5 Indicators That Might Tell You About A Recession Before It Happens
Predicting market moves is difficult and we should not try to time the market. But there are several indicators which could serve as so-called “early warnings indicator” as they could indicate a recession and bear market before it happens.
It is important not to look at these indicators in isolation as single indicators are more likely to produce false signals. The bigger picture is important and when several indicators are all pointing towards a recession, we can be more confident about that prediction being correct as if only one single metric is indicating a recession while all the other indicators are pointing in different directions.
In the following article I will present 5 indicators that could serve as early warning indicators for a recession.
Housing Market: Permits
A first early warning indicator is the housing market. Huge investments — and building one’s home is the biggest investment most people will make in their life — are often delayed or cancelled when times are tough from an economic standpoint. And the permits for new houses are the first step — preceding the actual construction process — and are therefore among the best indicators for the housing market.
Fluctuations for this numbers are rather the norm and therefore a declining number for some months does not necessarily have to indicate a recession. It is important to see a sharp decline, that is happening quite fast. You must look at the numbers of past recessions to get a feeling how the numbers must decline to indicator a recession.
So far, the numbers declined about 17.5% from 1,896 million in December 2021 to 1,564 million in September 2022. This is not the same steep decline we saw before past recessions, but it is a warning sign and aside from the COVID-19 crash it is the steepest decline since the Great Financial Crisis.
Labor Market: Initial Claims
Aside from the housing market we can also look at the labor market. And one of the first numbers to react to a potential recession is the number of individuals who filed for unemployment insurance for the first time during the past week (the so-called initial claims). As the weekly numbers are quite volatile, we rather look at the four-week moving average. The indicator is certainly not the best, especially as the numbers leave room for interpretation. We must interpret the changing numbers from week to week but the risk to misinterpret numbers that just increased for a few weeks is rather high.
And since April 2022 we see a clear increase from 170k to about 250k, but right now the number is declining a bit again. This could be the turning point indicating an upcoming recession, but it is hard to be sure by just looking at the initial claims. However, I am pretty sure it is indicating a recession — as it is being in line with many other indicators.
ISM Purchasing Manager Index
The ISM Purchasing Manager Index is based on data from purchasing and supply executives nationwide. Purchasing products is among the first steps in every production process as raw materials have to be purchased before anything can be produced or sold by a company. Hence the buying decisions of these managers — and a consequence also the ISM PMI — is reflecting a change in sentiment before many other indicators show the economy shifting. And a PMI reading below 50 indicates that the economy is declining and heading towards a recession.
In the last few months, the PMI fell from above 60 — the highest reading since the 1980s to slightly above 50 and a number below 50 is indicating a declining economy (and the likelihood of a recession). However, when looking at the data above, we see the PMI being below 50 countless times and in most cases a recession didn’t follow. In cases of a recession, it usually declined to 40 or lower. Right now, the PMI is sending warning signs, but is not clearly indicating a recession.
CPI / Inflation
One of the better early warning indicators is the consumer price index (or the year-over-year change of that number, which is known as the inflation rate). The consumer prices index (CPI) is measuring the monthly change in prices the U.S. consumers must pay. It is calculated by the Bureau of Labor Statistic by calculating the prices for a basket of goods and services and focusing on 8 major categories (including apparel, transportation, communication, medical care, food, and beverage as well as housing).
Simply put, a high inflation rate preceded almost every recession since the early 1960s. And especially when the CPI rose above 5%, a recession followed every single time. Of course, there were two instances when the CPI hardly increased (and did not get above 5%) but a recession happened anyway — the recession following the Dotcom bubble and the COVID-19 recession.
Right now, the CPI is around 8.5% (and therefore clearly above 5%) and we can be quite confident a recession will follow in the coming quarters. Additionally, we witnessed one of the sharpest increases in inflation (from zero to almost 10% within two years) in the last few decades, which is also not a good sign.
Yield Curve
The last — and probably best — early warning indicator is the inverted yield curve. The yield curve is a line that connects bonds (in our case U.S. treasury bonds) that have equal credit quality but different maturity dates. Usually that line is an upward sloping curve (as bonds with a later maturity date should have a higher interest rate) but when the line is inverted it is indicating trouble for the economy.
And to make it simpler we are looking at two metrics — the 10-year treasury yield minus the 2-year treasury yield as well as the 10-year treasury yield minus the 3-months treasury yield. We simple can watch out for the two metrics falling below zero. And especially the 10-year minus 3-months was an extremely reliable indicator with hardly any false signals since the 1970s.
While the 10-year minus 2-year yield already declined below zero a few months ago, the 10-year minus 3-months yield followed in the last few weeks. And with both clearly declining below zero we can call the yield curve inverted and a recession will follow with a high probability in the next few quarters.
Conclusion
Right now, it seems highly likely that the United States will enter a recession next year as basically every major early warning indicator is pointing that way.
