How Can You Tell If a Recession Is Coming?*

By Mitchell J. Smilowitz, CPA

While there’s no sure-fire way to predict a recession, economists follow these eight indicators to forecast whether a recession is coming. There is no agreement as to which indicator is most important and the order of the indicators in the article does not reflect significance.

The Unemployment Rate

Rapid increases in the unemployment rate can signal a recession on the horizon. One method compares the current unemployment rate (based on a 3-month average) to its low point in the previous 12 months (also based on a 3-month average). A gap of 0.3% indicates an elevated risk of a recession. A gap of 0.5% means that the downturn has probably already begun.

Unfortunately for recession prognosticators, the unemployment rate is a lagging indicator; it is unlikely to be the first sign that a recession is coming. What it lacks as an early warning of a recession it makes up for in reliability. The unemployment rate almost always spikes in a recession and rarely rises much without one.

• The unemployment rate, currently at 50-year lows, does not signal a recession.

The Yield Curve

When long-term interest rates on 10-year Treasury Bonds fall below the interest rates on three-month bonds, economists say that the yield curve has inverted. Investors generally demand higher interest rates for tying up money for longer periods of time; therefore long-term rates are generally higher than short-term rates. When investors see the economy slowing down, they are willing to accept lower yields for the safety that bonds generally provide. While an inversion of the yield curve has preceded the last several recessions, some analysts believe it may be less relevant in today’s low interest rate environment.

• The interest rate on 10-year Treasury Bonds briefly  fell below interest rates on short-term bonds in August. As of September, however, the yield curve is no longer inverted.

ISM Manufacturing Index

The Institute for Supply Management (ISM) Manufacturing Index is a true leading indicator of a recession. It is a survey of purchasing managers at major manufacturers about their company’s orders, inventories and hiring. ISM creates an index based on this data. Readings above 50 indicate the economy is growing; below 50, it is contracting. The index rarely falls below 45 without a recession occurring. ISM releases the data early each month. As manufacturing shrinks as a component of the American economy, however, the ISM Manufacturing Index may become less effective in forecasting a recession.

• The ISM Manufacturing Index in August was 49.1, its lowest level in the last 12 months.

Consumer Sentiment

The American economy is driven by consumer spending. When consumers stop spending, the economy is probably already in a recession. Economists and policymakers follow two surveys to gauge consumer confidence: the Consumer Confidence Index® produced by the Conference Board and the University of Michigan’s Index of Consumer Sentiment. Because measures of consumer sentiment can vary greatly from month-to-month, economists look at year-over-year variation. There’s no specific level of change that foreshadows a recession, but a year-over-year decline of 15% is reason for concern.

• As of September 2019, the University of Michigan Index of Consumer Sentiment shows an 8.1% year-over-year decline. The year-over-year results from the Conference Board’s Consumer Confidence Index® shows a slight increase in consumer confidence.

Temporary Staffing Levels

When companies expand, many rely on temporary workers; they are easy to hire when demand is high and easy to fire when business lags. This simple relationship makes temporary staffing levels an effective indicator of business sentiment – and the possible approach of a recession.

• Temporary staffing is near a record high, but growth is slowing.

The Quits Rate

When workers are confident that they can find another job, they are more likely to quit their current position voluntarily. The quits rate reached its low point shortly after the Great Recession ended.

• The quits rate rose steadily after the Great Recession of 2008, but is leveling off.

Residential Building Permits

Residential building permits are generally issued several weeks before construction begins. This makes them a leading indicator for the economy. Historically, the issuance of new residential building permits has decreased before recessions begin and increased prior to the economy’s emergence from recession. Residential construction makes up a smaller proportion of the economy today and housing starts never fully recovered from the Great Recession so this indicator may have less power in predicting an economic slowdown.

• Residential building permits have generally declined since their 5-year high in March 2018, though they did increase in July 2019.

Auto Sales

Like residential building permits, sales of new cars are an indicator of economic performance. After housing, cars are the most expensive item consumers purchase. When people purchase new cars (vs. used), it’s a good sign for the economy. Retail auto sales are generally highest before a recession and decline rapidly once a recession begins.

• U.S. new vehicle sales in August 2019 increased 8.1% from July 2019 and 10.9% from August 2018.

Forecasting a recession is as much art as science. None of these eight economic measures, on their own, can accurately predict every recession. Some economists place more faith in one set of indicators; others choose a different array. Understanding indicators improves your ability to evaluate what commentators are saying about the economy.

For long-term investors, the best hedge against a recession is your asset allocation. A diversified asset allocation that balances your financial goals with your comfort with risk should allow you to weather recessions while benefiting from periods of economic expansion. To discuss your asset allocation, contact the JRB via email or call 888-JRB-FREE (572-3733). 

_{*This piece summarizes an article appearing in the July 29, 2019 issue of The New York Times.}