There is no standard formula that defines what a recession is. A generally accepted principle is that it involves a significant and prolonged decline in economic activity, usually with two consecutive quarters of falling real gross domestic product accompanied by rising unemployment. In the US, there have been 13 of these downturns since World War II. Most were brief and shallow, although some, like the 2008 financial crisis, were quite severe and lasted longer.
One source of concern is that these effects can become self-sustaining and generate a negative feedback loop if left unchecked. For instance, a persistent weakness in demand can lead businesses to fire workers as they scramble to slash costs, which can eventually depress consumption even further, and boomerang back to strike down employment in a vicious cycle.
To prevent this from happening and avoid economic catastrophes, governments and central banks have taken the responsibility of stabilising the economy when needed. The classic recipe once a crisis hits is that the central bank cuts interest rates to stimulate borrowing and investment, while the government rolls out powerful spending programmes or tax cuts to refuel demand.
Leading indicators flash warning signs
Investors typically estimate the probability of a recession by analysing leading economic indicators. Some of the most prominent are business surveys, consumer confidence metrics, housing sector data, and inventory levels. These indicators have a solid track record of identifying turning points in the economic cycle before they happen, in contrast to official government data that is often lagging and backward-looking.
Looking at any single leading indicator in isolation can be misleading, and oftentimes they send conflicting signals. That said, when several of them point in the same direction, their predictive power increases, putting investors on high alert that trouble is on the horizon. One leading indicator flashing red is not overly worrisome, but five of them make a royal flush.
As far as leading indicators go, perhaps the most popular method for predicting recessions is an inversion in the yield curve. When longer-term interest rates on government debt fall beneath short-term ones, it indicates that bond traders are betting the central bank will be forced to cut interest rates in the future to deal with some economic shock.
Such an inversion has preceded every US recession since the 1950s, so the yield curve is considered one of the most accurate forecasters of economic downturns. The main drawback is that this indicator has also generated false signals in the past, warning of a recession when none happened.
That said, there haven’t been many incorrect signals, hence why investors pay such tremendous attention to the yield curve.
The New York Fed has a model that utilises the yield curve to calculate the likelihood of a US recession, specifically by looking at the difference between three-month and 10-year treasury yields (see Fig 1). This model currently attaches a 58 percent probability to a downturn over the next 12 months, much higher than what it estimated before the ‘dot com’ or the 2008 crashes.
A crucial aspect of the yield curve that is often overlooked though, is that the curve un-inverts just before a recession actually begins. This dynamic reflects the fact that once the economic data pulse truly weakens, traders start betting on the central bank cutting rates immediately to help the economy, which drags short-term yields down. In other words, a yield curve inversion signals that storm clouds are gathering, but only when the yield curve steepens again is the recession just around the corner.
Luckily we have not reached this point yet. The curve is still inverted and the inversion continues to deepen, reaching its most extreme levels since the 1980s. Therefore, the US economy is not about to fall off a cliff just yet. Unfortunately, the longer the curve remains inverted and the more extreme the inversion becomes, the more reliable is the signal that there is economic pain in the pipeline.
What pushes an economy downhill?
Several factors can cause an economic downturn. Wars, banking crises, natural disasters, excessive debt levels, asset bubbles bursting, and energy shocks are among the usual suspects. Sometimes these elements can even join forces, inflicting a double whammy on the economy.
In this case, however, it is mostly central banks threatening to torpedo the economy. The Fed has embarked on an exceptionally aggressive tightening campaign, rolling out a series of rapid-fire rate increases in order to slow demand and ultimately crush inflation. This process inevitably involves some economic hardship, and even the Fed’s own research staff recently projected a ‘mild’ recession to start later this year.
With interest rates rising so quickly, the first cracks in the economy are likely to show up in debt markets. Consumer debt levels exploded after the pandemic to hit new record highs in late 2022, with credit card debt in particular rising at a dramatic pace as people struggled to afford increasingly expensive necessities like food or energy.
Credit cards charge consumers exorbitant fees to borrow money, often exceeding 20 percent in annual interest rates. As such, there is growing concern that households are approaching a breaking point, something evident by the rising trend in delinquencies. While US consumers still have excess savings left from the pandemic, that safety cushion is quickly being drawn down and by most estimates will be depleted by the end of this year.
Can a strong jobs market save the day?
One ray of hope comes from the labour market, which continues to fire on all cylinders. The unemployment rate is near five-decade lows, open job positions in the US economy far exceed the number of people actively looking for jobs, and applications for unemployment benefits remain historically low. By every metric, businesses are still competing to attract scarce workers.
At first glance this incredible strength in employment implies that recession fears are overblown. After all, when jobs are plentiful, people spend that income and consumption in the economy is sustained. It’s difficult to have a crisis when the economy is at full employment. The problem with this argument is that the labour market is always at its strongest right before the economy crashes.
Employment is effectively the last domino to fall in every economic cycle. It is one of the most lagging economic indicators, as it takes a long time before rising borrowing costs translate into job losses. By the time unemployment begins to rise, the economy is usually in a recession already. Therefore, labour market indicators typically have limited predictive power.
Instead, a more formidable tool is corporate earnings growth. The usual pattern is that an ‘earnings recession,’ that is a decline in corporate profits for two consecutive quarters or more, usually precedes a slump in the real economy. Unfortunately, this process is already underway. Corporate earnings on Wall Street contracted in the final quarter of 2022 and, according to analysts, the decline is set to persist for another two quarters in the first half of 2023.
Even so, investors have not hit the panic button yet. Stock markets have been remarkably resilient in the face of a plethora of negative events, from the energy crisis to the turmoil in the banking system. Most of this durability likely stems from the colossal liquidity injections by central banks in the aftermath of the banking episode, which helped calm nerves in financial markets. The question is what happens once this liquidity ‘sugar high’ fades, especially in an environment where equity valuations are stretched and arguably disconnected from economic fundamentals.
Don’t fear the reaper
Now to be clear, a recession is not a foregone conclusion. There have been three instances over the last century where the Fed managed to raise interest rates without inflicting severe damage on the economy, most notably in 1994–95 under Chairman Alan Greenspan. This is the famous ‘soft landing’ scenario that the current Fed wants to emulate. It is certainly possible, although history would caution it is not very likely.
On the bright side, a recession is not the end of the world. Every crisis ultimately passes and most downturns in the past were relatively mild and short-lived. The 2008 collapse was a once-in-a-century outlier, not the classic template. This might be particularly true this time, as the economic slowdown is driven mainly by policy decisions, not some external shock. If the Fed is engineering a period of weakness to squash inflation, it can also turn the ship around before it sinks.
From an investment perspective, there is great opportunity in a crisis. Investors that manage to keep their cool in a panic environment are often rewarded with attractive entry points for the long term. In past cycles, markets usually bottom out a few months before the real economy does, so paradoxically, the best time to invest is when the economy is at its worst. Even in the financial world, it is darkest just before dawn.