Roth: What are the warning signs of a recession?

You have been hearing more about the dreaded economic “R” word: recession. Many Wall Street analysts and economists are now increasing their expectations for a recession, so how concerned should you be?

While there are often clear indicators that point to the economy’s future, many of those indicators have been substantially disrupted by the fiscal, monetary, and other policy decisions made over the past couple of years. So, while certain economic warning signs may be flashing red, based on the overall backdrop of the economy, today they are a bit more difficult to decipher.

Additionally, what is a recession? Recessions are declared by the National Bureau of Economic Research, usually after they happen. The bureau's website says the “traditional definition of a recession is that it is a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” While they usually look to three “D” factors — depth, duration, and diffusion — extenuating economic situations can change that. The economic areas that are evaluated include inflation-adjusted or “real” GDP, real income, employment, industrial production, and wholesale and retail sales.

Given all of that, here are some things to watch for.

The consumer, the consumer, the consumer

Looking to the consumer is important for predicting economic decline, because consumer spending accounts for about 70% of economic activity. Declines in consumer confidence can become a self-fulfilling prophecy, as concerns about a recession can lead to consumers cutting back their spending, which can then lead to a recession. Key areas of weakening consumer spending, such as declines in car sales or housing sales, are often leading indicators, as is a weakened consumer financial position. Increasing defaults on credit cards, mortgages, or other loans and increasing delinquency rates often point to a recession.

What we know today is that the consumer is under a lot of pressure due to inflation. The personal saving rate has dipped down to 6.3%, below February 2020 pre-COVID levels. The University of Michigan Consumer Sentiment Index dipped to its lowest in more than a decade in March 2022. Credit card balances were up a whopping 20.7% in February, according to the Fed’s recent Consumer Credit data release. Retail spending is up, but the growth is slowing. So keeping an eye on future reports and trends is critical.

Changes in inflation, including commodity prices

Changes in inflation, including rapid inflation, can be a sign of a pending recession. Increasing commodity prices, which are obviously linked to inflationary pressures as they trickle through the economy, can also flash a warning sign.

Obviously, those indicators are definitely not bullish for the economy. Inflation is at the highest levels in four decades, and commodity prices are continuing to add to costs throughout the supply chain, impacting consumers.

Yields on U.S. Treasuries

Followers of the markets often look to the bond market as a prognosticator of economic strength. For example, in the Treasury market, the relationship between the yield on the U.S. two-year note and the U.S. 10-year note is evaluated. The yield is the return you receive from your investment in the note or bond, expressed in percentage terms. If you think about risk, normally it is riskier to hold bonds for longer periods of time, so you would demand a higher interest and overall return as a risk premium than you would for a note that is shorter in duration.

The further apart the percentage yields between the short-term and longer-term notes are, the steeper the yield curve. As the yields get closer together, the yield curve is said to flatten, and that is a sign that investors believe there is a lot of short-term economic risk (i.e., worry about a lack of economic growth).

When the yield curve inverts, meaning investors are demanding a higher yield for two-year notes versus the longer-term 10-year notes, that is looked at as a potential recessionary indicator. While there are other reasons for inversions, the Wall Street Journal has reported that an inverted yield curve has predated every recession.

The yield curve recently inverted in early April, and the spread between the two rates currently stands at around a positive 34 basis points (100 basis points is equal to 1%).

By the way, the bond market is not the only recession indicator. Illiquidity and weakness in the stock market can signal declining confidence in the economy or other systemic issues that can indicate or lead to a recession.

Slowing of manufacturing

This is fairly self-explanatory, but obviously if manufacturing is slowing, it is because there is an expectation that consumers and businesses will be buying less.

Currently, the ISM’s Manufacturing Purchasing Managers Index (PMI) for March showed a reading that was expansionary, but that had slowed over February’s numbers.

Obviously, the manufacturing industry is under pressure from continued and new supply chain disruptions, among other factors, which can weigh on the overall economy.

Issues with employment

Unemployment is both an indicator and outcome of a recessionary environment. When you see high unemployment and fewer people quitting their jobs, that is often a warning signal.

That couldn’t be further from the current situation. Given the number of people who left the workforce and similar factors, the unemployment rate as of March is only 3.6%. The most recent data also showed about 1.8 jobs open for every American looking for work. The quits rate, set to be updated later this week, at last count was 4.25 million for January 2022, a robust rate, but the lowest since October 2021. This is equal to about 2.8% of the labor force versus about 1.96% on average over the last couple of decades.

The supply/demand imbalance in the labor market is one that makes the economic landscape so difficult to predict. It is likely we might see more slowing of quits and job movement versus a major increase in the unemployment rate.

Increases in fraud rates

An interesting and perhaps unexpected indicator is fraud. If you remember noted investor Michael Burry of "The Big Short" fame, who was among the first to see (and profit from) the coming collapse in the housing market ahead of the Great Recession financial crisis, he correlates the increases in amount and complexity of frauds, scams, and other illicit activity to economic collapses.

The FTC showed $5.8 billion in fraud losses counted via consumer fraud reports for 2021, an incredible 70% increase over 2020.

Of course, there is also the Federal Reserve’s tightening of monetary policy, meant to slow the economy, which could also cause a recession.

While the economic landscape today has a number of challenging indicators, as you can see, we may not end up with a recession. We could potentially end up with stagflation (a stagnating environment with substantial inflation). While less likely, there is always a possibility we muddle through and return to some semblance of normalcy.

In the meantime, it’s prudent to be prepared for the worst while we hope for the best.