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A do-it-yourself recession prediction

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      By Stewart D. TaylorInvestment Grade Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - I can say without reservation that many of the smartest people I know are economists. I can also say without reservation that the worst predictors of markets and the economy are also economists. This is particularly true in late cycle environments as the expansion peaks and the economy transitions into recession. To be fair, most economists focus on modeling economic behaviors rather than predicting cycles or markets. However, even economists tasked with predicting recessions fail miserably. Whether resulting from a failure in elaborate multivariate econometric models or a behavioral bias, the results are clear.

      In the vast majority of past recessions, the economic consensus failed to predict a recession until months after the recession began. A recent research paper by Fathom Consulting found that of the 469 recessions experienced in the global economy since 1988, International Monetary Fund economists only anticipated the downturn a grand total of four times. The IMF found similar results when they audited themselves. I always chuckle when an economist friend trots out the Nobel Prize-winning economist Paul Samuelson's tongue-in-cheek quip, "The stock market has predicted nine of the last five recessions." Ironically, that's five more recessions than economists predicted.

      Economists fail because it's a complex ever-changing world that confounds both easy answers and complex models. Unfortunately, the unprecedented central bank interventions of the last decade make forecasting the next recession even more difficult than usual. However, here are three indicators that you may find helpful.

      The yield curve: There is a good reason inversions in the Treasury curve are the most widely recognized and reported recession precursor. Every yield curve inversion since 1977 has produced a recession. In an economy growing ever more dependent on finance, the economic impact of rising short rates is becoming ever more profound.

      The Federal Reserve (Fed) increasing policy rates creates the inversion. Sharply rising short rates reliably create economic stress one to two years later. As stresses become evident, the Fed realizes they have increased rates too rapidly and begin cutting them to stimulate. This steepens the curve. I prefer not to focus on the inversion. Instead, I focus on the steepening moves that follow an inversion or near inversion of the curve.

      Recessionyields

      Employment and claims for unemployment: Sharp upward moves in unemployment and initial claims from very low levels do a good job of anticipating downward turns in the cycle. I pay the most attention to claims data. They are released weekly and provide almost immediate feedback when employers begin reducing employee head count in significant numbers.

      recessionclaims

      Leading economic indicators year-over-year change turns negative: Every downturn since 1970 has included a year-over-year decline in leading indicators. The only false positive was a single month in 1996 after the Fed preemptively moved from tightening to easing in 1995, prolonging the expansion.

      recessionindicators

      Bottom line: Economists make wonderful friends but when assessing the economic cycle, I prefer to rely on these three erstwhile companions. Realize that every economic cycle is different. There are no guarantees these indicators will work as well as they have in past cycles.