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Three ways to spot a recession before it happens

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We asked investment managers to highlight the key indicators to watch ahead of a recession.

Investors could be forgiven for feeling nervous as we approach the end of 2018.

The FTSE 100 is down 7.2% since the start of the year and it’s difficult to ignore the stream of negative headlines which continue to haunt prime minister Theresa May ahead of the UK’s exit from the European Union (EU).

Looking ahead to next year, much will depend on whether there is a ‘hard Brexit’ or no deal, which would see the UK give up full access to the single market and customs union. Alternatively a ‘soft Brexit’, which sees the UK retain close ties with the EU, could spell better news for the UK economy.

“If Theresa May gets a deal through, there will be a slowing of the UK economy this year and next, but it will not be devastating,” says Julian Chillingworth, Rathbones’ chief investment officer.

“If things drag on and there is a possibility of a disorderly exit, I think this would be bad news for the UK economy,” he adds.

Brexit aside, it is also important to monitor the health of the US economy and the world economy in general. The US is the largest economy in the world and unwittingly can lead other nations into recession, defined as six months or two consecutive quarters of economic contraction.

Some readers are likely to have vivid memories of the 2008 recession, which saw the world’s financial system teeter on the brink of collapse. While there is nothing to say that the next recession is imminent, most fund managers believe we are now in the later stages of the investment cycle.

So what should investors look out for? We asked investment managers to highlight the key indicators to monitor ahead of a recession.

1) Inverted yield curve

The yield curve is a graph that plots the yields of bonds of similar quality against their maturities. It shows the yields that are being offered on bonds of different maturities and tends to indicate expectations about the direction of travel for interest rates later down the line.

Typically the curve slopes upwards, reflecting the fact that investors expect to be rewarded with higher interest rates if they buy longer dated bonds.

However, an inverted yield curve happens when the yield on a two-year government bond moves higher than 10-year government bond yield. It is seen as a sign that the economy is slowing and could be headed for a recession.

Chillingworth describes the inverted yield curve as a pretty “fail-safe indicator” going back to the 1950s. However, this indicator is not always able to accurately indicate the timing of an upcoming recession.

“The point I would make is it is variable in its predictive timeline. So in the ‘Great Financial Crisis’, it was roughly 18 months too soon. During the tech boom it was two to three quarters too soon,” Chillingworth explained.

While the yield curve in the UK currently offers no reason to feel nervous, the same can’t be said over in the US. Here, the gap between the 10-year and two-year US Treasury bond stands around 12 basis points. This compares to the UK where there is a 56 basis point difference. This suggests that it is worth watching the US yield curve during the new year.

2) Economic Cycle Research Institute – weekly lead indicator

The Economic Cycle Research Institute describes itself as “the world’s leading authority on business cycles”. Andrew Wilson, chief investment officer at wealth manager Lockhart Capital, pays close attention to its weekly leading economic indicator, which has a good track record of signalling recessions in advance – even if it is prone to the odd false signal.

It combines data on corporate bonds, US Treasury bonds, the stockmarket, the labour market and credit market. It has an average reading of -4.2 at the start of recessions and Wilson is concerned that it stood at -4 in early December.

“It is getting perilously close to sounding a warning,” he adds.

3) The stockmarket

Investors are always looking ahead to try to understand the direction of travel for markets and economies. Peter Sleep, a senior investment manager at Seven Investment Management, describes the stockmarket as a “forward discounting mechanism” – this has been shown time and time again through history.

Nevertheless, Sleep points out that investors’ pessimistic tendencies can mean that the stockmarket predicts more recessions than actually occur.

“The joke is that the market has predicted nine of the last three recessions,” he added.

Is it time to panic?

In spite of what some of the indicators are currently suggesting, Rathbones’ Chillingworth describes the likelihood of a recession happening over the next 12 months as “pretty low”.

“We look at a number of indicators on a composite basis, which are suggesting there is a pretty low percentage chance of a recession in the next 12 months,” he adds.

Regardless of what happens in markets over the coming year, he suggests that the most important thing is for investors not to panic and to be open to any investment opportunities that emerge.