The signs that tell you a recession is coming

There's a growing change the UK will slip into recession this year as the Bank of England wages war on sky-high inflation. The central bank has increased the Bank Rate to 5 per cent, shocking markets with a 0.5 percentage point increase, as it tries to depress rising prices.

However, the higher rates go, the more likely the UK economy slips into a 'technical recession', as money is sucked out of the economy to cover more costlier debts, such as mortgages, and lending falls, as it becomes more expensive to borrow.

An economy is in recession when it has seen at least two consecutive quarters of economic contraction – or negative growth – in gross domestic product (GDP). However, the problem is that waiting for this quarterly data takes many months, meaning that the start and end points of recessions are usually only identified long after the fact.

This is a problem for investors because identifying the beginning and end of a recession matters. According to CIBC Asset Management, markets tend to trough long before economies do, but there hasn’t been a case in the past 50 years where markets bottom out before the recession starts. Knowing whether a recession is under way would give us an indication of whether the conditions for a market bottom really have been met. But that is easier said than done.

First to broader macroeconomic indicators. In the US, economists at the NBER use a wide range of macroeconomic indicators to define a recession. These include real personal incomes, employment figures, consumption expenditure, retail sales and industrial production. A deterioration in any of these figures can indicate an economic downturn – and, crucially, they can all be monitored through monthly releases. 

Though quicker than waiting for quarterly GDP releases, these macro indicators only tell us what has already happened. Forward-looking survey data can give us a sense of where the economy is heading next. 

Purchasing Managers Index (PMI) data is a widely used survey measure. Businesses are asked to report on conditions over the past month, plus give an indication of how they expect output to change over the coming year. PMIs are produced for various sectors of the economy, and ‘composite’ PMIs provide a weighted average of manufacturing and service sector data. ‘Flash PMIs’ are released early each month, when 85 per cent of responses are in. A figure below 50 indicates a contraction, and is historically consistent with recession risk.

The PMI is not the only survey of business sentiment: other widely noted examples include CBI surveys in the UK, and the Empire State Manufacturing Survey, Philadelphia Fed Manufacturing Business Outlook Survey and the Chicago Fed Survey of Economic Conditions in the US. Consumer surveys also provide a valuable source of real-time information, gauging how consumers see their economic prospects developing. The UK’s GfK Consumer Confidence Barometer is closely followed, as are the Michigan Consumer Sentiment and Conference Board Consumer Confidence surveys in the US. 

It goes without saying that ‘hard data’ (official macroeconomic releases) and ‘soft data’ from surveys don’t always tally. In this cycle, sentiment has deteriorated faster than macroeconomic data – although the latter will probably catch up. 

There are also composite indicators, which collate a range of data points to gauge when an economic turning point is approaching. The OECD publishes a range of country-specific leading indicators, which for the UK includes new car registrations as well as the performance of the FTSE 100. In the US, the Conference Board publishes a leading indicators index (LEI), which covers 10 components, including the performance of the S&P 500. Historically, the LEI tends to peak around 11-12 months ahead of a recession – and the last peak was in February 2022. 

Looking at the bond market

So-called yield-curve inversions are also a popular recession indicator. A curve inversion means that investors earn higher returns on short-term bonds than longer-term ones, and is usually seen as a sign of choppy economic waters ahead. The gap between 10 and 2-year borrowing costs (the 10-2 year yield spread) and the 10-year-3-month yield spread are closely watched by many economists. 

The yield curve has a pretty good track record of predicting past downturns, but is less good at indicating when a recession might hit: for the US, research suggests that it could be anywhere between 6 and 24 months after the curve inverts. It is also worth noting that we might sometimes ascribe it too much predictive power: the US yield curve briefly inverted in 2019, but the pandemic-induced recession that followed was something that no one had foreseen.