IN FOCUS6-8 min read

Schroders Recession Dashboard: why we’re on high alert

It’s clear to see from our dashboard how the blistering pace of US interest rate rises is taking effect, supporting our belief a US recession is the likely outcome.

14/09/2022
September_SRD

Authors

Tina Fong
Strategist
Simon Keane
Investment specialist

The US Federal Reserve (Fed) has raised the target range for its main policy interest rate five-fold in the past four months. This has set alight the Schroders Recession Dashboard, which is now flashing red, warning of an imminent downturn in the world’s largest economy.

The dashboard offers a balanced way of monitoring recession risks, which would not be possible by focussing on any one measure. That said, the very strong signal of recession currently emanating from the ‘Monetary’ indicators is eye-catching, and worth exploring in detail.

All eyes on Fed as it prioritises taming inflation

Of the six Monetary indicators that we track, five are currently flashing red (see highlighted section of table, below). Quite a turnaround from the spring when none were signalling recession. This suggests to us that the Fed’s actions are materially impacting the rate of growth in the quantity of money, or “money supply”, flowing around the US economy.

In other words, the central bank is bringing about “monetary tightening” at such a pace that a recession will be the very likely cost of reducing inflation from a four-decade high. As a result, markets are currently intensely focused on whether the Fed will opt for a third consecutive 0.75% increase in interest rates at its meeting next week (20-21 September).

Chart_1_final

Scroll to the end of article for more details of how monetary tightening affects the economy - see ‘Schroders Recession Dashboard – tracking the economic cycle’.

Back in the spring many of the dashboard’s ‘inflationary’ indicators had begun flashing red (see highlighted section of chart, below). They were suggesting that capacity was running short in the US economy and it was overheating – most clearly reflected in the indicators tracking the (ongoing) strength of the jobs market.

Chart_2_final

The Fed has responded to higher inflation with higher interest rates, as per the playbook of economic cycles prior to the Global Financial Crisis. But it’s the speed of the response this time that has caused almost all (more than 80%) of the ‘monetary’ indicators to turn red in very short order.

Barring the Great Recession of 2008 to 2009, this is the highest reading in three decades. Monetary indicators tend to point towards recession five to 13 months down the line.

Such an outcome would be consistent with the baseline forecast of the Schroders Economics Team for a recession in the US next year (see: Why recession looms for the developed world).

Significant proportion of dashboard indicators cross key threshold

There have been points in 2022 when individual dashboard indicators have flashed red; however, focussing on any one measure does not give a balanced picture.

The inversion of yield curves last spring generated much discussion about recession (see: Schroders Recession Dashboard: what is it telling us?). Then in early summer, the start of a bear market in US stocks dominated commentary.

The dashboard does track the short-term performance of the S&P 500 (see ‘near-term macro and financial markets’ indicators). But, as we explained at the time, past bear markets have not always foretold recession (see: Do bear markets herald a recession?).

Since then, however, the number of variables flashing a recession warning has crossed a key threshold (see chart, below). Back in April, just under 40% (7 out of 20) of indicators were signalling recession risk. This jumped to 60% (12 out of 20) at the end of August.

Chart_3_final

US recessions have typically followed when more than 40% of the indicators flashed red. The exception being towards the end of 1995 when the threshold was breached but a US recession avoided, albeit growth materially slowed.

Looking ahead, most near-term macro and financial market indicators flash red when recession is about to happen, typically a month in advance.

We will continue to closely monitor the Schroders Recession Dashboard and keep readers regularly updated with any new developments.

Schroders Recession Dashboard – tracking the economic cycle

The dashboard can give us an indication of where an economy is in the “economic cycle”. This is the period in which an economy moves from a state of expansion to one of contraction, before expanding again.

We monitor three broad categories of indicator to help guide us as to when a cycle might be entering its contraction, or recessionary, stage. There is a logical ordering of the dashboard indicators, into “inflationary”, “monetary” and “near-term macro and financial markets” categories (see below).

Economic cycles since the Global Financial Crisis have differed to those of the past due to the very low inflation and interest rate environment, and more recently Covid-19 distortions.

However prior to this, all US recessions between the 1970s and 90s were preceded by a pick up in inflation and interest rates (see: A snapshot of the global economy in April 2022).

1) Inflationary indicators provide early warning signals that the US economy is at full capacity and overheating. They have typically flashed recession risk around 15 months to 24 months before past recessions.

2) Monetary variables. As inflationary pressures accelerate, this eventually triggers the Federal Reserve to tighten monetary policy. The monetary indicators are then impacted as the central bank hikes interest rates. They have typical lead times of between five to 13 months.

3) Near-term macro and financial markets indicators. At some point, increasing interest rates take their toll on economic activity and this hits market sentiment. This category is the last to signal recession risks, as most of the indicators flash red when recession is about to happen, typically a month in advance.

Authors

Tina Fong
Strategist
Simon Keane
Investment specialist

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