Oct 072019
 

How to spot the warning signs of a looming recession

Last year I wrote a blog post explaining that a recession may not be far away. A recession is 2 consecutive quarters of negative economic growth. The indicators at that time were still questionable. But fast forward to today and wow, the signals have become much clearer! Here are 10 economic indicators that strongly suggest a U.S. recession could be imminent.

recession indicators to keep an eye on

  1. Inverted yield curve
  2. Unemployment rate reaching an inflection point
  3. The long term unemployment is flattening out
  4. Declining GDP growth
  5. Lower expectations for corporate earnings
  6. Manufacturing index PMI falls to 10 year low
  7. Global uncertainty index at all time high
  8. Declining Cass Freight Index
  9. The Fed Bank of New York drastically raised the likelihood of a recession
  10. Rising auto loan delinquencies

Additional breakdown of each of the 10 indicators below.

The yield curve has inverted

The graph below shows the difference between the 10 year treasury yield and the 2 year treasury yield. The yield curve tends to get flatter when the economy reaches the end of an expansion cycle. The vertical gray bars on the graph represent periods of recession. How reliable is this indicator? Over the last 50 years, every recession was preceded by a yield curve inversion. 😮 The graph dropped to below 0% earlier this year in March, officially inverting the yield curve. According to Credit Suisse, a recession occurs about 22 months on average after a yield curve inversion.

US 10 year treasury against 2 year treasury yields from FRED

 

The unemployment rate is bottoming out

A lower unemployment rate is good for the economy. But at the end of every full employment cycle is a sharp increase in the civilian unemployment rate, usually accompanied by a recession. When we last looked at this graph in 2018 the unemployment rate was at 4% and heading down. Today it is lower at 3.7%, a 50 year low in fact. Practically speaking it cannot drop much more than this. Historically we can see in the chart that after the lowest point in each employment cycle, the unemployment rate shoots up abruptly, usually coinciding with a recession.

Unemployment rate cycle against past recessions. The correlation is very clear.

 

Long term unemployment is hitting a low point

Similar to the previous metric, this one shows the number of civilians who are unemployed for longer than 6 months. This chart has nearly 70 years of data. After each time this number falls over multiple years it eventually changes course and moves back up, often very quickly.

Notice how every steep move upward is almost always accompanied by a recession? The number has fallen from nearly 7,000 in 2011 to about 1,200 now. The rate of decline has slowed down lately, signalling a possible reversal soon, leading to millions of Americans losing their jobs, and a recession.

Showing the correlation between long term unemployment rates and U.S. recessions

 

GDP slow down

Gross domestic product in the U.S. is slowing. The economy expanded by only 2% in the second quarter of this year. 2% is the lowest growth rate since 2018. One quarter isn’t a solid trend to look at. But it’s worth thinking about since GDP ties in with other economic indicators.

A recession is defined as 2 quarters of negative GDP growth.

 

 

Lower estimated corporate profits

According to Factset, there are more S&P 500 companies that have issued negative earnings guidance (82) than companies that have issued positive earnings guidance (only 31.) Wall St. is also lowering growth estimates. Last December, analysts estimated S&P 500 earnings growth for the year would be around 7.6%. That’s a pretty typical growth rate in a normal economy. But that number has now fallen to only 2.3%. 🙁

Things are looking especially bad for the 3rd quarter of 2019. In December 2018, the estimated earnings growth rate for Q3 2019 was 3.4%. But by June 2019, the estimated earnings declined to -0.3%. Ouch. Stock market valuation is based on earnings growth so this does not look good for equity investors.

business profits are expected to slow down

 

Manufacturing in decline

The ISM Manufacturing PMI in the US slowed to 47.8 in September 2019, dropping to the lowest level in almost 10 years. It is down from 49.1 in August, and from 51.2 in July. This trend is not anyone’s friend. Any reading below 50.0 means contraction.

Manufacturing sector is a good bellwether for the economy in general

 

Uncertainty index at all time high

The Economic Policy Uncertainty Index measures policy related worries around the world. It reached an all time high of 348 in August 2019. It’s hard for society to prosper when people feel uncertain about economic policies.

As policy uncertainty rises the risk of political and civil unrest increases as well, which could lead to economic turmoil.

 

Continuing decline of the Cass Freight Index

The Cass Index is a monthly measure of rail, trucking, and air freight volume. It declined 3% in August from a year earlier marking 9 straight months of decline. Although not a perfect predictor of GDP, the Cass Freight Index does correlate with GDP growth as we can see in the graph below comparing the two, signaling a possible economic contraction soon.

The cass shipments index may be used as a forward indicator for the general economy

 

Recession probability model skyrockets

Based on the spread between the 10-year and three-month Treasury yields, the regional Federal Reserve Bank of New York compiles data about the likelihood of a recession in the next 12 months. Usually a recession would occur when the probability rises to 35% or higher. According to its latest chart, the NY Fed believes there is a 37.9% chance of recession in the next year. This is a dramatic increase from a 10% chance just a year ago, and represents the highest probability since the previous recession in 2008, which this model correctly predicted. (Grey bars represent recessions.)

This chart is over 85% accurate in predicting past recessions

 

More auto loans are delinquent

Over the past decade the auto loans and leases outstanding have ballooned to $1.3 trillion, a 76% increase. Of those $1.3 trillion, 4.64% are more than 3 months delinquent. That’s a record of $60.2 billion. Borrowers struggling to make their payments on time is a bad sign, and can put a serious drag on the economy.

Final verdict 

I’m not an economist, but it seems to me like the U.S. economy is showing some signs of weakness. Recency bias causes us to more prominently recall and emphasize recent events than those in the distant past. But looking at economic data that spans many decades like we did today can help put things into perspective. Although history doesn’t repeat itself exactly, there are still trends and recognizable patterns that we can use to help us make better long term decisions. 🙂

Investing is a lot like being a blind person at an orgy. There’s a lot of uncertainty, and you just have to feel things out for yourself. 🙂 But being able to recognize some red flags may help prevent any uncomfortable mistakes.

Even though ten recession warning signals are already flashing red, we can’t time recessions with complete certainty. Predicting a market downturn is easy. The hard part is predicting when. The most we can do against uncertainty is to positions ourselves accordingly with the proper asset allocation and try to protect our downside. Given what we know so far, I would put a 70%+ chance that a recession will start in the U.S. before the end of 2020.

 

 

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RICARDO

Never knew that Morticia was such a philosopher. Will have to re-watch the Adams family again!

ddivadius
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ddivadius

Interesting analysis. What is your prediction for how big the hit to the S&P would be? >30%?