Key Indicators to Watch for Next Recession

It seemed like just yesterday that the economy was humming, with employment accelerating, orders flowing and consumers releasing pent-up buying demand after two years of pandemic lockdowns and other disruptions.

Now, with the Russian invasion of Ukraine and surging gasoline prices, that outlook doesn't look so reliably sunny as before.  Granted, the economy just grew at a blistering 6.9% annual rat in the fourth quarter, but many things have changed since then, including two more months so far in 2022 of continuing high inflation.  

Few economists have started warning of a recession anytime soon, but the risks are rising.  Here are some key indicators to watch:

Leading Economic Indicator Still Green 

The economy is still growing, and most indicators show that. But most also don't yet reflect the fallout from the Russian invasion and the surge in oil prices over the past couple of weeks. 

A widely accepted gauge for identifying economic turning points comes from the Leading Economic Index, a grouping of ten indicators.  It's still flashing green but less brightly than before.  The index includes a range of statistics tracking manufacturing orders, consumer sentiment, housing building permits, employment, credit/interest rates and more.  

"Widespread strengths among the leading indicators still point to continued, albeit slower, economic growth into the spring." said Ataman Ozyildirim, senior director of economic research at the Conference Board, in a statement.  The group compiles the leading economic indicators. 

The index rose a solid .07% in December after and 0.8% increase in November, but that was followed by a 0.3% decline in January, the first drop since February 2021.

Are Stock Prices Telling Us Something?

Stock prices, specifically those in the Standard & Poor's 500 index, are one of the ten leading indicators.  Stocks are a real-time way to measure the public mood, and they account for a lot of personal wealth.  If the current market slump lingers or worsens, people could feel poorer and might cut back on spending, slowing the economy. 

However, much if not most of this reflects paper losses on what were huge paper gains built up over the prior two years.  It remains unclear whether most investors will start to feel permanently poorer.  

Besides, the stock market isn't a reliable gauge to predict pending recessions.  

Nicolas Colas, co-founder of DataTrek Research, looked at the eight recessions since 1961 and concluded that the stock market's "recession-calling track record is mixed, at best."  Of those eight recessions, a significant market drop correctly anticipated three of those economic declines, but it failed to predict five others, he said.  

In fact, corrections or declines of at least 10% are common, having occurred in 24 years since 1980, about once every other year on average, according to data compiled by JP Morgan Asset Management.  Recessions are only about 1/4 as frequent.  

Foreign Energy Chaos Is Troubling

Unfavorable international developments - wars, currency crises, debt problems and the like - can take a toll on the US economy and send stock prices into a tizzy.  We already are seeing this with the situation in Ukraine, even though neither country is an especially large trading partner of the US.  

Geopolitical events with an international flavor can upset stock market investors, through prices generally recover fairly quickly.  Comerica Wealth Management analyzed the impact of 13 such events starting with the Japanese attack on Pearl Harbor in 1941.

On average, the S&P 500 was up 1.9% within a month, 7.4% within six months and 13% higher within 12 months, though prices still lagged after three of those events (the 1956 Suez Canal crisis, the 1973 Arab oil embargo and the 9/11 terrorist attacks).  The oil embargo, notably, contributed to a deep recession.  

Bad Things Happen When Yields Invert

Another recession indicator is found in interest rate comparisons.  Normally, a given type of bond with a short-term maturity will tend to pay or yield less than longer-maturities of the same bond.  For example, three-month US Treasury bills normally yield less than ten-year Treasury notes, which yield less than Treasury bonds coming due in 30 years.  In this example, the issuer is the same - the federal government - but the yields go up as maturities lengthen.  

There are sound reasons for this relationship.  Investors who go further out on the time scale are accepting more risk, such as the likelihood that inflation could worsen in the meantime eroding the value of their future payments.  As such, they demand higher yields to compensate for the added risk.  They are also facing an inconvenience factor since they won't get their principal back for a longer period. 

Inflation Rate:  CPI Rises at Fastest Pace in 40 Years

Investors often analyze these differences on charts that show a yield "curve" that's normally upward sloping - meaning, for example, that the three-month yield is lower than the one-year yield, which is below the ten-year yield, and so on up the line. 

The key point here is that you don't want to see short-maturity bonds yielding more than longer ones. 

"An inversion of the yield curve has preceded every US recession for the past half century," the Financial Times observed following a partial inversion in December, when twenty-year Treasury bonds briefly yielded a bit more than the thirty-year bonds.

That anomaly has since straightened out, and yields now increase steadily with longer maturities.  But if the curve inverts again and stays that way for weeks or months, it might signal an impending recession. 

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