Recession Indicators Are Sending Warning Signals| Barita Insights | April 11, 2022

Introduction
Throughout most of the developed and developing worlds, inflation has become a matter of grave concern as prices across almost every category of goods have catapulted well beyond the upper limits of Central Banks’ inflation target range. Over the previous decade, following the global financial crisis, the world at large became accustomed to very low inflation levels, a consequence of several factors; chief among which we believe have been globalization and technological improvements. But, much has changed following the pandemic as supply chains that were carved out over several years were dismantled. As pandemic constraints were gradually lifted, nations have realized that the reassembling of these supply chains in mere months has proven difficult to say the least. Added to that, the Ukraine/Russia war has further shaken the globe, mainly through higher commodity prices, worsening what had already been a severe inflationary issue.

Effects
In this world of uncertainty, financial markets have continuously looked at some key indicators. Among these, the Treasury Yield curve has been at the forefront as a time-tested gauge of good times, moderate times, and impending doom (recession). While the economic reasoning for the shape of the treasury yield curve can be argued; statistically, its ability to “predict” recession has been impressive, bar none. On that note, we can revisit some important history where we’ll recall that every recorded inversion of the treasury yield curve since 1955 has been followed by a recession some 6 to 24 months (average of 18 months) after the inversion. This is important as the yield curve inverted temporarily at the end March and at the start of April 2022. Now, with the track record of the inverted yield curve, this presents obvious concerns and the US Central Bank (The Federal Reserve or The Fed) has tried to calm such fears by making it clear that the specific inversion that is typically watched by the market provides no true economic reasoning for a recession. However, the addendum to this is that there is possibly a “reverse causality” effect associated with inversions, as per The Fed. This implies that the inversion itself does not cause a recession, but the market’s expectation of recession (given the historical precedence) following the inversion, worsens what is already an enabling environment.

The enabling environment
But what does this enabling environment look like? Well, with inflation at an uncomfortably high level, The Fed has now positioned itself squarely on bringing inflation down. The typical action to slow inflation is to raise interest rates (increase the cost of borrowing on everyone across the entire economy) and reduce the amount of cash in the financial system. The Fed has committed to doing both but in the past, this has led to some recessions. For greater context, if inflation and inflation expectations are allowed to become embedded with no constraints, it worsens. The Fed and most central banks are therefore the “inflation police” with the mandate of keeping inflation within a comfortable range. The problem, however, is that the policies and tools used to enact the functions of The Fed are blanketed. This simply means it is difficult for the Fed to target specific goods that are seeing runaway prices and so, The Fed is somewhat forced to place a constraint on the whole economy, at large, as opposed to specific goods, sectors, etc. In many historical cases, this attempt at cooling down the economy and therefore, cooling down inflation, has resulted in a recession.

A “soft landing”
The Fed is well aware of this and has communicated to the market that what it aims to do is enact a “soft landing”. That means the Federal Reserve aims to increase interest rates so smoothly that it reduces inflation while GDP growth remains on an uptrend, i.e., avoiding a recession. But to be clear, the likelihood of this happening was tepid early in the year as inflation was already inconceivably high, and growth was already slowing. Added to that, the war in Ukraine and the resulting increase in commodity prices have placed an even greater strain on the growth outlook; an outlook which has been reduced by the entire market. This implies that a soft landing, while not impossible, is likely difficult.

Other Signals are warning
With that in mind, we can revisit the idea of reverse causality because some areas of the market are already somewhat positioned for a potential recession. For example, defensive sectors that typically perform relatively well during recessions are currently leading the market. Further, another less popular but perhaps, more informative curve, the Eurodollar futures curve, has also inverted. These occurrences, and others, have led to the market-implied probability of recession moving from 18% in January and 13% a year ago to its current level of 28%.

Concluding Thoughts
At the beginning of March 2020, the probability of recession was approximately 80% as COVID-19 quickly transitioned from a Chinese problem to a global nightmare. That said, at 28%, there are still significant uncertainties but, in our view, the warning signals are growing more apparent. A recession for the US largely represents a global recession given the country’s importance and reach. While there’s no certainty, particularly considering the inversion did not last for an extended period, we believe investors should begin to consider positioning their portfolios more defensively, with a greater focus on high quality assets.