The “R” word is top of mind for many this year. After all, talk of it is all over the news, and at the same time the markets are down, uncertainty is high, inflation has become increasingly painful, and the economy is showing signs of stress.

So, what is a recession?

A recession is commonly defined as two consecutive quarters of declining gross domestic product (GDP), which is made up of consumer spending, business investment, government spending and net exports in the United States (US). However, the National Bureau of Economic Research (NBER) Dating Committee, which is actually responsible for declaring recession, has another definition:

“a significant decline in economic activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.”

When thinking about the economy, it’s always important to keep in mind that jobs create income and income fuels spending. As confidence in the economy begins to wane, business activity takes a hit. This weighs on the labor market and negatively impacts income, which in turn forces the consumer to dial back further on spending. As this occurs, the economy slows further and begins to contract. As it does and if it doesn’t improve, we find ourselves in a recession. Jobs are lost, businesses fail, markets tumble, and uncertainty runs rampant.

Recessions are not a matter of “if”, but rather “when”. They are also a natural part of the business cycle. Depending on your perspective, the US has weathered as many as 48 recessions going as far back as 1777. The NBER, however, has identified 32-34 recessions since the mid-1850s and 13 since WWII. They also clearly have different causes and varying lengths. Recessions can be caused by a sudden economic shock (oil supply, pandemic etc.), asset bubbles (real estate,, excessive debt, runaway inflation/deflation, and technological change.

The longest recession in US history was actually a depression, which is commonly defined as an extreme recession that lasts three or more years or leads to a decline in real GDP of at least 10% in a given year. The Great Depression of 1929 lasted a punishing 120 months. After the Great Depression, the next longest (which many of us still vividly remember) was 18 months long. It was the Great Recession (December 2007 – June 2009), where unemployment peaked at around 10%. The shortest on record (and also one of the deepest) was the COVID-19 Pandemic of 2020. GDP plunged some 31.4%, and then roared back some 33.4% on the heels of swiftly delivered and unprecedented levels of stimulus. Because of the swift and significant aid, it lasted a mere two months, which really does not come close to meeting the NBER’s definition of recession. If we consider the last 10 recessions since WWII, less the Great Recession (unusually long) and the COVID-19 Pandemic (unusually short), from the mix, the average length of recession comes in at roughly 10.4 months. It’s also worth noting that the nine recessions since 1960 account for just under eight years in total. That means that over the last 61 years, economic growth has prevailed roughly 86% of the time. I’ll take those odds any day!

While we would all rather avoid recession, they are arguably both healthy and necessary. Recessions help to clean out the aberrations, imbalances, and excesses following a period of economic strength. As a result, what commonly follows are upticks in productivity, competitiveness, and new efficiencies. After all, “in the midst of every crisis, lies great opportunity” (Albert Einstein).

Again, recessions are not a matter of “if”, but “when”. So, what are our thoughts and are we currently seeing any red flags? We are monitoring several measures that have historically been reliable indicators:

Yield Curve (3-month vs the 10-year):
The yield curve is the difference between short- and long-term interest rates of fixed-income securities issues by the US Treasury. Inversion of the curve occurs when short-term debt yields more than longer-term debt. Historically, inversion of the yield curve is a warning sign for the markets and the economy because it indicates that investors believe the near term carries more risk than the long term. Put another way, an inverted curve points to widespread loss of confidence in the economy.

While various parts of the curve invert at different times, inversion of the 3-month/10-year has historically been the most accurate indicator. Today the 3-month/10-year yield curve is sloping upward and nowhere near inverted. No warning sign here.

Conference Board Leading Index:
This is a composite index consisting of ten leading economic indicators that The Conference Board (which is a non-governmental organization) uses to forecast future economic activity and point to possible peaks and troughs in the business cycle. The index is composed of many of the same things we look at as we watch for recession, as well as others.

Currently, the index has trended downward and is signaling “CAUTION”.

Labor Market (Initial Jobless Claims):
As mentioned earlier, jobs create income and income fuels spending. Initial claims measure the number of individuals who have filed for unemployment insurance for the first time over the prior week. This weekly reading gives us a directional illustration about the health of the labor market. If claims are trending upward over time, the labor market is experiencing stress.

The labor market is still very healthy and initial claims have not established a definitive rising pattern. As such, this indicator is clear for the time being.

Single Family Housing Starts:
Housing starts are the total number of single-family houses that started construction in a given month in the US and are commonly regarded as a leading indicator for the health of the US economy.

Previously, starts were moving sideways, but as the Fed has become more aggressive with rate hikes, mortgage rates have also moved higher. This negatively impacts affordability and curbs demand for housing. In May of 2022, starts fell to a 13-month low. While one month does not make a trend, this is one we’ll continue to keep a close eye on. For now, this indicator is not screaming “caution”, but could be moving in that direction.

ISM Purchasing Managers Index (PMI):
This is a monthly gauge of US economic activity based on a survey of purchasing managers at more than 300 manufacturing firms. It gives us a glimpse into how well large manufacturers are doing and points to the health of the US economy.

A PMI number above 50 indicates that the manufacturing sector is expanding (healthy), while a number below 50 indicates that the manufacturing sector is contracting (unhealthy). As of May of 2022, Manufacturing PMI came in at 56. For the moment, this indicator is in the clear.

Consumer Sentiment (University of Michigan):
When the consumer begins to lose confidence in the economy, spending begins to taper off and the economy slows further and faster. As such, this is an important measure.

Today, this measure is flashing “WARNING”.

While the various indicators we are watching are clearly not all pointing towards immediate recession, it’s still worth considering what one may want to do to prepare. As you’ve heard from us many times in the past, we encourage everyone to have a disaster recovery plan in place. We do this with the portfolios we manage by strategically addressing and managing risk in different areas. One can do the same thing when considering their overall financial picture:

Avoid over-extending yourself (taking on large or additional debt) during periods of economic stress. Instead, focus on paying down debt and building a cash safety net.

If you are gainfully employed and can afford to continue to contribute to a retirement plan, there is no better time to do so than when stocks are on sale. Relative to where they were last year, it’s a great time to buy.

If you are already invested, stay invested. It’s critical to remember that “time in the markets always beats attempting to time the markets”.

Do your very best to remain calm, focused, and disciplined. Diversify, allocate appropriately and most importantly, do not make any significant changes unless your fundamental goals and/or financial plan has changed.

Whether we find ourselves in recession this year, next year or even further out, the most important thing to understand is that we have been there many, many times before. Just as we have in the past, we will get through the next one and, arguably, be better off as we emerge.

Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.

About The Author

Matthew Clarke, CIMA® is a Vice President and Senior Client Portfolio Manager for Washington Trust Bank’s Wealth Management & Advisory Services. Within the Portfolio Management Group, he works with a team of portfolio experts who analyze and coordinate strategies on behalf of our clients who require both a high level of customization and expert communication. Working with our Relationship Managers, Matthew represents a client-focused, comprehensive and disciplined approach to investment management that emphasizes our consideration to the client’s “big picture.” His active participation in our client relationships is instrumental for our continuous success in meeting their goals. Matthew has over 10 years of financial industry experience and is often called upon for investment strategies that support the sale of business, concentrated stock holdings and other financial events that require significant consideration and analysis.