A recession is coming. Perhaps. It may start this year. Or not. The truth is, we don’t know. In a recent survey, 44% of business economists say that the probability the US economy will enter a recession in the next 12 months is greater than one-half — but 53% say it is less.[1] How can we be so uncertain about something so important?
It turns out that predicting recessions is hard, and even experts are not very good at it. An IMF study found that private sector forecasts failed to predict 148 of 153 recessions in 63 countries in the year preceding the recession; the IMF itself missed 147.[2] Why?
- Recessions are rare. Economies spend about 10% of the time in recession,[3] but there have been only nine US recessions since 1960.[4] Rare events offer little data to work with.
- We don’t fully understand recessions. Some are triggered by supply shocks and others by demand. Policymakers can create recessions by doing the wrong thing or failing to do the right thing.[5] Financial crises play a role. With so many causes, it’s hard to know where to look.
- There is no single best predictor of recessions. Spreads between long-term and short-term yields are one indicator: yield curve inversions often precede recessions. But different spreads work better over different horizons and sample periods.[6] Other predictors, such as the Conference Board Leading Economic Index[7] or proxies for the financial cycle,[8] work just as well.
- The meaning of indicators changes over time. Yield curve inversions are a less reliable predictor when they do not indicate tight monetary policy,[9] and the natural rate of interest—the rate that neither stimulates nor contracts the economy—changes over time.[10]
So, don’t hold your breath waiting for the next recession; you’ll know when it arrives. Or not. The NBER announced the start of the last recession just a few months after it began, but most determinations take much longer.[11]
It’s also hard to predict what will happen in a recession. The NBER defines a recession as “a significant decline in economic activity that lasts more than a few months,”[12] but every recession is different. The Great Recession of 2007-2009 was the longest since World War II.[13] A decline in the US housing sector triggered a financial crisis, which spread the downturn to other sectors and countries. Recovery was slow, and the economy remained weak after the recession ended.[14] The 2020 recession, by contrast, lasted just two months, but the fall in real GDP was more than twice as large. Many sectors were affected, but recovery was much faster.[15]
The unpredictability of recessions may hold lessons for investors. Sector rotation strategies allocate assets dynamically through the cycle, for example, by shifting into economically sensitive sectors like real estate and consumer discretionary as the economy recovers, and then back to less sensitive sectors such as consumer staples and utilities as it moves into recession.[16] Sector ETFs make it easy to implement such a strategy, but the difficulty of timing recessions and their variable impact on sectors can undermine results. A more promising approach may be to base rotation on rolling sector portfolio alphas from asset pricing models, rather than economic indicators.[17],[18] This exploits changes in sector returns over time without the need to predict recessions or commit to a rigid view of relative sector performance through the cycle.
We know much less about recessions than we would like. Sometimes, however, knowing what we don’t know can be just as important.
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[1] National Association of Business Economists. 2023. NABE Business Conditions Survey, April.
[2] An, Z., Jalles, J., and P. Loungani. 2018. “How Well Do Economists Forecast Recessions?” IMF Working Paper. International Monetary Fund, March.
[3] Claessens, S., and M. Kose. 2009. “What Is a Recession?” Finance and Development 46, no. 1: 52-53.
[4] National Bureau of Economic Research. 2023. “Business Cycle Dating.” Accessed 27 April. https://www.nber.org/research/business-cycle-dating.
[5] Bernanke, B. 1995. “The Macroeconomics of the Great Depression: A Comparative Approach.” Journal of Money, Credit and Banking 27, no. 1: 1-28.
[6] Miller, D. 2019. “There Is No Single Best Predictor of Recessions.” FEDS Notes. Board of Governors of the Federal Reserve System, 21 April.
[7] Murphy, M., Romero, J., and R. Webb. 2019. “Predicting Recessions.” Economic Brief 19-12. Federal Reserve Bank of Richmond, December.
[8] Borio, C., Drehmann, M., and D. Xia. 2019. “Predicting Recessions: Financial Cycle Versus Term Spread.” BIS Working Papers, no. 818. Bank for International Settlements, October.
[9] Cooper, D., Fuhrer, J., and G. Olivei. 2020. “Predicting Recessions Using the Yield Curve: The Role of the Stance of Monetary Policy.” Current Policy Perspectives. Federal Reserve Bank of Boston, 3 February.
[10] International Monetary Fund. 2023. World Economic Outlook: A Rocky Recovery. Washington, DC, April.
[11] National Bureau of Economic Research. 2020. “Determination of the February 2020 Peak in US Economic Activity.” 9 June. https://www.nber.org/news/business-cycle-dating-committee-announcement-june-8-2020.
[12] National Bureau of Economic Research. 2023. “Business Cycle Dating.” Accessed 27 April. https://www.nber.org/research/business-cycle-dating.
[13] Rich, R. 2013. “The Great Recession.” Federal Reserve History. Board of Governors of the Federal Reserve, 22 November. https://www.federalreservehistory.org/essays/great-recession-of-200709.
[14] Weinberg, J. 2013. “The Great Recession and Its Aftermath.” Federal Reserve History, Board of Governors of the Federal Reserve System, 22 November. https://www.federalreservehistory.org/essays/great-recession-and-its-aftermath.
[15] Center on Budget and Policy Priorities. 2023. “Chart Book: Tracking the Recovery from the Pandemic Recession.” 13 April. https://www.cbpp.org/research/economy/tracking-the-recovery-from-the-pandemic-recession#pandemic_recession_deeper.
[16] Emsbo-Mattingly, L., Hofschire, D., Weinstein, J., and C. Dourney. 2021. “The Business Cycle Approach to Equity Sector Investing.” Fidelity Institutional Insights. Fidelity Investments.
[17] Sarwar, G., Mateus, C., and N. Todorovic. 2018. “US Sector Rotation with Five-Factor Fama-French Alphas.” Journal of Asset Management 19, 116-132.
[18] Alexiou, C., and A. Tyagi. 2020. “Gauging the Effectiveness of Sector Rotation Strategies: Evidence from the USA and Europe.” Journal of Asset Management 21, 239-260.
