The start of a new year is supposed to be a time of renewed optimism for the year ahead. Unfortunately, everyone seems to be pessimistic about the US economy. Even though 2022 was full of turmoil, the broad economy still managed to avoid a recession.
Will this new year be different? Will there be a recession in 2023?
It wouldn’t catch anyone by surprise. Economists are convinced we are headed toward one. CEOs are also on board with this sentiment.
Is this a self-fulfilling prophecy or will we manage to avoid the train we so clearly see coming?
Let’s examine five indicators to gauge where the economy is and where it might be headed.
The Yield Curve
One of the most popular recession indicators is the inversion of the yield curve.
Why is this a big deal?
First, a quick explanation:
The government sells Treasury bonds to finance its operations. In a normal environment, short term bonds have lower yields, while long term bonds have higher yields. This makes sense—if you are loaning your money out (by buying a Treasury bond), you want to be compensated for tying up your money longer. Thus, investors demand higher rates, or yields.
When short term rates are higher than long term rates, the yield curve is inverted. This doesn’t cause a recession, but it’s an indicator that the Fed’s monetary policy is getting too restrictive. The fear is that this can trigger a financial crisis and/or credit crunch, where lending grinds to a halt.
What’s the bond market telling us? Well, the yield curve has been inverted since earlier this year.
This chart shows the spread, or difference, between a three-month US Treasury bill and a 10-year US Treasury bond. A reading below 0% means that this portion of the yield curve is inverted. The gray shaded areas show US recessions. As you can see, these recessions have occurred after periods of an inverted yield curve.
But the timing of a recession after an inverted yield curve is tricky—it’s not an immediate phenomenon. Past instances saw recessions start anywhere from six to twenty two months after inverting.
The Housing Market
One area of the economy that is in a recession is the housing market. Ultra-low mortgage rates fueled a housing spree in 2020 and 2021. Higher rates caused the market to freeze as many would-be-homebuyers could not afford the cost of a new house.
Housing affordability (the dark gray line) plummeted as mortgage rates (light blue line) spiked.
A slowdown in housing means a slowdown in housing-related sectors (e.g., construction, remodeling, real estate agents, and mortgage loans). This is important because spending on housing accounts for 15-18% of GDP.
Housing is a domino that has already fallen. The question is, will mortgage rates remain high and continue to squeeze out potential buyers? Is a recession in housing enough to tip the rest of the economy into a recession? Or will rates turn over and cause housing to be a tailwind to the broader economy?
The Job Market
The job market has not received the recession memo. The unemployment rate remains historically low at 3.70%.
The tight labor market is actually a reason the Fed wants to continue keeping monetary policy restrictive. A tight labor market means companies have to pay workers more. This increases their input costs and makes it tougher to fight higher prices.
But the Fed has a dual mandate—stable prices and maximum employment. They are hyper-focused on the first part by fighting inflation. But they also must be concerned with employment, which is why they don’t want to torpedo the economy.
The Stock Market
Yes—the stock market is not the economy (and the economy is not the stock market). But stock prices tend to be forward-looking. If a recession is expected, stocks move down before the economy. They can also recover while the economy is still in a recession (because they are looking forward to the coming economic recovery).
Stocks are in the middle of a bear market, with the S&P 500 finishing 2022 down over 19% and the NASDAQ-100 down over 32%. There were a lot of contributing factors—spiking interest rates, an aggressive Fed, the war in Ukraine, and decades-high inflation.
But what is the stock market telling us about 2023? That’s tough to know. On one hand, stocks could have sold off because it expects a recession. On the other hand, the bear market to this point could have been all about the rise in interest rates and the wringing out of the excesses from the past two years. A coming recession might not be “priced in” to today’s stock prices. If that’s the case, stocks are likely to bottom within the first few months of the recession.
The Conference Board’s Leading Economic Indicators
The Conference Board’s leading economic indicators (LEI) have declined for nine straight months. The LEI consists of indicators such as labor, spending, manufacturing, money supply, consumer sentiment, and stock prices.
According to their data, they project a recession is likely to start in the beginning of 2023 and last through mid-year.
What can go right in 2023?
With everyone expecting a recession, doesn’t it seem somewhat plausible that we can avoid one?
Of course, it would help for a few things to go right. The biggest risk is the Federal Reserve’s fight against inflation. People are worried that the Fed will tighten monetary policy too much into an economy that is slowing down.
Here’s the good news: inflation has been cooling for months, consumers are in good shape, corporate balance sheets are strong, and banks are well capitalized.
This is the “soft landing” scenario the Fed is hopeful for. Here they won’t have to keep monetary policy overly restrictive. If a recession occurs, it would be shallow and short-lived, nothing like 2008. But a recession could also be avoided altogether.
Will there be a recession in 2023? Of course, the answer is uncertain. Don’t be overly swayed by a single indicator or economist. For everything that can go wrong, there’s also something that can go right.