How Can Investors Detect a Market Downturn Using 3 Economic Indicators?

Inflation dropped sharply, surpassing expectations and hitting 3% in June. But the recession that many analysts had forecasted has yet to materialize, as evidenced by the near 50-year low 3.6% unemployment rate and the S&P 500 Index’s 19% gain year-to-date.

Even though the market might be indicating that a recession is unlikely, there are three metrics that have historically been reliable predictors of an economic downturn. These leading economic indicators are key economic variables that tend to move ahead of changes in overall economic activity, providing an early warning system for shifts in the business cycle. Let’s explore three of these indicators and how investors can use them.

Yield curve inversion

The yield curve is a graphical representation of the relationship between short-term and long-term interest rates on government bonds. Usually, long-term bonds have higher yields than short-term bonds to reward investors for the risk of investing their money for a longer period.

Historically, an inverted yield curve has often been a precursor to recessions. This indicator implies that investors are apprehensive about the near future and expect interest rates to decrease due to a probable economic downturn.

The two-year Treasury yield is currently 3.25%, while the 10-year Treasury yield is 2.95%, which is typical of periods preceding a recession. This has been the case since September 2022, and historically there’s a nine- to 24-month gap before the economic contraction takes place.

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Leading economic indicators (LEI)

The Conference Board, a nonprofit research organization, compiles a set of economic indicators referred to as the leading economic indicators (LEI). These indicators include building permits, stock prices, consumer expectations, average weekly hours worked and more.

When these indicators start to decline or show a pattern of negative movement, it can be an indication of an upcoming recession. The consumer confidence index for July reached a reading of 117, the highest level in two years. Moreover, according to The Conference Board, the probability of a recession in the next six months is 25%, lower than the 30% recorded in June.

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Purchasing managers’ index (PMI)

The purchasing managers’ index (PMI) is a metric used to measure the health of the manufacturing sector, and is based on five core indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. A PMI of above 50 points to an expansion, while readings under 50 suggest a contraction. The PMI is considered to be a reliable tool, as it provides up-to-date and accurate data.

The S&P Global U.S. Manufacturing PMI dropped to 46.0 in July 2023, lower than the 46.9 recorded in June and 48.4 in May. This is the lowest figure since December 2022, indicating that the manufacturing industry is in a state of decline. In short, the global economy is slowing down, which is having a negative impact on demand for exports from the United States.

The Federal Reserve is in a tight spot

The U.S. economy is currently sending out a range of signals. Despite a strong consumer demand supported by rising salaries and low unemployment, industrial expansion indicators have stayed weak throughout 2023. In addition, bond markets show a reluctance to take on risk-on positions.

This caution is due to the expected monetary policy tightening and further interest rate hikes anticipated by the Federal Reserve for 2023. These contrasting signals demonstrate the difficult situation for those in charge of the interest rates.

If the Fed tightens policy too much, it could slow down the economy too quickly, potentially leading to a recession. On the other hand, if the Fed is too lenient, it could trigger high inflation, which diminishes purchasing power and can destabilize the currency.

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