PRISM Macro Insights: Are We Finally Entering the Next Recession? Multiple Indicators Stating Yes.

Last week’s market selloff driven by disappointing economic reports and earnings events have investors turning up the volume on a question that’s been on minds for some time now “Are We Heading Toward a Recession?”. While the answer isn’t entirely clear, some indicators are screaming yes while others give some pushback on the thought.

Inverted Yield Curve Flips

Today the 2- and 10-year Treasury yields flipped from negative to positive for the first time in over two years. When a yield curve becomes inverted it typically indicates the occurrence of a recession will happen. However, when the inverted curve becomes positive again, it’s an indicator that a recession is imminent. A yield curve inversion means that investors are pricing yields on bonds will pay better in the shorter term than the longer term suggesting that they believe their return on the instrument will be less valuable in the future. When the curve shifts back to normal short-term yields are dropping faster than longer ones on expectations the Federal Reserve will cut interest rates to support a weakening economy.  In the past four recessions – 2020, 2007-2009, 2001 and 1990-1991 – the 2/10 curve had turned positive by the time a recession occurred.

Sahm Rule Triggered

Friday’s jobs report came in much weaker than expected. The report cited July nonfarm payrolls growing by 114K m/m vs consensus of 175K as unemployment ticked higher to 4.3%, triggering the recession-predicting Sahm Rule. This indicator signals the onset of a recession and is when the three-month moving average of the U.S. unemployment rate is half a percentage point or more above the lowest three-month moving average unemployment rate over the previous 12 months. Since the early 1970s, the indicator has never been triggered outside of a recession.

A Less Negative Leading Economic Indicator Index

The Leading Economic Indicator Index (LEI) combines 10 economic indicators into one composite index to help predict overall economic performance. This index typically suggests a recession may be coming 11-12 months after the index peaks. Its last peak occurred in 2022 and currently paints a bleak picture of short-term economic growth. The index declined by 0.2% in June. However, The Conference Board’s last report also stated that the six-month growth rate of the LEI has trended less negative, switching off the recession signal.

Are Markets Overreacting?

While the unemployment rate has ticked higher, bullish commentary suggests the rise could be due to higher new/returning entrants that the labor market has yet to absorb rather than solely due to rising layoffs. Additionally, July payroll weakness may also be attributed to weather related hurricane impacts producing temporary layoffs. While some earnings reports received some negative blowback, Q2 EPS growth has been 11.5%, the highest since Q4 2021 and Mag 7 has still produced close to 30% earnings growth. There have also still been some favorable flow trends as US equities have seen inflows for their fifth straight week that has pushed the YTD total above $200Bn. Buybacks have also been above elevated levels from a year ago.

While some bulls are considering this to be more of an overreaction, some indicators are showing more longer-term back data with serious signs that a recession may be here. This week will likely be a quieter week of data and earnings, however, eyes will be on Thursday’s weekly unemployment claims as the markets look for further indicators on the health of the US economy and which direction they can expect it to move.