Are We Entering A Recession? How Investors Know When A Recession Begins

Key Takeaways

• There are five major indicators that signal a potential recession.
• While gross domestic product did have negative growth for two consecutive quarters, we are not officially in a recession right now.
• An inverted yield curve has been a reliable litmus test for signs of a recession.

Many people want to know if the U.S. economy is entering a recession. Many experts have stated that we already entered one this year, as the gross domestic product was negative for two consecutive quarters. But many key economic indicators were not indicating an immediate recession. Here are the main signals of a recession so you can better understand when the economy slides into one.

Signs of a Recession

The potential for a recession is one of the biggest news headlines of late. Some financial experts feel that it’s a certainty, while others aren’t so sure. What is certain is the fact that the economic indicators for a recession are making themselves known. However, as of now, they have yet to coalesce into an economic environment that’s definitive.

To call a recession, all of the following elements must be present to one degree or another, and there must be 6 months of economic contraction. They include:

• A slowdown in consumer spending
• A spike in unemployment
• The slowing of manufacturing activity
• A drop in personal income through job loss
• An inversion of the yield curve

So far, some of these elements still don’t qualify, and it remains unclear when or if they’ll strengthen or disappear altogether. During past recessions, all five elements were present, with everyone from consumers to corporations feeling the pain of an economic slowdown.

Consumer spending slows

Consumers slow down spending to hedge against a reduction in employment hours or job loss. They also reduce spending because of higher prices due to inflation. The savings rate increases, and people feel they have less discretionary money to spend. However, the end of the third quarter of 2022 shows that consumer spending continues to move higher, signaling the strength of the consumer’s financial position.

Related to consumer spending is the gross domestic product (GDP), which increased by 2.6% after two consecutive quarters of decline. Consumer demand is a significant part of the gross domestic product measurement. Had the GDP declined for a third quarter, it would have signaled that a recession was likely. However, the upturn in the third quarter signals that a recession really hasn’t hit yet.

Unemployment spikes

Corporations quickly reduce their workforce in reaction to an adverse economic event. A recent example is the housing industry. The Federal Reserve sharply raised interest rates and caused several mortgage originators and real estate builders to lay off thousands of employees. The tech industry is reacting to reduced revenue and trying to control costs before laying people off. However, employment has risen despite the layoffs in certain industries.

It remains to be seen if unemployment numbers will spike due to the unique situation after the pandemic. Industries are losing people to retirement, disability from long COVID, deaths from the pandemic, and employment shortages. An average of 420,000 jobs were added each month so far in 2022, with the unemployment rate hovering around 3.5%. Many believe that businesses are reluctant to lay off workers because it has been so challenging to find quality workers that stay.

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Manufacturing activity slows down

Manufacturers slow down their production processes in response to reduced demand for their goods. Reduced demand typically comes from inflation and consumers spending less money. However, the current reduction in manufacturing output is primarily due to overenthusiastic buying by retailers and supply chain disruptions due to the pandemic. Major retailers failed to factor in the effect of stimulus money on people’s ability to purchase high-ticket goods and the saturation rate for said goods.

The stimulus money issued during the pandemic allowed consumers to purchase items that may have previously been out of their reach or buy multiple items and store them. Once the stimulus ended, people bought fewer goods because they ran through the money, and many popular goods reached a saturation point.

In the meantime, retailers forecasted their inventory needs based on an anomaly and have now wound up with excess inventory that has to sell. Retailers are focusing on clearing out inventory and ordering less from manufacturers, causing a slowdown in manufacturing activity.

During a traditional recession, manufacturing activity slows because people have less money to spend, and inflation increases the cost of commodities used in manufacturing. Prices of finished goods increase as a general rule. In turn, retailers respond by ordering fewer items to sell apart from essential goods that people need for daily life.

The Institute for Supply Management (ISM) measures the signal for a decline in manufacturing. It found that the manufacturing Purchasing Managers’ Index (PMI) was at 52.8% in August, which meant the manufacturing sector grew instead of contracting. A reading over 48.7% indicates an expansion, and the most current reading is well above that.

Personal income falls

A slowing economy results in reduced hours of employment and job losses. When people lose the income they’ve been accustomed to, they can’t spend on items outside of necessities. Inflation also eats away at people’s ability to spend because prices rise higher and faster than income. A consumer can’t buy what they can’t afford. That means they buy less at the grocery store and funnel their money into shelter, utility bills, and transportation costs.

Inflation causes consumers to feel broke and unable to buy the goods they could once afford, even though they’re making the same amount of money. A loss of income has the same effect but comes with more uncertainty because of the unknown factor of how long it will take to find gainful employment again.

The current culprit for making people feel broke is inflation, as the low unemployment numbers signal that people are earning and able to maintain their living standards. Consumers are leaving more goods on the shelf in general, but this is because prices spiked, not because of a loss of income. While weighted wage growth grew 6.7% for September 2022, this is below the inflation rate of 8.2%. Even though people are earning more, it doesn’t feel like it since the prices of the goods they buy are rising faster.

Inverted yield curve

An inverted yield curve is when the yield for long-term bonds is less than the yield for short-term bonds. Historically, yield increases as you invest in longer-term securities because you take a more significant risk. When there is fear of a recession, people want to invest in long-term bonds because they offer protection for the longest period and because stocks tend to offer below-average returns as the economy slows.

Since yields drop when demand increases, you get an inverted yield curve. The yield for short-term bonds increases to encourage investors to buy these bonds, and the yield drops for long-term bonds because so many investors are buying these bonds.

An inverted yield curve, while not a traditional economic indicator like the other signals listed, is still a reliable warning of a recession. Since 1955, an inverted yield curve has predicted every recession. Currently, there is an inverted yield curve. It first inverted early in 2022 and has persisted since.

Bottom Line

Many indicators will tell us when the economy goes into recession. It is important to remember that a recession is a relatively common event. It is a normal part of the economic cycle. The economy grows, then slows down, only to grow once again.

There are degrees of severity. In many cases, recessions are mild. There is some slowing of the economy and job losses. It is not always like the Great Recession in 2008 that wiped out millions of jobs and caused many Americans to lose their homes.

The key to surviving a recession is to ensure that your finances are in order. Limit the debt you carry, have ample savings, and be willing to take any job should you lose yours. While it will be a struggle, it will pass.

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