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Portfolio > Economy & Markets > Economic Trends

Schwab’s Sonders Breaks Down 6 Popular Recession Indicators

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Liz Ann Sonders has noticed an uptick in “recession chatter,” as she calls it.

“Recession chatter is abundant lately,” the chief investment strategist at Charles Schwab said. “It’s increasingly the focus of Q&A sessions at investor events at which I’ve been speaking. I also received a series of questions last week about recessions from a Schwab colleague who has many younger Schwabbies on his team, most of whom have not lived as working adults through a recession.”

According to Sonders, these heightened recession concerns are expected given the duration of the current cycle. But, she added, that the increased concern may also be “because of the recent deterioration in economic data across a fairly wide spectrum of indicators.”

In her recent market commentary, Sonders took a look at several popular economic indicators that she hears cited often when recessions are discussed. She also highlighted the importance of understanding the difference between lagging and leading economic indicators

1. Unemployment rate

“When discussing recessions with investors, and listening to many pundits in the media, we often hear today’s low unemployment rate cited as a reason not to fret a recession any time in the near future,” Sonders wrote. “But here’s the rub — the unemployment rate is one of the most lagging of all economic indicators.”

According to Sonders, the unemployment rate has always been low at the outset of recessions.

She wrote that the unemployment rate’s “most significant period of deterioration” has historically been during recessions, not in the lead-up to them.

“Put another way, a rising unemployment rate doesn’t cause recessions; recessions cause the unemployment rate to rise,” she said.

2. Unemployment Claims

Although less “popular” as an indicator, the most leading of the various employment indicators is initial unemployment claims, according to Sonders.

“The fact that claims recently broke out to the upside suggests we need to be on guard for the signal they’re giving about the length of time between now and the next recession,” she wrote. “If they continue to tick higher, the risk of a recession starting sooner rather than later will move up.”

3. Consumer Confidence

“In addition to hearing the unemployment rate cited as a reason not to fret a recession, I often hear the same about consumer confidence,” Sonders wrote.

The Conference Board’s measure of consumer confidence remains high in level terms but is “clearly off the peak,” Sonders noted.

Consumer confidence — as a leading indicator — has typically peaked not too far in advance of a recession’s start, according to Sonders.

4. Leading Economic Index Peak

Looking more broadly at the full set of leading indicators, Sonders focused on the Leading Economic Index (LEI) put out by The Conference Board.

She noted that historically the span between LEI peaks and recession starts has been 13 months, with a range of eight to 21 months.

“In its presently constituted form, the LEI never failed to give a heads up that a recession was coming,” Sonders wrote.

The LEI peaked last September and declined in two of the subsequent four months.

“It’s perhaps too soon to judge whether last September’s peak was the peak for the cycle, especially given the temporary effects of the government shutdown, but we’ll see,” Sonders wrote.

5. Fed Models

While the Federal Reserve has not distinguished itself historically with forecasting recessions, according to Sonders, it does have forecasting models.

According to Sonders, the model from the Federal Reserve Bank of New York is fairly popular.

Currently, it’s showing a 24% chance of a recession, which Sonders wrote “doesn’t sound high.”

“But … with the exception of the late 1960s and mid-1990s, once the model reached that level it continued to rise and recessions were soon on the way,” Sonders wrote.

6. Yield Spread

Sonders called the yield spread “the mother of all recession indicators.”

According to Sonders, the yield spread — specifically, between 10-year and three-month Treasuries — has arguably been the best recession forecasting indicator historically.

According to Sonders’ analysis, inverted yield curves (when long-term rates fall below short-term rates) have generally been followed shortly thereafter by recessions.

Sonders also points to a recent working paper from Fed staffers arguing that the spread of short-term Treasury rates, which is the difference between the six-quarters-ahead forward rate and the three-month yield, might be preferable as a predictor. This is because it focuses on expectations of the near-term path of monetary policy.

“For what it’s worth, that spread did invert briefly at the beginning of January this year,” Sonders wrote.

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