When one thinks of the word recession: the first thing that comes to mind is the global financial crisis of 2008.
Subject to much media coverage and analysis, the recession of 2008 led to the loss of over 8.7 million jobs worldwide, in addition to the collapse of the housing market in America and the worst financial crisis the world had seen in decades.
In other words: recessions are certainly not good news. However, what we colloquially refer to as “recession” generally refers to a financial crisis.
In business terms, a recession refers to a business cycle contraction that leads to a general economic slowdown. According to many economists, the world experienced a huge economic slowdown from 2007 to 2012, with consequences varying across markets.
Can You See a Recession Coming?
To understand how one can predict a recession, it is important to go into the details of why recessions occur. Recessions are often unpredictable. The financial market is a patchwork of thousands of spending behaviors, not all of which are one hundred percent rational.
Financial analysts are often blindsided by recessions because they generally tend to be preceded by periods of sustained economic growth.
In other words: it’s not exactly possible to predict a recession. However, there are clues one can look out for.
Recessions generally occur when there is a widespread drop in spending. This is called an adverse demand shock. A demand shock is generally a surprise event that increases or decreases the demand for certain goods or services.
So, an adverse demand shock would mean a sharp decline in demand for said goods and services. This may be triggered by various events, such as a financial crisis, an external trade shock, an adverse supply shock or the bursting of an economic bubble
For example, in 2008, during the global financial crisis, America saw a massive drop in consumer spending due to various factors including the subprime mortgage crisis, which led to the burst of the housing bubble.
To counter this, the US government decreased interest rates, to make housing loans easier to pay back.
In other words, it’s not always possible to see a recession coming. However, keeping an eye out for some key trends and watching a little bit of the news certainly helps. Let’s find out how.
Is a Recession About to Hit?
The United States is generally is the epicenter of economic changes around the world
Currently, the US is going through a period of economic growth, with unemployment levels at a record low of 3.9 percent. Under the Donald Trump government, the tax cut fuelled economy has ushered in an era of corporate profits, but it is also widening the fiscal deficit and increasing the already high national debt.
If the national debt is already high, the Fed will try to strike a balance between rising inflation and sustained economic growth, by hiking the federal funds rate.
This comes with the risk of upsetting the balance between the neutral rate and the yield curve. Depending on how uncertain the market is, a rise in the federal funds rate might lead to a reversal in the yield curve, which is usually an indicator of recession.
India, fortunately, has a market that is mostly dependent on domestic factors, therefore, it will be shielded from the effects of the US economy to some extent.
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However, our private sector still has strong ties with the world economy, so if a recession does occur, it will be the private sector that suffers the most.
If the US hikes the federal fund rate, the dollar is likely to get stronger compared to the Rupee. With the exchange rate at a record high, this might put pressure on India to hike up its own federal funds’ rate, which comes with a risk of upsetting the yield curve.
Will it Affect India?
Heading into 2019, Indian markets are going to be walking on eggshells for the first half of the year, thanks to the upcoming elections, a major geopolitical factor
Elections cause uncertainty because changing governments may have different economic policies, which has a direct effect on markets. Rising crude oil prices is also an unpredictable element that adds to this uncertainty.
However, once the elections take place and the coast is a little more clear, economic markets are bound to pick up and do better.
But for now, India is a perfect storm of economic and geopolitical uncertainty. This is bound to last for a while, as investors watch the market closely and refrain from investing too much.
In other words: yes, a global recession might be on the way. Since recessions normally occur after periods of sustained economic growth, and both the United States and India have been experiencing economic expansions, it is possible that rising debt and interest rates will eventually force a slump.
But it is highly unlikely that it will be as bad as the recession of 2008-2012. Especially in the case of India, things should clear up after the elections, but till then, caution is the need of the hour.
What Could be Indicators for Recession?
Certain economic trends, if followed closely, are great indicators of economic health. Following them can help one stay in touch with the latest trends in the market and prepare for a recession.
Four of these trends are:
- The Leading Economic Index (LEI), which captures the pulse of the business cycle,
- The shrinking spread between the 10 year and 3-month treasury rate;
- How far the Federal Reserve of the United States (“Fed”) Funds rate is above or below the neutral rate
- Geopolitical Factors
1.The Leading Economic Index
This index consists of 10 economic components whose change tend to precede changes in the overall economy.
- The average weekly hours worked by manufacturing workers
- The average number of initial applications for insurance
- The amount of manufacturers’ new orders for consumer goods and materials
- The speed of delivery of new merchandise to vendors from suppliers
- The number of new orders for capital goods unrelated to defense
- The number of new building permits for residential buildings
- The S&P 500 stock index
- The inflation-adjusted monetary supply The spread between long and short interest rates
- Consumer sentiment.
This data, along with the state of the business cycle and general economic conditions, can help predict general trends in the rise and fall of markets and can help investors make better-informed decisions.
Monitoring treasury bonds can also give us a good indicator of economic health.
2. Treasury Rate
If the difference between treasury yield over a long period of time (say a ten year period, because recessions generally occur in cycles of ten years), and a short period of time (say 3 months) is expanding, then it is generally an indicator of a sound market, with healthy economic activity.
However, if this difference between rates shrink, or worse, inverts, it indicates that a period of poor economic performance is imminent.
3. Federal Funds Rate
Thirdly, one of the most important indicators of economic health is the federal funds rate.
The federal funds rate is the rate of interest charged by banks when they lend reserve balance to other banks on an overnight basis.
The federal fund rate directly impacts the money supply in the system. The optimal rate of interest for interbank loans in a healthy economy, i.e the hypothetical federal funds rate that would keep the economy at the optimum growth rate, is called the neutral rate.
So, if the federal funds rate is below the neutral rate, it means the money supply is a little more freed up, and there is room for the economy to grow.
However, if the federal funds rate is above the neutral rate, it is indicative of a restrictive economic climate, because lending institutions are less confident.
Thus, A large positive difference between the federal funds rate and the neutral rate is also indicative of an impending recession.
4. Geopolitical Factor
The fourth factor perhaps is the most unpredictable one, it is geopolitics.
Although economic data is reasonable and easy to predict, geopolitics is unpredictable in nature because countries often get into roadblocks over issues of national pride.
This can cause miscalculations. For example, things like the US trade dispute with China, or the nuclear standoff with Iran affect the economy.
If the level of geopolitical uncertainty is high, the level of uncertainty in markets is also high, which means that unforeseen events can trigger a recession.
Disclaimer: The views expressed in this post are that of the author and not those of Groww