If There is a Recession Coming, How Can We See it Before it Happens?

by Tony Wyman


June will mark the 10th anniversary of the end of the Great Recession, the longest and deepest economic downturn this country had seen since World War II.  Unemployment doubled, housing values dropped 30%, the S&P 500 declined 57% and U.S. households lost $14 trillion of wealth, more than 20%, during the nearly 19-month decline.

SInce then, the country has enjoyed one the longest periods of expansion in the nation’s history, thanks to the aggressive and unprecedented responses by fiscal and monetary policy makers in the Bush and Obama administrations that saved the country from possibly slipping into a depression and primed it for one of the largest economic expansions in American history.

But, of course, this long period of expansion has economists, business planners and investors wondering when the next recession will arrive.  It isn’t a question of whether we will have a recession, they say, but when.  After all, there have been at least 47 recessions in American history, averaging 22 months in length, meaning the U.S. has been in a recession more than 35% of its lifespan.  So, when is the next one hitting?

Back in December 2018, Politico ran an article called “Trump Advisers Fear 2020 Nightmare: A Recession,” which listed a handful of things indicating a recession may be heading the president’s way before the 2020 election begins in earnest. It also quoted economic advisers to the president, like Stephen Moore, a conservative commentator the president recently nominated to fill an open spot on the Federal Reserve Board, and Larry Kudlow, Director of the National Economic Council, both of whom claimed there was no recession anywhere in sight, thanks to the Trump Administration’s handling of the economy.

“Anytime you see the stock market fall by 1,400 points in two days, there is lots of nervousness,” the article quoted Mr. Moore as saying, referencing stock market volatility late in 2018 that had spooked investors. “But the economy is fundamentally strong in terms of construction, manufacturing and corporate earnings. I don’t think they are worried about a recession.”

“I am amazed at this miniwave of recessionary pessimism that has swept the media,” Politico writer Nancy Cook quoted Mr. Kudlow as saying during an event at the Wall Street Journal.  “The evidence is quite different than these speculations. We are humming.”

But, despite the optimism of Trump Administration figures, it is a matter of time before the American economy takes a breather.  Here’s some things to look for so that you are out in front of the next economic downturn:

The Quits Rate

As strange as it may seem, when the economy is strong and workers are confident in their employment prospects, the number of people quitting jobs goes up. Why? Because in a strong economy, there are more open jobs available for those seeking advancement or higher pay.  But, when the economy starts to slow, one of the first indicators predicting a downturn is the quits rate, the percentage of workers leaving one job for another one.  Workers spooked by a troubled economy are less likely to gamble on a new job and stay, instead, in the one they already have, causing the quits rate to drop.

As shown in the chart below, the number of workers quitting jobs plummeted during recessions and slowly rebounded at the economy regained its health.

Quits Rate chart
The Quits Rate is used by the Bureau of Labor Statistics to determine how many people are quitting their jobs during a given month. Economists use it as an indicator of the strength of the economy and of the job market when making projections.

During and following the Great Recession, the quits rate went from a high of 2.2 in 2007 to a low of 1.2 in August 2009.  It took until January 2017 for the rate to climb back up to the 2007 level of 2.2.  Today, the rate sits at an 18-year-high of 2.3.  While this is good, the problem is, the rate has been at 2.3 for eight straight months, the third time since 2001 that the rate has stagnated for so long.  If it stays at 2.3 in February, that will be the longest period of stagnation since the Fed started keeping records.

While the rate remains at the highest point its reached since May 2001, economists are waiting for the February and March numbers to see where the trend is going.

The Hires Rate

Like the quits rate, the hires rate reflects the way companies see the future of the economy.  Companies that are optimistic about the future, that have growing backlogs of orders and strong demand from customers, create new positions and hire more employees than ones that are pessimistic about the years ahead.

Hires Rate Chart
The Hires Rate reflects the number of positions companies fill during a given month. The higher the number, the more positions are created and filled. When the rate climbs, economists believe business is optimistic about the future.

The current hires rate is 3.9, which is strong.  And it has remained between 3.6 and 3.9 since August 2014, strong job growth levels for nearly five years, accounting for why unemployment reached a record low of 3.7% last Fall.  If the rate remains steady, that indicates businesses no real directional change in the economy.  Conversely, if it falls or climbs, businesses believe the economy is either weakening or strengthening, depending on the direction the numbers take.

The Yield Curve

Undoubtedly the most watched indicator by economists of the direction the economy is going, the yield curve is, simply, the difference between the returns on three-month and ten-year treasury bonds.

The New York Fed maintains a probability chart based on the yield curve that currently shows the chances of a recession over the next 12 months at a little over 27%.  This is up from 23.6% in February and the highest it has been since July 2008.  It is important to note that the New York Fed rated the chance of a recession prior to the Great Recession at 39.4% and the highest it has scored the chance of a downturn was 46.3% in Dec 2001.

Recession probability chart
The New York Federal Reserve Board maintains a chart predicting the possibility of a recession 12 months in the future based on the spread between the rates of return on 3-month and 10-year Treasury bonds.

Also important to note, the spread between the return on 3-month bonds and 10-year bonds inverted in late March for the first time since 2007.

When the spread “inverts,” it means the rate paid by the 3-month bond is actually greater than the rate paid on the longer-term issue.  Under normal circumstances in a healthy economy, longer-term investments are typically riskier than short-term ones, so investors require a greater return in exchange for buying the 10-year bond.  When the return inverts, that indicates the market believes short-term investments are riskier than long-term ones.

While this inversion doesn’t mean a recession is certain, it is one of the stronger indicators that economists watch that the market believes a downturn is pending.

The reason why the inversion of rates is so important has to do with lending and the impact that the availability of money has on the economy.  Banks borrow money at short-term rates and lend it out at long-term rates.  When the short-term rates at which banks borrow climb, it becomes less profitable and, in turn, more risky, for them to loan out money.  When the yield between short-term and long-term rates inverts, there is no profit incentive for banks to loan money at all. In response, banks stop lending money to businesses, who, in turn, cancel expansions and other plans that fuel economic growth.  The lack of growth stalls the economy, sinking it into a recessionary period.

Historically, every recession since the Great Depression has been preceded by an inversion in short- and long-term rates.

Business Confidence Index (BCI) and Consumer Sentiment

The BCI is created from surveys down by businesses expressing their opinions about the future of the economic climate, particularly relating to future growth and development, production rates, inventories and order backlogs.  As the BCI is a survey, it is less reliant on hard data, relying, instead, on business sentiment.  Economists take this into account when assessing the value of the data.  That said, the BCI is often matched with consumer sentiment to determine if there is a disjunction between the attitude of business leaders and those of consumers that could predict a change in economic futures.

BCI
The BCI remains about 100, which indicates optimism, but the index has lost all the gains it made since the election of Pres. Trump.

Billionaire investor Jeffrey Gundlach, in January 2019, called the gap between consumer sentiment and business expectations, the biggest since March 2001, a major indicator of an impending recession.  “The most recessionary signal at present is consumer future expectations relative to current conditions. It’s one of the worst readings ever,” he tweeted.  And, while Mr. Gundlach doesn’t believe the gap is an indication a recession is imminent in the short-run, he believes there are indicators “turning yellow” that one is coming in the long-run.

“I think right now it’s too early to say that we have the necessary conditions in place for a recession on the foreseeable horizon, which is good news,” he said in an interview with Yahoo Business. “But the bad part of that news is the foreseeable horizon is typically no longer than six months, usually, more like four to six months.”

The gap that concerned Mr. Gundlach grew to its widest point in January when the BCI was at 116 and consumer sentiment plummeted from 98.3 to 91.2.  Since then, consumer sentiment climbed to 98.4 in March, up from 93.8 in February.  According to Bloomberg News, the jump in sentiment was attributable to “a sizable jump in income expectations among middle and lower earners” after hourly pay rates increased by the most since 2009.  Low gas prices and interest rates also played a part in buoying consumer sentiment, as did a rebounding stock market.

Temporary Employment Levels

When businesses hits hard times, the first employees to feel the pain are the temps.  After all, companies have the least invested, both financially and emotionally, in temporary workers.  So, when orders dry up and the future looks bleak, the workers whose names no one bothered to learn are the first shown the door.

Temp worker chart
The number of temporary workers climbed above the three million level for the first time ever in May 2018 as demand for workers remained strong.

The ranks of temp workers hit an all-time high in December 2018 when 3.06 million Americans received paychecks as temps.  The number has since dropped, as it does after the Christmas season, to 3.031 million workers, but that number is still significantly higher than historical averages.  While unfilled job openings remain high and unemployment flirts with modern record lows, the number of temporary workers shows no sign of decreasing.  And while that may be in part due to new strategies by businesses to invest in fewer permanent workers, it is also a sign businesses still have confidence in the future of the economy, at least in the short run.

Layoffs and Jobless Claims

The last two indicators to look for when trying to foresee the arrival of a recession are the most depressing.  Nothing is worse in a recession than the number of people forced out of work by a downturn in the economy.  When jobless claims and layoffs go up month after month, it is past time to worry about whether a recession is coming or not; it is time to start preparing for it, because it is coming.

Jobless claims chart
Historically, the highest numbers of workers seeking unemployment benefits typically happens at the end of a recession, rather than at the beginning. This makes unemployment claims numbers an unreliable indicator of a future downturn and a better predictor of improved conditions ahead.

Companies struggle in good economies to find enough skilled workers to fill their payrolls, so the last thing they do is let hard-to-find talent go, even when things slow down a little.  So, if companies have gotten to the point where they need to lay-off large numbers of workers, things have gone south for that business.  And when businesses all over the country start cutting their payrolls, an economic contraction is right around the corner, if it hasn’t already arrived.

The problem as you can see in the above chart is the peak of unemployment claims tend to happen at the very end of a recession, not at the beginning.  Jobless claims are, therefore, a better indicator of when a recession is about to end than one warning the country of one about to happen.

Recessions are Hard to Call

The problem with trying to predict a recession is, even for the best economic minds, it is a very hard things to do. The sheer size and complexity of the American economy alone makes the task of determining with any real certainty what direction consumers, businesses and workers will go over the months ahead.  Add to that the fact that our economy is tied closely to the global one and things getting even tougher to predict.

“Recessions are hard to predict until they are upon you,” said Nobel Prize-winning economist Robert Shiller.  “Remember we’re trying to predict human behavior and humans thrive on surprising each other…Economists are like weather forecasters.  Weather forecasters can go out a few days. Economists can go out months, but going out a year or two they get really iffy.”

 

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