Close Close

Portfolio > ETFs > Broad Market

Beware These Early Warning Signs of an Upcoming Recession

Your article was successfully shared with the contacts you provided.

Given that a growing number of economists and strategists are expecting a recession this year or next and that recessions are almost always officially recognized months after they start, what indicators should advisors be watching as early warning signs?

Here are some of the indicators that market strategists and economists are citing in their recent outlooks.

Yield Curve

There are multiple warning signs that economists and strategists cite as key indicators of an upcoming recession but probably none as often as the inverted yield curve — when the short-term Treasury yield tops the long-term yield.

Once the yield curve inverts, recessions usually follow about 12 to 18 months later, though the time delay can be as short as six months and as long as 24 months, according to analysts.

“Each of the past nine recessions were preceded by a yield curve inversion,” according to Fitch Ratings, referring to the spread between the when the 10-year Treasury note and one-year Treasury bill.

Others reference the 2- and 10-year Treasury spread, but Cam Harvey, partner and senior advisor, Research Affiliates, and a finance professor at Duke University, says, “the crucial thing is to use a very short-term interest rate” in the calculation, such as the 3-month Treasury bill. “I get nervous when I see people talking about the 10-year minus the 2-year.”

The spread between the 3-month Treasury bill and 10-year Treasury note is close to flat, at about 28 basis points, with the 10-year yielding more than the T-bill. A year ago, the 10-year Treasury was yielding 100 basis points more than the 3-month bill.

The current narrower spread primarily reflects the increase in short-term rates as a result of Federal Reserve rate hikes. Long-term rates, too, have also risen but less than one-fifth as much as short-term rates, and the 10-year Treasury yield is now about 50 basis points below its recent 3.25% peak reached in October.

Economic Data — From the Fed

“Recession models can be categorized into two groups: those which use economic data and those which use financial market data,” according to Bank of America Merrill Lynch economists writing in the firm’s mid-November Economic Viewpoint report. The former focuses on the current economy; the latter on a more ‘forward-looking’ view, which includes the yield curve analysis.

Among the economic data models cited by the Merrill economists is the “smoothed recession probability” published by the Federal Reserve Bank of St. Louis. The data series consists of four economic indicators: nonfarm payrolls, industrial production, real personal income excluding transfer payments and real manufacturing and trade sales, and it is currently at its highest level since March 2016.

 Economic Data — From NBER

The National Bureau of Economic Research (NBER) is the body that declares the official beginning and end of U.S. recessions, and it does so always after the fact, with a usual lag of several months.  According to its web site the NBER’s business Cycle Dating Committee “does not have a fixed definition of economic activity” but “examines and compares the behavior of various measures of broad activity,” including “real GDP measured on the product and income sides, employment and real income,” and may consider other indicators that don’t cover the whole economy, such as real sales and industrial production.

Merrill economists suggest that recession watchers monitor five economic indicators that track the NBER’s recession-dating exercise: initial jobless claims, auto sales, industrial production, Philadelphia Federal Index and aggregate hours worked. Except for the Philly Fed Index, a manufacturing indicator, all these indicators remain strong, indicating no imminent signs of recession.

Keep in mind that there will be less economic data released during the government shutdown. Even the Labor Department, which is funded for the current fiscal year, reports that its household survey, which forms the basis of the unemployment rate, could be impacted if the shutdown continues because many Census Bureau staff members who collect that data have been furloughed.

The Census bureau also releases the monthly retail sales and new home sales report, which won’t be published during the shutdown. The Commerce Department, like the Census Bureau, is also shut down and won’t be releasing its reports on GDP, personal income, trade balance and current account balance while the shutdown continues.

Other Economic Data

Goldman Sachs, which is not forecasting a recession for this year or next, points to several indicators to support its view: private-sector financial balance, personal savings rates and real income growth, which are all above trend. In addition, the ISM manufacturing index and the firm’s own U.S. current activity indicator remain “safely above typical recessionary levels” along with industrial production and consumer confidence, according to Goldman.

“The labor market, in particular, continues to be strong. The US economy added 312,000 jobs in December, average hourly earnings rose at a cycle-high pace, and the unemployment rate remains below estimates of full employment. Since 1946, the unemployment rate has risen by a median of 30 basis points during the two months prior to the start of a recession.”

Goldman economists note that “If economic growth slows to below 1% or the unemployment rate rises sharply, history suggests that a recession could start in the subsequent two to four months.” A continued rotation into cash by investors would also be a troubling sign, according to Goldman.

The Stock Market and the Economy

Even without a recession, the stock market could still turn sharply lower, which is what the stock market did in late 2018. “There have been four bear markets without a recession since 1946,” according to Goldman.. “The S&P 500 declined by an average of 21% for a period of 8 months during those bear markets.”

A stock market decline could also indicate an upcoming recession. “The recent slide in U.S. equities — the S&P 500 index dropped nearly 14% last quarter — suggests that the bull market likely peaked early last fall,” writes Erik Ristuben, chief investment strategist at Russell Investments, in a recent blog.

 In the post-World War II era, markets have reached their high point, on average, roughly six months before a recession — and the longest distance from a market peak to a recession has been 12 months (although the 1987 bear market was outside of a recession).”

— Related on ThinkAdvisor:


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.