The Advisor’s Cheat Sheet to Recession Indicators

Recession indicators work less like a compass and more like a pilot’s cockpit full of maps, instruments, and flashing lights.

Economists often use imperfect historical information to form opinions about the economy’s direction. Markets are uncertain, with no guarantees. And the National Bureau of Economic Research typically adjusts a recession’s start date after the fact. This means we don’t know a recession is happening until it’s well underway.

But recessions don’t have to catch advisors and clients by surprise.

Advisors should look at a combination of indicators to check the health of the economy. Here’s what Morningstar tracks and where indicators stand.

To get 40 charts and graphs showing key market trends, download the full Markets Observer report.

Here are a few of the recession indicators that economists track.

• Rising inflation. In an economic expansion, inflation tends to rise. The Federal Reserve may raise interest rates to keep it under control. The Fed hopes to contain inflation and encourage growth without causing a recession by over-tightening monetary policy.
• Stock market declines. Economists look at the difference between stock market performance and its peak. A downturn is a stock market decline from its peak by 20% or more.
• Credit spreads indicate the broader economy’s health and investors’ confidence in credit markets. Spreads show the yield difference between two fixed-income investments with the same maturity but different credit qualities. Negative spreads have predicted recessions in the past but can’t pinpoint their exact start date, severity, or duration.
• The inverted yield curve describes when short-term bond yields climb above longer-term ones. Historically, this has happened ahead of recessions. It indicates an expectation of lower interest rates, and thus lower growth and inflation, down the road.
• Decrease in real GDP. Consumers tend to tighten their belts in response to economic uncertainty. That could lead to lower economic output, layoffs, and economic contraction.
• High unemployment. Recessions tend to stifle wage increases and promotions. Factors like job sentiment, wage growth, and initial jobless claims can indicate that we’re in a recession.
• Business spending has often declined, on an annual basis only, at the start of a recession. This includes business investment, housing, and inventories.
• Price of gold. When investors anticipate an economic downturn, they tend to flock to gold as a store of value.
• New housing starts and home prices. In a recession, home sales often decrease, which can lead to a decline in housing prices. But a recession isn’t the sole cause.
• The Sahm rule says that anytime the unemployment rate is over half a percentage point above the lowest three-month average from the previous year, a recession always follows. This has held true since World War II in the United States.

After fully recovering from a late 2023 downturn, the US market expanded further in the second quarter of 2024. While small- and mid-cap equities saw negative returns, the outsize positive performance of large-cap stocks drove the expansion.

While most central banks seem finished with their rate-hiking campaigns, many sovereign 10-year yields traded higher in 2024’s first half. This comes after rates plummeted in 2023’s final quarter.

Resilient economic data and higher-than-expected inflation in the second quarter sent yields higher. Market participants lowered their expectations for an eventual loosening of monetary policy and rate cuts.

The yield curve has remained inverted since 2022, reaching its deepest level in the banking crisis of March 2023.

US Treasury yields fell in June 2024 but ended higher over the previous three- and 12-month periods. Yields increased across most segments of the curve in 2024’s second quarter on the back of strong job creation and inflation data.

The Federal Reserve acknowledged a slightly higher-for-longer inflation outlook. While many experts expected six rate cuts this year at the start of 2024, market expectations have fallen to one.

Credit spreads remained at historically tight levels during 2024’s second quarter, suggesting rich valuations. A resilient economy has provided a tailwind for corporate bonds. However, weakening corporate fundamentals, sticky inflation, and the upcoming 2024 US presidential election could all cause future credit market volatility.

We expect US gross domestic product growth to slow over the next year, owing to the delayed effects of monetary tightening along with the depletion of household excess savings.

Easing supply constraints and cooling demand are pushing inflation down. We expect inflation to be about in line with the Federal Reserve’s 2% target in 2024 and beyond. This will allow the Fed to begin cutting rates aggressively, triggering a GDP growth rebound in 2026 and the following years.

Expectations for monetary policy haven’t changed greatly since last quarter. Eurozone inflation has come in slightly hotter than expected, leading to a modest upward revision in rate expectations.

But the big picture remains. Central banks for major economies are set to cut policy interest rates substantially over the next year. The European Central Bank kicked things off with a rate cut in June 2024. The Federal Reserve is expected to follow with its first cut in September 2024.

Core inflation peaked for most major economies in 2022 or early 2023 but has trended down in 2024 through June. It’s too early to declare victory, though, with core inflation above central banks’ 2% targets and progress slowing somewhat in 2024.

Still, inflation should normalize as supply disruptions resolve and demand cools off. China’s low inflation could spread to the rest of the world through expanded exports, but this could run afoul of protectionist backlash.

After dipping in 2022 through early 2023, housing price inflation reaccelerated to over 6% year over year as of 2024’s first quarter.

Geographically, the gains are fairly broad-based. For now, homebuyers have little relief on high mortgage rates. But they may be hoping to refinance in a few years when the Federal Reserve eases monetary policy.

The recent job report showed that the economy added 114,000 jobs in July 2024, significantly lower than the forecast 175,000. The unemployment rate also rose to 4.3% from 4.1% in June, against the estimate that it would hold steady.

One reason for worry is that the unemployment rate has crossed the “Sahm rule” threshold. But as Morningstar chief US economist Preston Caldwell explains, while the rule has some value, it may not be as reliable for predicting the future as some might think.

Diversified portfolios should help clients reach their long-term goals and withstand downturns in the meantime.

That perspective isn’t always reassuring for clients worried about a recession. Our behavioral finance researchers created a checklist for guiding clients through a recession.

• Be the go-to source for advice. Create content to answer common client questions in simple terms. Then share through meetings, emails, and social media.
• Gauge client expectations. Remind overly optimistic clients that market downturns are inevitable and unrealistic expectations could lead to panic. Remind pessimistic clients about the value of staying the course.
• Create concrete action plans. Ask clients to identify triggers that might cause them to tinker with portfolios. Ask them to create an “If, then” list to identify what to do if those triggers happen. Then have them sign it to commit to the plan.