Recession Ahead? Here’s the Latest View from the Capital Markets

Is a recession coming?

We are getting that question a lot now because there are conflicting signals. An article[1] in last week’s Wall Street Journal captured the uncertainty well: “Conflicting Surveys Paint Mixed Picture of Service Providers.” It highlighted how one well-respected survey showed a thriving economy while another equally respected survey indicated a struggling one. What to do?

It’s as if you are driving a car, with the view in the rear-view mirror being sunny, the side windows being an odd mix of storm clouds and sun, and the view ahead through the windshield being blocked.

Predicting the direction of the economy reliably, and the timing of economic change, is notoriously difficult. Much of what is to come depends on future decisions, like what the Fed does with interest rates and level of confidence among consumers.

Still, there are clues available that help provide insight. We can look to the capital markets (stocks, bonds, commodities, but also housing and labor). They can be emotional and noisy, but they also provide certain indicators that, when combined, tend to paint a reasonably reliable forecast of what might come in 12-18 months.

We believe these indicators, when viewed collectively, reveal a high probability of recession in 12-18 months. Current signs are that it could be relatively mild, although there are wildcards which may further shape the trajectory.

THE INDICATORS: A SUMMARY

Equity Markets

• We believe stocks are expecting at least a mild recession already, as well as rising (but not surging) interest rates. At their lows in June, the S&P 500 was down 23% and the tech-heavy Nasdaq 100 down 33%–both within the historical range of roughly 10%-40% often associated with recession cycles. NOTE: Remember that stocks are forward-looking and typically do WORSE in the 12 months before recession than during recession itself[2]… and just because they are down does not guarantee recession on their own.
• Defensive stocks have done best year-to-date, signaling a cautious outlook.
• Economically sensitive sectors, especially homebuilders and leisure (resorts, cruise lines, etc.) are down 33% and 26% year to date at 9/6. They are already pricing in some degree of bad news from these companies in the months ahead.

Bond Markets

• Bonds, in our view, are beginning to forecast recession but not stagflation. Inverted yield curves[3] (over a meaningful period) have a strong historical record of predicting recessions, and some important curves (the 1Yr- and 2Yr yield curves vs. the 10YR, respectively)  have inverted since early summer. Another important curve–the 3-month yield vs. the 10-year–has not inverted yet; inversion there would make the signal more certain.
• At the same time, bond markets do not expect runaway inflation; the Treasury market anticipates inflation to fall to 2.3% in two years. This is in stark contrast to reported CPI of over 8% today, and core CPI of over 5%. We interpret bond markets as saying that prices will naturally soften with Fed policy and slowing activity. This would be positive, in our view.
• Also on the positive side, bonds show confidence in corporate balance sheets; credit spreads (a measure of risk of defaults) have risen but remain within normal bounds.

Other Indicators

• A respected survey from the Conference Board[4] shows several months of declining activity along key metrics. Sustained weakness over multiple months tends to be a reliable predictor of recession historically. Reported weakness since March raises the probability of recession in 12-18 months, in our view.
• We have been following the Quits Rate in labor markets for some time, as a possible read on confidence among workers as they leave one job for a perceived better one. That rate remains strong at 32% (within a historical range of 15% to 36%), indicating confidence, although it is starting to decline.

THE WILDCARDS

The story continues to unfold, of course, as the capital markets assess and react to developments. We see three main wildcards that should determine the course of events for the next six months:

1. Inflation: Will it remain more entrenched than bond markets currently forecast? It should continue to fall, perhaps to 4%-5% by year-end, but a higher, sustained rate would be negative for stocks and bonds. It would mean the Fed will have to push harder to fight inflation, slowing economic activity more than currently expected.
2. US Consumer: Will the consumer maintain a strong spending rate? We are starting to see slower activity in some sectors, a natural extension of higher prices. Markets are expecting slowing spending already, as housing weakens and higher rates take hold. But slower activity has not yet fully appeared in corporate earnings forecasts yet, in our view.
3. Non-US Economies: Economies outside the US are having a tougher time already. High energy prices in Europe, sustained relative strength of the US Dollar, and property challenges in China could ultimately put pressure on the US as well. Non-US economies are likely to enter recession sooner, with inflationary pressures on higher imports and energy prices, which would spill over into the US.

IMPLICATIONS

From an investment standpoint, we began making changes to portfolios last summer, fall and early spring as the risks and opportunities around rising rates and slowing growth emerged. Please see our June commentary and November 2021 note (last section) which recounts those decisions. If your risk profile is aligned with your medium- and long-term goals, we do not recommend making changes at this time. For long-term investors, we see attractive opportunities today, recognizing that calling a bottom is not possible.

More importantly, we believe the capital markets help each of us make adjustments for the coming year, in the event that recession materializes. We recommend being proactive rather than reactive to the economic news.

For families and institutions relying heavily on withdrawals from portfolios, the adjustments depend on lifestyle, spending, and intended legacy.

For business owners, it means evaluating the liquidity, cash flow, risks and opportunities of the business—as well as assessing the degree of the owner’s financial independence FROM the business. Ultimately, through sound planning, business owners can use economic dislocation to manage their business, to become stronger as a result. Even if recession does not occur meaningfully, it’s a good practice.

Separately, we will be writing a note on proactive ideas and best practices for both families and business owners. Meantime, please speak with your adviser if you have questions or would like further details on this outlook.

[1] WSJ on September 6, 2022.

[2] History shows that over the 11 recessions since 1950, the S&P 500 performed worse in the 12 months before recession in seven of those occasions. Ironically, in three of those cycles, the S&P 500 posted POSITIVE returns before and during recession, indicating that equity markets are not always good leading indicators. Importantly, in the 12 months after recession it was up in all but one of them (2001). See this article from Forbes which offers a good review (April 2022).

[3] An inverted yield curve in bonds is when shorter-term yields are HIGHER than longer-term yields. When economic growth is steady and expected to continue, bond yields are generally upward sloping, meaning that investors in longer term bonds expect to be compensated for the risk of receiving their principal at a future date. When the economic outlook worsens to the point of pessimism, the slope of the yield curve can be downward sloping (inverted). Over the past six months, short term rates have risen faster than long term rates as the Fed begins raising rates to tame inflation, at the increasing risk of driving the economy into recession. This is creating an inverted curve between certain maturities (the two-year vs. the ten-year yield, for example) but not yet in others (the 3-month vs. ten-year yield).

[4] The Conference Board is a wide-followed nonprofit organization that issues monthly reports on various economic indicators, including Leading Indicators, Concurrent Indicators, and Lagging Indicators. The reports help observers define where we are in economic activity, and what might be coming.