3 Recession Indicators We’re Watching

3 Key Recession Indicators We’re Watching

If bestowed with a crystal ball, there are plenty of things we’d be interested in learning. Indeed, over the course of the last few months, uncertainty about the future has been a constant theme during meetings with clients and colleagues. There’s plenty to consider: market volatility, political uncertainty, trade disputes, currency fluctuation, and a steady flow of economic data points – all of which can be dissected and analyzed any number of ways. One key concern is the risk of recession – a contraction of growth, spending, and economic activity in the business cycle – which could lead to more significant and sustained decreases in stock prices.

As investment management professionals, part of our mandate is to evaluate the potential for continued growth in the near term while keeping an eye out for trouble on the horizon. Indeed, there is much data that suggests the US economy remains strong, and that stocks will continue to enjoy appreciation in the near term. Still, we are watching a number of data points for signs of a recession that would lead us to assume more defensive positioning.

So, what are we looking for?

Historically, there have been three key data points that tend to predict or coincide with an economic recession:

 

The Yield Curve

The shape of the yield curve – the difference in the yields, i.e., interest rates, between a 2-year Treasury bond and a 10-year Treasury bond (the “2-10 spread”) – has been a reliable leading indicator of recession in the past. Currently this difference is 0.2%, down from over 2.5% back in 2014. This means the yield curve is “flat,” as short and long rates are pretty much level. An inverted yield curve – when short rates are higher than long rates – is what could be a predicator of recession. As long as the spread is positive, as it is today, this indicator does not suggest that a recession is imminent. But – we’re watching closely.

 

Employment

Employment data can also serve as an early warning sign of an economic recession. Many investors pay close attention to the current percentage of the workforce that is unemployed. But this tends to be more of a coincident (or even lagging) indicator than a leading one. Observing changes in the unemployment rate can be useful, though: the specific event to watch for here is when the 3-month moving average of the unemployment rate increases by more than 0.3%.  For this to happen from today’s levels of unemployment, monthly net job gains would have to fall to 100,000 for a continued 3-month period – down from the current 200,000+ level. Hence, at present, this indicator suggests that the economy is still healthy.

 

LEI Composite

The Composite Index of Leading Indicators (a.k.a. Leading Economic Index, or LEI) is a composite of ten indicators measuring the health of the US economy. The composite is comprised of data such as manufacturers’ new orders, average weekly hours, new residential building permits, and even the speed of delivery from suppliers to vendors, to name a few. When taken together, these data points represent a snapshot of spending, investing, employment, and other economic activity. The LEI, based on a formula and represented in numerical form, has historically been a reasonably accurate predictor of recession. Specifically, the LEI crossing zero into negative territory has, in the past, preceded economic recessions. While the LEI has weakened from its highest levels in 2018, it today remains above 4.0, which is generally considered to be a healthy sign.

 

Of course, every rule has its exceptions and as such, we avoid making decisions that hinge on individual signals. While these key indicators are integral to our investment team’s regular and ongoing dialog, they are only a part of the myriad factors that inform our ongoing risk assessment and asset allocation outlook. First and foremost, however, portfolio positioning must reflect the unique needs of the investor.

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