Seven Reminders While on Recession Watch

In recent months, the consensus of economists has become less certain about the outlook for a recession in the U.S. economy. A recent survey asking economists about the probability of recession next quarter shows a retreat in expectations from a high of 47 percent at the end of 2022 to just 34 percent, according to the Philadelphia Federal Reserve.

It’s not hard to see why recession expectations have changed. The typical follow-through from leading indicators to coincident indicators has not happened. Coincident data is slowing generally, but not as quickly as leading data would have suggested. For example, when the 6-month annualized change in the Conference Board’s Leading Economic Index (LEI) has fallen below -5 percent for the first time, it has typically taken coincident data – like employment and income – between six and seven months to turn negative, on average. It’s been 13 months since the LEI has breached those levels, and the rate of change in coincident data is still mostly positive.

Because of this, it remains too early to confidently forecast a recession. But with stock market valuations still extended, recession remains one of the biggest risks stock investors face. So, as we all remain on recession watch, here are some ideas to consider on the topics of recessions, stock market performance around economic contractions, indicators to watch, and risks to consider.

1) A recession would bring three horsemen to the stock market’s front door

In his new book on longevity, Peter Attia outlines a framework for extending one’s lifespan. He suggests that the most effective approach is to establish early-life habits that can help prevent or delay the onset of the conditions he refers to as the “Four Horsemen.” His Four Horsemen are: heart disease, cancer, neurodegenerative disease, and type 2 diabetes. This line of thinking about longevity can be applied when considering which risks most frequently bring bull markets to their end.

Here are my suggestions of the stock market’s Four Horsemen: extended valuations, interest rate pressures, recessions, and sudden, destabilizing events (like a global pandemic). We already have two in place. A recession would join with extended valuations and the recent steep rise in interest rates. This collection of three of the four Horsemen would likely topple the extended rebound from last October’s low.

How do the two Horsemen already in place look today, relative to history? Valuation Strains, in the left panel below, are illustrated by the ratio of non-financial market-capitalization to GDP, made popular by Warren Buffett. While valuations are lower than their peak levels of last year, they remain elevated when compared with history. The right panel, in blue, shows a measure of interest rate pressures. The 10-year interest rate is up more than 360 basis points over the past two years. That’s the largest increase in 40 years. Moreover, rates have advanced from extremely low levels. To capture this, the blue line measures the advance in rates from the prior two-year low, as a fraction of the ending yield. Using this method, interest rate pressures are just shy of the record surge last year.

Valuations Strains