News in Charts: Recession spotting

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

Economists and investors do not have a particularly strong track record of forecasting the timing of recessions. Trying to predict them is important, however, because they will typically signal a turn in the monetary cycle, which should lead to an improvement in sentiment towards risk assets. In this note we assess what some of the indicators are suggesting about the likelihood of an imminent US recession.

After two consecutive quarters of falling GDP, the US economy is already in recession by one commonly-used yardstick. But this rule of thumb is less useful than it was, not least because falling trend growth across the advanced economies over the last 20 years has rendered two consecutive quarters of falling output both more likely and less damaging than before. The National Bureau of Economic Research (NBER) has a business cycle dating committee dedicated to identifying the peak and trough months in US economic activity. Exercising a degree of judgment based on various indicators, the committee identifies recessions as a significant decline in economic activity across the economy, lasting more than a few months, that occurs after a peak. Its judgments are however usually issued long after the event.[1]

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In search of timelier ways of tracking recessions, Fathom has analysed how several key indicators have behaved, on average, either side of the peaks in economic activity identified by the NBER that preceded past US recessions. With personal consumption accounting for close to 70% of all expenditure in the US economy, unsurprisingly the peak in consumption typically coincides with the peak in economic activity, and is not a useful forward marker.

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Both investment and equity prices can provide a warning sign, however, with investment typically peaking one quarter before and the S&P500 seven months before the peak in economic activity. US investment fell in 2022 Q2, while the S&P500 reached a peak in December 2021; so both of these series are behaving in a way consistent with US economic activity peaking about now. But they are both volatile series and will behave like this at other times too. As Paul Samuelson observed in 1966: “The [US] stock market has forecast nine of the last five recessions”.

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Nevertheless, other indicators are flashing red, including the slope of the yield curve (ten-year minus two-year treasury yields), and expected new orders in manufacturing as recorded by the Empire State survey, both of which are at levels that in the past have signalled recession.

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At the time of Fathom’s last Global Outlook, finalised in early June, we saw around a 40% chance that the US would be in recession by Q3 of this year; we are likely to revise up this probability in our Global Outlook, Autumn 2022.[2] If the US does enter recession, history suggests we should expect to see a sudden drop in payrolls employment, of the order of 50,000-100,000 within a single month, and a much larger fall in private investment than we saw in Q2. Thus far, the labour market has been showing significant resilience. Nonfarm employment increased by 528K in July and by 437K on average over the latest three months.

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All in all, a number of indicators currently suggest that activity in the US economy may have peaked, although some of these have given false signals in the past. At the same time, the developments in some indicators are not consistent with a recession. Nevertheless, we suspect that there is an increasing risk of recession in the third quarter. Key for a more constructive outlook for risk assets is whether this leads to a major pivot in terms of monetary policy.

[1] Business Cycle Dating Procedure: Frequently Asked Questions | NBER

[2] Fathom’s Global Outlook, Autumn 2022 will be available for all Refinitiv users via Chartbook from October. For a breakdown of key topics we will be discussing this quarter, please see here: https://www.fathom-consulting.com/wp-content/uploads/2022/08/Global-Outlook-Autumn-2022-web.pdf

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