This article covers:

• What is a Recession?

• Five Warning Signs of a Recession

  • Rising Unemployment 

  • Inverted Yield Curve

  • Weak Consumer and Business Sentiment

  • Falling Commodity Prices

  • Cooling Property Market

Naturally, inflation and rising interest rates are two of the fundamental factors that may influence the likelihood of a recession occurring. Some individuals may suggest these headwinds are warning signs about an impending recession, but in and of itself, it is the resultant outcomes that investors should monitor to gauge the risk of a recession. 

So how do we know whether an economy is heading for a recession? Let discuss.

Don't forget to read our guide to recession-proof industries.

What is a Recession?

Traditionally, two consecutive quarters of negative GDP growth would have been labelled a recession. This has long been the informal definition of a technical recession, and during each of the most recent 10 instances where the US economy contracted over two straight quarters, a recession was subsequently confirmed.

However, a recession is officially declared by the National Bureau of Economic Research (NBER). Their definition centres on a significant decline in economic activity that is spread across the economy and lasts more than a few months.

Aside from the GDP reading, this definition is taken to include several other factors such as a decrease in business output and investment, falling corporate profits, and rising unemployment.

In most instances, the NBER does not declare a recession until months after it commences. As such, just because an economy is not officially cited as being in recession after two quarters of contracting economic growth, it does not mean the economy is out of the woods.

Five Warning Signs of a Recession

1. Rising Unemployment

A sustained rise in the unemployment rate is considered one of the more reliable indicators of an economic downturn. 

As far as the number of concern to look out for, estimates put the increase in the unemployment rate somewhere between three-tenths of a percentage point, and one-half of a percentage point, averaged over several months.

Over the long-term, the US economy has typically entered recession territory nine months after unemployment hits a bottom' in the cycle.

As a historical indicator, this is not to say it will occur again in the future, but a rising unemployment rate indicates job losses are increasing, and new hiring is slowing down. 

In the context of economic growth, this suggests businesses are tightening their wages expenses in response to uncertain or difficult trading conditions.

2. Inverted Yield Curve

Among the most well known recession signals is the inverted yield curve'. This occurs when the yield for 10-Year Treasury bonds falls below short-term Treasury yields. Typically, longer-term bonds would pay a higher yield since investors lock their money away for longer. 

However, in this instance, short-term bond investors are offered a higher return on their investment. This is because an uncertain economic environment prompts investor demand for long-term Treasury bonds, thereby reducing their yield.

The reason why this peculiar phenomenon takes place is because investors anticipate a recession may be imminent, in which case, the central bank would likely respond by cutting the official interest rate.

Each of the last seven recessions in the US has been preceded by an inverted yield curve. It is not uncommon for the yield curve to invert well ahead of a recession. Based on the averages, this trend may take place as much as 18 months before a recession follows. 

Generally speaking, when it comes to forecasting a recession, the 3-month yield is considered a better gauge than the two-year Treasury yield for comparison against the 10-year rate.

3. Weak Consumer and Business Sentiment 

When we look at the composition of the US economy, consumer spending represents as much as two-thirds of GDP. 

Although consumer sentiment and spending may not necessarily be aligned at times, especially when consumers have accumulated savings, the former is widely viewed as a lead indicator regarding the direction of the economy.  

In some respects, this can become a self-fulfilling prophecy, whereby consumers' expectations regarding a downturn in the economy bring about that outcome as they tighten their wallets. 

When inflation is high, and interest rates are rising, consumer sentiment faces the greatest pressure as buying power diminishes and consumers modify their shopping behaviour and/or choices. But what economists look at closely is the velocity with which consumers adjust their behaviour.

At the same time, when consumers begin to pare their spending, producers face a downturn in terms of manufacturing non-essentials. This may translate into a fall in business confidence and investment, which are both headwinds for the economy, and increase the odds of a recession.

4. Falling Commodity Prices

A recession involves a temporary contraction in economic growth, which on the whole also means less business activity across industry.

Certain commodities like copper and oil are used as key gauges for the health of the global economy. When investors anticipate a recession may be on the cards, they effectively slash their demand for these key commodities, which results in falling commodity prices.

In other words, investors predict construction activity will decrease due to less demand for new housing. When the economy is roaring, however, demand for copper, as a key construction material, typically rises, supporting commodity prices.  

Similarly, energy prices tend to deflate when investors begin to expect a recession is around the corner. This is compounded when inflation has previously resulted in a sudden spike in petrol prices. 

A recession would tie in with less overall demand for oil - think about its diminishing use as an input for production and travel needs - so when oil prices enter a sustained contraction, it is generally because investors expect the worst for the economy. 

5. Cooling Property Market

While considered less reliable than some of the other indicators in this article, a cooling property market has previously signalled a recession is a distinct possibility. 

This ultimately depends on whether the property market actually bursts, as it did during the Global Financial Crisis, because if this happens, financial contagion may occur. 

Financial contagion refers to the spread of market disturbances on an international scale. Due to this, the subprime mortgage crisis in the US had devastating consequences for countries around the world back in 2008.

Fortunately, since the GFC, regulators have compelled banks to build up enormous capital buffers and improve their lending practices. As a result, this once concerning risk may be less problematic today. 

Nonetheless, with housing being one of the key drivers of economic activity in both Australia and the US, it is arguably more useful to keep an eye out for indicators such as new home sales, building permits, and housing starts (i.e. new construction activity). In the US, since 1960, housing starts have fallen by an average of 20% in quarters with a recession.

A slowdown in these areas may give clues on whether a recession is likely or not, as it ultimately reflects the confidence homeowners (and builders) have about their employment stability, wages, and the economy at large.

What do you think? Is a global recession imminent? Will Australia be spared?