August of 2007 said well, we're going to hold the rate steady because we're concerned about inflation. You could literally copy and paste it into the FOMC statement July 31st.
- [26:47]
Mike Wahlberg
So I'm looking at it now. Listeners should go check out Cam's post on this if you want to. It's just really, it's fascinating. It's kind of terrifying. At the same time, we know what happened after that, but hopefully that's not what we're up for.
- [26:59]
Dr. Cam Harvey
The similarity is the Fed in action. So they should have begun cutting. And remember 2007, this was a time of high uncertainty where you've got companies going under that are mortgage companies and banks being stressed and the Fed holds the rate at 5.25%. So there are similarities but also fundamental differences. And I'm on the side of a soft landing and let me explain what I mean by that. So a soft landing is a mild recession and we've had mild recessions before. So for example, 2001 was a mild recession, 1990-91 mild recession. One of those recessions didn't have negative real growth year over year, that negative quarters, but not year over year. So a soft landing is a mild recession or just slower economic growth. And there are some key differences between today and in 2007. 2007 was the beginning in December of a hard landing recession. So a few key differences let me mention. So number one has to do with leverage. So the big banks at the time were highly levered, you know, 40 to 1. They were operating like hedge funds and not a very good hedge fund were the government effectively is guaranteeing their funding the deposits and there was an implicit sort of promise of bailout. So, so we had a situation where banks were highly levered and if there was a banking problem that would spread over and negatively impact the economy today, the banks are far less after the regulatory reforms, number two, the housing sector. So back in 2007, given the extremely cheap and aggressive tactics to get people into mortgages and then having a mortgage cover essentially 100% of the value of the property, consumers were Highly levered. So the equity that they had in housing was very limited. So today it is a different story completely. So there are 32 million Americans with houses and mortgages that could go to the bank and draw at least 100,000 in terms of extra financing if they need it. So the debt percentage of the equity in housing is only 46%. So it's not 95 plus percent, it's 46 plus. So that suggests to me that even if we go into a slowdown that it'll be muted because housing sector will not cause a snowball. The other thing that I look at very carefully is employment. So employment is a coincident indicator, it's not a leading indicator. So I think of employment in the future. And the key metric that I look at is, is the number of job openings to the unemployed. And over the past year and a half that has gone from two to one to approximately one to one. And that one to one is still really good. So if we go into a slowdown, obviously the openings will be slashed, but they're not going to be completely slash. So maybe 50% would go away and that means there will still be some jobs available. And what this does again it mutes the downturn. If you think about what happened in 2007, there's mass layoffs and when you get people laid off is very bad for economic growth. They don't spend because they can't. So it actually deepens the trough of the business cycle. So I think that's also important to actually look at in terms of a mitigating factor.
- [31:14]
Mike Wahlberg
Yeah, the. I know folks are getting pretty worked up about the SOM rule when that, when that went through last week was triggered. But I thought it was interesting that Claudia Som, the originator of that particular predictor, said that this, she was talking about other own predictor. This time really could be different. She said she's not concerned about that we're in a recession. And she, she pointed to growing household income, resilient spending and business investment. So not as dark as maybe the market is interpreting it.
- [31:41]
Dr. Cam Harvey
Yeah. So her indicator is very useful not for predicting but telling you if you're actually in a recession. Because the way it works, we're often in a recession. We don't really know. The National Bureau of Economic Research doesn't date a recession in real time. They wait so might have to wait a year before they backdate the beginning of a recession. So obviously an exception was Covid because it was so obvious. But often it is not obvious. So you can't just look at her indicator. I think you look at other information. And when you look at openings to unemployed, that tells you something about what will happen in the future. So the idea that the duration of the unemployment will be reduced given the number of openings. The last thing that I will mention in terms of mitigating factor, and it might seem a little counterintuitive, but let me pitch the idea. The yield curve. So the yield curve has changed its role since I published my dissertation. So it used to just reflect expectations of economic growth and now it's more causal. And what do I mean by that? So the yield curve inverts in November of 2022. People notice it now. Oh, this is like eight out of eight. It's inverted. So we need to be careful. And in particular for corporations, it gave them time to exercise some risk management. So there's a probability we're going into recession and our company needs to be strong in that recession. So we saw all of these layoffs like 5%, 10% of your workforce laid off. Giving the laid off employees plenty of time to relocate. But companies became more efficient and strengthened their balance sheets.
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Mike Wahlberg
Yeah, it's a good time to term out your debt. Right. Long rates are down.
- [33:44]
Dr. Cam Harvey
Exactly. And this is the situation whereby if you go into to a slower growth phase that you avoid slashing and slashing investment or slashing, you know, employment, that again deepens the downturn. So you put all of this together and there are risks. And the main risk factor, the main thing pushing the probabilities towards a hard landing is having this rate at 5.25%. It's inexplicable, it's bad news. We know what happens that when that rate goes up. It is the deterrent for people moving because mortgage rates are so high. It's a deterrent for companies making investment because the cost of capital is high. This is something that degrades economic growth. And the other thing that is a major risk factor is, is just the size of the federal government debt. We have racked up $9 trillion in deficits over the last four years. Last year 1.7 trillion. So the interest is the second largest spending category for the government. It's more than National Defense. 36% of personal tax revenues go to just pay the interest. And let me tell you that the average rate on that interest is 3%. And as debt rolls over, as new deficits need to be financed, that number is going up. So that's a risk factor on the fiscal side. On the monetary side, with the Fed Even though the Fed policy has increased the probability of a hard landing, I still think the odds are for a soft landing.
- [35:38]
Mike Wahlberg
Key takeaway for the Fed get to work.
- [35:41]
Dr. Cam Harvey
I certainly hope that they undo some of the damage. So to be very clear here, I've been calling for cuts for quite a while and before that I was calling the Fed not hike that to take another look at the inflation data. So I'm hopeful that we see some action. We will likely have a 50 basis point cut the next meeting. That also means that the yield curve will uninvert. And this is also a key point that some people say, oh well, when the yield curve unadverts, will you declare that your indicator is a false signal? And I said no, because if you look at the last four recessions, the yield curve inverted before each of the last four and uninverted before the beginning of the recession. So this is just part of how it plays out. And I do believe that we are faced with slower growth in the longer horizon. I do think that the prospects are promising for the US Economy.
- [36:50]
Mike Wahlberg
Well, we'll wrap up on that positive note. Cam, final question here I usually put to my guests is, you know, looking back at your first job in the industry and what, what key piece of advice would you offer yourself on your first day? Seems like your first day as an intern was you made a lot of good decisions there. But looking back over your career in the industry and in academia, is there any kind of advice that you would offer to yourself to remember throughout that time?
- [37:15]
Dr. Cam Harvey
Well, let me tell you, many of my students go into asset management. And from my personal experience, I do offer the following that you need to go to the office every day knowing that there's a probability that you will be terminated. And sometimes you're terminated because the CEO wants to go in a different direction. It's not because you're doing a bad job. Sometimes you're terminated because of economic circumstances, but you need to expect that. And if you haven't been terminated, it's hard the first time that it happens. But when it does happen, if you're expecting that possibility, you need to step up and handle it very professionally and thank the firm for everything that you've learned. Build a rapport, and that will come back and benefit you because people will talk about how professional you were. So it's a little bit of negative advice, but it really works in the long term and it's really no big deal. Even my students hesitate to go into startups. They're worried that the startup's going to fail, they're going to be laid off. And I teach innovation. And I say, no, you're looking at it the wrong way. You build a network at your startup, you learn from that failure, and you can be placed fairly easily at somewhere else. So this is just part of the experience, building your human capital to go from firm to firm. So to know how to elegantly exit is important. And you should always be thinking about jumping to another firm to learn more. This is all about learning, and it's really important to message that to my students.
- [39:15]
Mike Wahlberg
I've been Speaking today with Dr. Cam Harvey, professor of finance at Duke University, director of research at Research Affiliates, and author of Defi and the Future of Finance. Thanks for joining me today, Cam.
- [39:26]
Dr. Cam Harvey
Thank you for inviting me, Mike.
- [39:28]
Mike Wahlberg
I'm Mike Wahlberg, and this has been the enterprising Invest.