Is A U.S. Recession Looming? Here Are The Key Indicators To Watch

by: Brian Sterz, CFA
Summary

While recessions are notably difficult to predict, there are several key indicators that are particularly relevant for assessing the forecast.

Although correctly identifying a coming recession can help investors preserve their wealth, over-reacting to a false-positive recession forecast can do the opposite.

Investors should keep an eye on key indicators, particularly since numerous warning flags are waving—and be mindful of the potential portfolio effects.

Find a parade and there’s a good chance you’ll also find someone waiting to rain on it. This metaphor can be applied to many things, and the economy is no exception. When it’s chugging along nicely, people love hand-wringing about when things will reverse course, yet things have been persistently bright as of late. The U.S. economy is now in its longest expansion ever—a stunning 120 months—despite predictions of a recession since 2011.

Still, most parades come to an end eventually, and it’s wise to be diligent about the economic forecast, particularly since recessions—defined specifically as two consecutive quarters of a decline in real GDP and a drop in aggregate demand—correlate so strongly with bear markets.

Some common causes of recessions are geopolitical events like trade wars and oil embargoes; asset bubbles or financial crises; and the tightening of monetary policy—usually in response to inflationary overheating. If you’re tuned in to the macroeconomy, some of those probably sound familiar.

The reality is that the U.S. and global economies are slowing, trade war actions are increasing and interest rates do appear to be decreasing. While recessions are notably difficult to predict (as the aforementioned eight years of false calls for one suggests), several indicators are particularly relevant for assessing the forecast. Let’s look at each one—and what the rain clouds in the distance are telling us.

First is the yield curve, which refers to the difference in interest rates between short-term and long-term treasuries. It’s unusual for short-term rates to be higher than long term rates—something called an “inverted curve”—and usually signals that economic growth and inflation will decline over the intermediate term.

Shape Of Current Yield Curve Inversion vs. Previous Inversions The spread between the three-month and 10-year treasury rate has inverted prior to every recession since 1945 (though to be fair, the curve did invert many times in the 1980’s, 1990’s and mid-2000’s without a recession following). With the curve currently inverted, now from the 3 month Treasury yield almost through the 20-year Treasury, this indicator suggests a higher probability of a recession.

On the flip side, the Labor Market Indicator suggests ongoing economic strength with initial jobless claims remain near all-time lows. Additionally, Claudia Sahm of the Federal Reserve has a recession indicator that has signaled each of the seven recessions since 1970 within five months of their start and without any false signals. Basically, it looks for a 0.5% rise in the three-month average unemployment rate above the unemployment rate’s low for the past 12 months. Right now, this reliable indicator says a recession within the next year has only a 10% chance of occurring.

Rising Unemployment Claims Have Preceded Past Recessions Additionally, the Leading Economic Index, published monthly by the Conference Board, tends to decline in the lead-up to a recession and isn’t signaling any such downturn quite yet. More specifically, the index is composed of ten variables covering production, employment, consumption and financial conditions. This index and labor market data both suggest that a near-term recession is not that likely, even if a slowdown in the economy’s rate of expansion does take place.

Next to consider are confidence measures—both business and consumer confidence, which are currently giving conflicting signals. Business confidence is most prominently measured by the Institute of Supply Management’s Purchasing Manager’s Index (PMI), which shows whether the manufacturing sector is contracting or expanding.

In May, the manufacturing PMI continued the downward trend that has been in place since late 2018, falling to its lowest level since before Trump’s election in 2016. The silver lining, though, is that the index is still in expansion territory—barely. Consumer confidence, on the other hand, is extremely strong.

Finally, we must evaluate the global economic picture which plays a substantial role in U.S. markets. Global PMI has fallen into contraction (below a reading of 50) due primarily to a slowdown in Europe and China. The European economy has been stagnant for some time and manufacturing indices have been in contraction for some time. Germany, Europe’s strongest economy, has seen contractions in its manufacturing indices for nearly a year. China, the world’s second largest economy, has been similarly weak for over a year as both internal monetary policy and increasing U.S. tariffs have slowed growth.

It’s worth noting that China, even with its slowdown, is still projected to have the highest GDP growth of any major economy. Put together, it’s evident that the global economy is slowing. Given that more than 50% of S&P 500 revenues come from abroad, investors must determine how much of the international malaise will flow through domestically.

Forecasting recessions is extremely difficult, and digging into these key indicators has perhaps, more than anything, served to illustrate just how challenging it can be. While correctly identifying a coming recession can help investors preserve their wealth, over-reacting to a false-positive recession forecast can do the opposite.

U.S. High Yield Spreads Are Not Indicating Signs Of Stress Despite the rising risks, the probability of a recession in the near-term seems unlikely. This mixed picture may make the current trade war, whose duration or path is basically impossible to predict, the main determinant of the timing of the next U.S. recession. Investors should keep an eye on these key indicators, particularly since numerous warning flags are waving—and be mindful of the potential portfolio effects.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.