Critical Recession Warning Signs

Three to watch for

Erik Norland, Senior Economist, and Bluford Putnam, Chief Economist, CME Group
Originally published in the October 2018 issue

The next recession: What are the warning signs?  What might it look like?  How will markets react? The nearly decade-long U.S. economic expansion may look a little long in the tooth, but it is not about to end due to old age.  Economic expansions need a catalyst that triggers a downward spiral of consumer and business retrenchment.  The most common recession catalyst for the United States has been the collision of rising interest rates with heavy debt loads, corporate valuations that appear to have run ahead of free cash-flow generation, or both.  Add trade tensions and geo-political uncertainties, which may work to slow global growth and – at first glance – it might seem like the current situation has the potential to trigger a recession.

While the current environment ticks off all the items on this list, that does not mean a recession is in the cards.  Indeed, equity markets have been placid thus far in 2018.  After a brief volatility spike in January, implied volatility has subsided to near record lows for equities, many related financial products and precious metals.  So far, neither markets nor U.S. macroeconomic data for labor markets or consumer confidence are flashing any signs of concern.

Our focus in this report is three-fold.  First, we want to examine the recession risk signals and evaluate the probabilities of a downturn coming in the next year or two.  Our conclusion is that recession risks are steadily rising, with a 33% probability of a recession coming in the next 12-24 months.  Second, based on our understanding of possible catalysts, we will look at the likely character of the next recession.  In this regard, the next recession is unlikely to look anything like the last one with its financial panic, mortgage crisis and failing banks.   The next time around, there might be parallels with the late 1990s when rising rates, emerging market currency disruption, and over-stretched corporate valuations led to a set of feedback loops that upended consumer confidence and resulted in sharp pullbacks in business spending.  Finally, we will review how markets might react – equity correction, bond rally despite debt loads, commodity weakness, and possibly a shift to a weak-dollar environment.

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