What’s that coming over the hill…is it a recession?

When speaking with clients, one of the first questions being asked at the moment is: do you think we are entering a recession? No single indicator, or even combination of indicators, will provide fool-proof predications of economic recessions. However, some may be more informative than others. The answer is also a long one and will vary depending on the region you are talking about, the time frame in question and a raft of unknown unknowns. So what tell-tale recessionary signs are we looking at within markets?

Yield Curve

A headline grabbing statement used frequently when discussing imminent recessions is ‘yield curve inversion’. Simply put, this is when the yield, the interest rate governments borrow at, of a shorter maturity government bond, say 2 years, is greater than that of a longer maturing bond, say 10 years. The logic is that markets expect longer-term interest rates to be lower than those in the more immediate future, an indication of economic pullback. Chart 1 shows the 2/10 yield curves for the US  government bond market. As you can see, these move negative (or invert) ahead of a recession, indicated by the grey shading. This sometimes happens many years ahead of a recession, defined as two consecutive quarters of negative growth.

Chart 1: US  2/10’s

The Federal Reserve prefer to use the short end of the curve (the first 18 months), which is the implied 3-month yield in 18-months’ time less the current 3-month yield. This curve (Chart 2) is yet to invert, suggesting on this measure that markets do not believe a recession is imminent. It has, however, moved substantially.

Chart 2: US 18 month forward 3 month, less 3 month

Earnings

Expectations for earnings, the revenue and profits a company makes from providing goods and services, are slowly being downgraded by analysts. Chart 3 shows the revision ratio, for which a number below 1.0 indicates more companies are having their earnings downgraded versus upgraded. Earnings for the next 12 months are expected to grow in the UK, Europe and Japan, and are actually improving from a low base in Asia and China. Chart 4 shows the 3 month change in those 12 month projections, where a positive figure shows an improving earnings outlook. In most cases, after nearly 2 years without a summer holiday and with a difficult winter ahead, the consumer is likely to do everything in its power to keep spending habits up this summer, especially on services. Beyond that is more uncertain, and will depend on the damage to real incomes caused by current high rates of inflation.

Chart 3: Earnings Revision Ratio

Chart 4: 3-month change in 12-month forward looking earnings

Source: Refinitiv Datastream & MAPM (M&G Investment Office)

Typically, earnings fall in the region of 30% during a recession and, currently, we are a long way from that. Nevertheless, we are watching the Q2 earnings season closely and listening out to what companies are saying about their costs, employees and, of course, the consumer.

Economic data

GDP data is published infrequently, and often with a time lag, but is very detailed. For a temperature check on economic activity, monthly survey data can provide a good indication of current momentum. In Chart 5, the US manufacturing survey data (US ISM – companies complete anonymous monthly surveys on a variety of business health measures) is shown in coral and, with a reading above 50, indicates mild economic growth. MSCI World equity performance over 1 year is shown in teal, and suggests that markets are more pessimistic on the outlook than some forward looking economic data is currently implying. Other high frequency economic indicators include consumer sentiment indices, retail sales, and PMI New Orders.

Chart 5: US ISM vs MSCI 1Y%

Some sound economic theory and various commentators have highlighted that, with such a strong labour market, the US is on a sound footing - at least for the time being. However, labour market expansion has never been a particularly good leading indicator for recession (see Chart 6).

Chart 6: US Non-Farm Payrolls

Instead, one interesting concept to monitor focuses on temporary workers. This is because businesses preparing for a significant slowdown will typically look to offload their temps first. As Chart 7 shows, we might be seeing the first signs of this plateauing, although post-COVID working flexibility may mean this series becomes more sensitive than in the past.

Chart 7: US Temporary Workers

As a team, we also monitor real time indicators like restaurant bookings or mobility data.

Commodities

Commodities are physical assets, typically raw materials that are consumed directly or as a building block to create other materials. They are also quite wide-ranging in nature and do not all behave in the same way when a recession is lurking around the corner. The chart below shows Brent Oil (coral), and Copper (purple) prices plus a broad Commodity basket index (teal) through time. In previous recessions (grey bars), these all typically fell, to varying degrees. Only Copper has retraced meaningfully in 2022 so far, and, while Brent is typically down over 60% in a recession, in 2022, it is off only 15% from its highs. Commodity prices have also fallen when a US recession was avoided, so proceed with care.

Chart 8: Commodity price and index moves

Property

The latest US house price data shows a slight slowdown, however, compared to history, prices are still rising at substantial rate. Although falling prices can indicate a weak consumer and economy, US house prices falling does not always indicate a recession (2010 to 2012) and recessions can occur even with buoyant prices (early 2000).

Chart 9: US House Prices

The National Association of House Builders (NAHB) is an index which rates homebuilders’ views of current and future sales traffic, where a reading below 50 indicates contraction. With sufficient headroom above 50 but falling confidence (as shown by the coral line in Chart 10 below), this measure suggests a slowdown on the horizon, but rubber stamping a recession seems premature.

Chart 10: NAHB Index versus housing starts

If you are interested in knowing more about recessions indicators and our latest thoughts please reach out to your Business Development Manager or request a call back.