Many signals are pointing to a coming U.S. recession. None of these have been perfect. Still, the evidence is mounting that the U.S. could see a recession in the medium term, or, perhaps one is already here. However, a recession may not be quite the bad news to markets that it may seem based on recent negative stock performance. The metrics to watch, include the yield curve, price action for stocks, Google search activity, recent GDP data and the current macroeconomic environment. Unfortunately, none are too encouraging.
An Inverted Yield Curve
Often when the yield curve for U.S. Treasury bonds has a downward slope, that can predict a recession. That event occurred earlier this year. It may happen again by around the fall if the Fed continues to raise rates, according to current market expectations. This metric has a strong historical track record, though a recession often occurs 12-18 months after the inversion of the yield curve.
A Bear Market In Stocks
About two thirds of the time, a bear market leads a recession. However, there are a few examples of bear markets without recessions. This occurred in the 1960s. We’ve also seen quite a few recessions without bear markets such as in 1990, so the link isn’t decisive.
So bear markets for stocks increase recession likelihoods. This link isn’t too surprising because the stock market is a sophisticated forecasting mechanism. Recessions often cause earnings of companies, and hence their valuations, to fall. So the stock market suggests a reasonable chance of a recession and there’s a reason to pay attention to that signal. It also shows how its hard to effectively time the market, because yes a recession may be coming, but perhaps it’s already been priced in to stock prices.
Google Search Activity
Google search activity for the term “recession” in the U.S. is peaking. This was the case around the last two U.S. recessions. However, the timing here isn’t always perfect. Search activity for recessions often rises several months before a recession hits.
Plus of course, Google search data has a fairly short history compared to the U.S. economy, so we can’t test the effectiveness of this method on too many U.S. recessions. So this metric is less decisive, but still doesn’t bode well.
High Inflation And Low Unemployment
Researchers at Harvard have shown that the combination of high inflation and low unemployment, just as we’re currently seeing in the U.S. predicts recessions. This is in part a reaction to the Fed raising interest rates. Rising rates have historically has often come ahead of U.S. recessions. The Fed is currently on a steep rate hike path, and as much as they may want to see a soft landing for the economy, that’s often very hard to pull off. This is another sign that a recession could be coming. This assessment broadly overlaps with what the yield curve is suggesting.
Negative Q1 GDP
It’s also important pay attention to negative Q1 GDP growth. In some sense this was due to unusual swings in trade, and perhaps omicron disruption early in 2022. However, a recession is often defined as two quarters of negative growth. It’s possible that simplistically with one quarter of negative growth in the books for 2022 we’re halfway there. The Atlanta Fed’s ‘GDPNow’ estimate of Q2 GDP currently is flirting with negative growth. This suggests that there’s a reasonable chance we may be in a recession right now, though economic forecasters are more optimistic that Q1 was just an anomaly and growth will resume in Q2.
Reasons For Optimism?
With all these metrics suggesting doom and gloom, are there any reasons for investors to be optimistic? Here it’s important to note that the last two recessions in the U.S. have been unusual in their extreme impact. The pandemic recession was unusually disruptive and the recession before that was unusually severe and long-lasting. So this time maybe we’ll see a softer recession as has been the case for quite a few post-war recessions.
Furthermore, no indicator is perfect, just about every recession indicator has been wrong before, or has been unable to predict the timing to within a year or two. Those sorts of margins of error can make a big difference. Knowing a recession might coming in 2024, isn’t massively helpful.
Finally, the stock market sell off has been fairly extreme over recent months. The market’s fear level is apparently extreme currently and the VIX as a measure of volatility implied by the options market is elevated. That’s to say that much of the assessment above is perhaps already assumed in stock market pricing to a greater or lesser extent. If a recession comes along it won’t be a complete shock to financial markets, especially if it’s mild. In fact, a recession, especially if it helps subdue inflation, may prompt the Fed to cut rates and that could be quite a positive for markets.