Stocks have marched higher since their early April low as the fear of an impending recession has receded. The S&P 500 is 2.3% below its mid-February high, having declined by almost 20%. The Magnificent 7, comprising Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has recovered to only 8.9% below its mid-December level. With many crosscurrents remaining, it seems appropriate to revisit the status of some timely recession indicators.
Recession Indicators
Accurately forecasting an economic downturn in advance with any accuracy is exceptionally challenging. However, in an environment with tariff threats, monitoring specific high-frequency data can provide an early warning about increased recession risks. These indicators are updated weekly or daily and have shown a strong correlation with economic activity. Indeed, other indicators are crucial, but they are typically only available on a monthly basis, sometimes with a significant time lag. Despite the economic data remaining resilient, consensus estimates of 2025 US GDP growth remain well below the levels seen earlier in the year. Economists generally expect the drag from tariffs to slow economic growth in the second half of the year.
Credit Spreads
Baa corporate bond data has a long history and provides a look at the “typical” credit quality of companies, as Baa credit rating is the lowest level of investment-grade bonds. The spread is the yield that investors demand beyond US Treasury bond rates to compensate for the default risk associated with buying corporate bonds. These spreads expand when investors worry that more bond defaults could be on the horizon, typically driven by deteriorating economic conditions. Spreads on Baa corporate debt are below the highs hit as stocks bottomed in early April. The narrowing of spreads is consistent with a lower risk of economic downturn.
Financial Conditions
The Chicago Fed produces the National Financial Conditions Index (NFCI) on a weekly basis. It looks at 105 measures across three categories, risk, credit, and leverage, to create a measure of financial conditions. According to the Chicago Fed, “Positive values of the NFCI have been historically associated with tighter-than-average financial conditions, while negative values have been historically associated with looser-than-average financial conditions.” The chart indicates that periods of tighter-than-normal financial conditions have frequently been correlated with recessions. Similar to credit spreads, the tightness of financial conditions has eased from the early-April highs.
Cyclical Stock Performance
The more economically sensitive cyclical stocks have recently been outperforming the less economically sensitive defensive stocks. The improved performance of cyclical stocks suggests that the economic growth scare is waning.
Yield Curve
The 10-year Treasury minus 2-year yield is arguably the most well-known predictor of recession. Historically, when the yield on the US 10-year Treasury falls below the 2-year yield, also known as yield curve inversion, a recession is likely to follow. Since the 1970s, a yield curve inversion has occurred before every recession. The only blemishes on its record are the 1998 and mid-2022 inversions, which did not produce subsequent economic recessions. The US economy did see a significant slowdown in the first half of 2022 but rebounded in the second half. Unfortunately, even when the signal is correct, it has widely variable lead and lag times. The yield curve still has a better predictive track record than economists and is used in nearly every Federal Reserve model; therefore, it is worth watching despite its flaws. The curve is not currently inverted and has generally been steepening instead.
Jobs
The labor market is the most crucial part of the economy since consumer spending eventually wanes without wages to fund the purchases. Initial claims for unemployment benefits are reported weekly, but the four-week moving average of claims is used here to reduce volatility. Initial claims are ticking higher, but the level is not exhibiting a strong uptrend or one consistent with economic woes.
The other weekly job data is ongoing claims for unemployment benefits, which are also off its lows and show a slow uptrend. The uptrend suggests that it is taking longer for those losing their jobs to find new ones. Recall that the number of employees in the US has more than doubled since 1970, so even though the current roster of those receiving unemployment benefits is as high as it was during the 1969-1970 recession, the numbers aren’t comparable. The labor market is softening, but it has not yet reached the tipping point.
The closely watched monthly jobs report was released on Friday. Payroll job growth was slightly better than expected at 139,000, but the previous two months were revised lower. The household survey reported job losses of 696,000, but the labor force contracted by a similar amount, leaving the unemployment rate unchanged at 4.2%.
Examining the employment of prime working-age people, aged 25 to 54, can provide a good indicator of the labor market’s condition. In addition to being a crucial group, the measure also avoids some of the demographic distortions associated with other methods. Prime-age employment to population ratio fell month-over-month, but using the three-month average to remove volatility, it held steady. The trend appears to be flat to lower, which adds some concern to the outlook.
Overall, job growth is adequate, with the labor market bending lower but not yet breaking. Markets reacted favorably to the monthly jobs report on Friday, indicating less worry about the economic outlook, with US Treasury yields and stocks moving higher.
Betting Odds
Lastly, the betting market has seen a steep drop in the odds of a recession in 2025. Betting odds move much more quickly than consensus estimates and should be considered more accurate since real dollars are at stake regarding the outcome.
What To Watch This Week
Wednesday’s May consumer inflation (CPI) reading will be closely watched as some tariff-related price increases are expected to be reflected. On the other hand, some other price decreases should keep the headline inflation growth in check. Consensus expects a 2.5% year-over-year rate, up from 2.3% last month. The Cleveland Fed’s estimate for May CPI is a bit lower at 2.4%.
The University of Michigan consumer sentiment reading on Friday will be notable. Consumer sentiment plummeted with the announcement of the wide-ranging tariffs on Liberation Day. While economic activity has not followed suit, the sharp plunge in sentiment has raised concerns about an eventual downturn. A rebound in sentiment would be welcome and could help alleviate those concerns.
Conclusions
Stocks have rebounded as the odds of a recession have fallen. There is still room for the odds to fall further, but the risk remains that they could rise again in the event of a reignition of a hotter trade war. Additionally, the pull forward in activity from and the weights of the tariffs will likely be seen in slower economic growth in the second half of the year.
While much of the existing US tariffs could be struck down by the courts, President Trump has other methods to implement tariffs, even if they take more time and effort. The possible headwinds from the tax-like impact of tariffs remain a threat. On the other hand, the US and China are meeting in London on Monday to negotiate trade matters, which always has the potential to de-escalate the conflict. Successful trade negotiations would help offset the tariff drag.
The House of Representatives passed the “big beautiful tax bill,” so the Senate is now working on it. The final bill is almost certain to include significant growth provisions, such as the extension of expiring tax cuts, additional consumer tax cuts, and the expensing of business investments. If passed, these growth initiatives could provide some sweet dessert to make the tariff vegetables more palatable to economic growth.
Investors should note that stocks are pricing in a relatively low risk of recession in 2025 and perhaps looking beyond a possible second-half soft patch to a brighter 2026. This rosy outlook could be correct, and there are potential upsides, as noted previously. However, the labor market appears to be fraying at the edges, so dodging an economic downturn is no sure thing. A host of high-frequency indicators still point to no sign of imminent recession, however.
Read the full article here
