The market selloff in December caused a lot of people to get really bearish really quickly. The following chart, from Google Trends, shows that searches for “recession” hit a five-year high last month. And it’s not just the average Google user who is increasingly worried about an economic downturn: a recent survey of U.S. CFOs found that 49% expect a recession in 2019 and 82% expect one by the end of 2020. Is there any substance to these concerns? Or is it just a case of fear-mongering by the media?
The New York Federal Reserve publishes an index, shown below, of the probability of a U.S. recession within the next 12 months. Currently, the index is at 21.4%, its highest level since August 2008. This index is based on the spread between the 10-year Treasury bond yield and the 3-month Treasury bill yield. A rule of thumb for some recession watchers is that when the yield curve inverts (when long-term bonds yield less than short-term bonds) a recession is likely in the near-term.
Source: Federal Reserve Bank of New York
You may be wondering why this rule of thumb exists. Well, yields are determined by investors. If these investors drive down long-term yields, this suggests they expect the Federal Reserve (which sets short-term rates) to cut rates in the future, in response to a recession. So it’s basically just a big survey of some (presumably) smart investors.
At least, that’s the predominant theory. There are other possible explanations, but we won’t bore you with the minutia of this economic debate. In reality, most people look at yield curve inversion as a recession indicator because it has done a good job of predicting past recessions. The next chart shows the 10-year yield minus the 2-year yield. You can see that almost every time it has gone negative, a recession has followed. However, it is important to stress “almost”: there are periods of inversion that weren’t immediately followed by a recession.
The Federal Reserve has also cited credit spreads as a possible recession indicator. Specifically, it cites the excess bond premium, which is a metric that attempts to capture investors’ risk sentiment towards corporate credit. By this measure, shown in the next chart, recession risks currently look quite low.
Another metric that some observers cite is employment. Critics of using employment point out that it is a lagging indictor (while the data is released monthly, it is for the previous month’s employment levels), so it isn’t very helpful when making predictions. As highlighted by the following chart, however, the change in employment has had some predictive power. As it stands now, employment is still growing, perhaps allaying some recession fears.
The stock market is thought to have some predictive power when it comes to recessions. The next chart shows that negative GDP growth, on average, has followed years of stock market losses. And with the S&P 500 dropping 6% in 2018, some are taking that as a sign a recession is on the horizon. That said, stock indices have fallen in many years when a recession has not followed. This observation has led to the overused joke that the stock market has predicted nine of the last five recessions.
Source: RBC U.S. Equity Strategy, Haver, S&P
So will there be a recession in 2019? We don’t know, but hopefully now you can appreciate why we’re pleading ignorance. There are many metrics that have done a good job of predicting past recessions. But there are also ample reasons to doubt that these same metrics will be able to tell us when the next recession is looming. The only prediction we’re comfortable making is that there will be another recession, and when it arrives we will not be deviating from our investment approach of holding investments for the long-term.