U.S. recession indicators are flashing warnings. However, there are still reasons for cautious optimism too. When I did a similar analysis at this point last year there was no imminent recessionary concerns, since then things have deteriorated in the U.S. and beyond. We’ll run through where we stand today. However, there is quite a bit of evidence that even if you can predict recessions successfully, then you still may not achieve the holy grail of predicting the stock market. For that, we may be better of focus on simply the U.S. market’s relatively pricey valuation rather than economic forecasts.
The Yield Curve Has Inverted
In 2019 the yield curve inverted. That inversion is now becoming both deeper and broader. This has historically mattered as a recession indicator, though various prominent economists argue that the current state of the bond market with low interest rates may make this time different. Models based on the yield curve today put the U.S. at around a 30% to 40% chance of hitting a recession on a one year view. Remember though, that based on this models the yield curve is telling us both that recession risk is higher than normal, but also that it’s more likely than not that we won’t hit a recession. To say it a different way, at any time there’s around a 1 in 5 chance of a recession next year, currently the chance is perhaps 4 in 10, so even though the chances are higher than normal, it’s still slightly more likely today, that we do not see a recession within a year based on what the yield curve is telling us.
Global Growth Is Slowing
Global economies are intertwined through trade. This means that slowing growth overseas can hurt the U.S. economy. Recently, China, Argentina, the U.K. and Germany have all seen deterioration in growth. Furthermore, there are no real areas of great strength to offset this, the U.S. had a relatively good 2018, but appears to be slowing this year. This doesn’t mean the U.S. will have a recession, but the global trade backdrop is becoming more of a drag. Also, issues such as Chinese trade tensions and Brexit continue to cause concern.
Unemployment Is Robust
Let’s not only look at the negative indicators. Unemployment at the U.S. is currently very low. July unemployment was 3.7%. That’s very low however you slice it. Unemployment is up a fraction from 3.6% in the spring, so if that becomes a trend, that would be a worry. Nonetheless, rising unemployment is a robust indicator that we are in a recession. A reasonable rule is to look for a 0.5% rise in the unemployment rate off the 12-month low, so if unemployment nudges over 4.1% then it’s time to worry. The lag of an unemployment spike suggests that we aren’t in a recession yet. Nonetheless, this is quite a short-term indicator, it will tell us once we’re in a recession. It’s less helpful telling us one is coming.
Recession Talk Is Increasing
Recessions can be self-fulfilling. It is therefore noteworthy that interest in recession-related topics appears to be increasing. Google search activity on recessions has increased recently, perhaps prompted by yield curve inversion. If enough people expect a recession and act accordingly, that may be enough to cause one since relatively small pullbacks in investment and spending can cause recessions if sufficiently coordinated.
What Could Change The Picture?
Growth is slowing across various American trading partners, were these countries to enter recession, that would point to a further negative outlook for the U.S. Also, a deeper and broader yield curve inversion may increase the likelihood of recession. Finally, if unemployment does start to move up that would increase the probability not just that a recession is coming, but that one is here. On the other hand if unemployment remains benign and the Fed’s actions cause the yield curve to regain an upward slope while the international outlook improves then the chance of recession may recede.
Does This Matter For Investors?
Should you worry about recession risk if you’re a stock investor? Recent research suggests perhaps not. A strategy of moving to Treasury bills when the yield curve inverts, tends to underperform simply staying in the market even before considering trading costs and potential taxes. This suggests that the market is pretty efficient. Yes, a recession may be coming or be more likely that normal, but the market may already reflect that information. However, what can be somewhat predictive of market returns over the medium term is valuation levels, and for the U.S. at least those are flashing a warning signal independent of any recession risk. So, we can conclude that recession risk in the U.S. is increasing, though it is unlikely we are in a recession yet. At the moment, the chance we see a recession in the U.S. is about fifty fifty, the same as successfully calling a coin flip. The chances of recession in the U.S. today are higher than normal, but not yet certain. Plus if you’re looking to make a stock market call based on recession predictions, you may end up doing your portfolio more harm than good. If you are worried about the U.S. economy, now may be a good time to check that you are well-diversified, as that can be a smart move in any market cycle, especially after the U.S. market’s great run in recent years.