Whether a recession is indeed around the corner remains a hotly contested subject among financial wizards. OverTraders.com analyzes the perspectives of two key groups: Chief Financial Officers (CFOs) and economists. Knowing their perspectives and the information they base their decisions on is essential for investors trying to navigate an uncertain economic environment like today’s. Though often in competition with one another, their predictions provide important practical guides as to which way the economy might be headed. This article discusses what goes into informing their forecasts. It takes a look at the indicators they have been using to determine the likelihood and timing of a recession.
The Signals: Yield Curves, Unemployment, and Debt
Decoding the Yield Curve
Of all the indicators that might flash warning signs, perhaps none is more closely watched than the Treasury yield curve. Specifically, it graphs the spread between Treasury bond yields for the short-term (3 months – 1 year) and long-term (10 years) maturities. The inverted yield curve happens when short-term yields exceed long-term yields. In the past, this occurrence has consistently foreshadowed recessions. That means investors are betting on lower levels of economic growth down the road. Because of this, they require a greater yield on risky short-term bonds. The current shape of the Treasury yield curve suggests a near certainty of recession. When that recession comes is very much up in the air.
Prior to the COVID-19 pandemic, an inverted or flat yield curve had been a reliable predictor of recession within 12 months. The extraordinary economic circumstances of the last several years have caused some to doubt its ongoing dependability. Perhaps quantitative easing and global capital flows distorted the yield curve. As a consequence, it’s turned into a more and more inaccurate leading indicator of future economic activity.
The Sahm Rule and Unemployment
Another more recent indicator that has turned out to be a pretty good predictor of recessions is the Sahm rule. This rule lags with the unemployment rate. Indeed, a major increase in the unemployment rate has historically been a reliable harbinger of recession. The Sahm rule was a very reliable rule for decades, acting as an early warning system for recessions by following the path of increasing unemployment. In July 2024, it set off a false alarm, illustrating the danger of leaning too hard on any one indicator alone.
The Sahm rule’s 2024 misfire is a reminder that predicting recessions can be difficult in a fast-moving economic landscape. Unemployment is always a big one to keep an eye on. We need to consider the bigger picture: inflation, consumer spending, and business investment.
Debt-Service Ratio
The Debt-Service Ratio is the second most cited metric for determining the probability of a coming recession. This ratio calculates how much of a typical household’s income is going to debt payments. When the debt-service ratio exceeds a certain threshold, that typically means consumers are overextended and thus more vulnerable to economic shocks. "The Debt-Service Ratio and Estimated Recession Probability," published by Econbrowser, illustrates how this ratio can be used to gauge recession risk.
The Debt-Service Ratio is a useful tool for gaining a clearer understanding of household financial vulnerability. So consider this good news, don’t forget that it’s just one part of the story. Other variables like interest rates, credit conditions and consumer confidence play a role in determining how likely a recession is.
CFOs' Perspective: Industry Insights and Pessimism
CFO Sentiment
As some of the most influential decision-makers in their organizations, CFOs have a unique read on the economy. This comes as a majority of CFOs (60%) predict a recession in the second half of this year. That’s a complete flip from last quarter, where just 7% of CFOs expected a recession until at least 2025. This is a striking reversal of sentiment that points to increasing pessimism among CFOs over the prospect of near-term economic improvement.
Connecticut CFOs’ recession predictions are understandably rooted in the realities their industry is facing. And nearly three out of four say they’re at least “somewhat pessimistic” about the current conditions of the U.S. economy. Further complicating matters, several factors seem geared toward fostering pessimism. Supply chain disruptions, rapid rising input costs, and demand weakening in some markets are to a large extent responsible.
Optimism in Their Own Industries
Curiously enough, 75% of CFOs are negative on the U.S. economy. The same percentage is hopeful about the future of their own industries. This seeming contradiction is in fact indicative of the confidence that some have in their ability to weather an anticipated economic storm. Some believe their sectors are more insulated from recessionary headwinds.
The contrast between general economic outlook and sector specific favorable outlook is remarkable. That points to the importance of looking at microeconomic factors when gauging the likelihood of recession. Macroeconomic indicators provide high-level view of economy at-large. The industry level dynamics can have a significant effect on how well or poorly specific companies and industries are doing out.
Key Risks Identified by CFOs
CFOs’ forecasts are further affected by their opinions on trade policy, inflation, and consumer demand. Roughly a third of CFOs consider trade policy to be a major threat. What’s really got them spooked is the potential for tariffs and trade wars to completely upend their businesses. Inflation stands as the second most pressing concern, with 1 in 4 CFOs calling it a top risk. We know that rising prices can eat into profit margins and limit consumer spending, which can harm business performance. In fact, consumer demand is the biggest risk according to 20% of CFOs. They are concerned that any slowdown in consumer spending would push the country into recession.
CFOs seem to be buying the idea that Fed Chair Jerome Powell mentioned a few weeks ago, in that any price increases from tariffs will be temporary in nature. Sixty percent of chief financial officers predict a recession in the last six months of this year. If true, this would mean they assume the Fed will continue to overlook inflationary risks associated with trade disruptions.
The Economists' View: Data-Driven Analysis
Economists' Prediction
From gauge models to leading indicators, economists employ different approaches to predicting the chances of a recession. These models frequently include explanatory variables like GDP growth, inflation, unemployment and interest rates. Appropriately enough, economists are usually good at providing a data-driven, quantitative assessment of recession risk. By comparison, CFOs often feel forced to make more qualitative judgments.
It’s true that economists tend to look at a broader set of economic indicators and use more complex analytical methods than CFOs. This helps them spot risks and opportunities they wouldn’t see from a solely sector-focused lens.
Factors Leading to Recession
Here are the mostly perfectly reasonable conditions people argue could slam the U.S. into a recession. What that means is that during boom years, investors tend to get way too optimistic. This reckless behavior often leads to asset bubbles and unsustainable debt levels. The COVID-19 pandemic, with its disruptions and business closures, the subsequent inflation shock, aggressive policy rate hikes by the Federal Reserve (Fed) and other central banks, and a mini-meltdown in the U.S. regional banking sector all contributed to economic uncertainty.
As the incoming Trump administration prepares its trade policy agenda, there is a real danger that it will pursue the wrong policies with tariffs. If implemented, these policies start a global trade war; they would start a recession. Trade wars can disrupt supply chains, increase costs for businesses, and reduce consumer spending, leading to slower economic growth or even a contraction.
Contrasting Views
Economists and CFOs alike view recessionary potential with dramatically different perspectives. Their conflicting interpretations come from their different points of view and the different data they are each operating off of. CFOs take a closer look at the unique situations they may face, the challenges and the opportunities in their respective industries. By comparison, economists take a counterintuitive, wider macroeconomic view. These different lenses result in radically different forecasts on the future of our economy.
Economists and CFOs provide some of the best, earliest recession red flags. It’s always important to test their forecasts against other sources of information. After all, no single indicator or oracle can accurately divine the future. That’s why it’s so important to consider a variety of indicators and take a holistic approach when measuring recession risk.
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