Preparing for a recession

As the U.S. economy continues to navigate uncertain times, the question on everyone’s mind is whether or not the country is headed for a recession. 

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To answer this, Samuel Lau, portfolio manager with DoubleLine Capital in Los Angeles, looks at three key indicators for insight on the near future of the U.S. economy. 

All three indicators have historically preceded economic contractions. Based on these signals, Lau said the U.S. will likely enter a recession within the next 10 months.

First, Lau considers the Conference Board’s leading economic index (LEI), which serves as an indicator when the year-over-year index flips negative. According to Lau, the lead time has historically been between six to eight months from the time the index first dips into negative territory until a recession hits. 

As of March, Lau said, the LEI has been in negative territory for approximately seven months. Based on this measure, he said the economy could either already be in or very near the beginning of an recession.

Lau also looks at the U.S. headline unemployment rate. When the unemployment rate rises above the 12-month and 36-month moving averages, the recession indicator is triggered, he said.

The 12-month and 36-month averages are 3.6% and 5.7%, respectively. According to the latest reading, for February, the unemployment rate in the U.S. was 3.6%. 

Similar to the LEI, using the 12-month moving average as the indicator, the lead time before a recession is approximately six to eight months. The 36-month is an even better indicator, he said, but it is typically triggered around the time a recession begins, so it offers little foresight. 

Despite being on the precipice of triggering the 12-month indicator, Lau said the unemployment rate needs to break through to consider it a signal. However, in the past, he said once the unemployment rate begins to move higher, it can move rather quickly.

Lastly, Lau said the shape of the U.S. Treasury yield curve can be another recession indicator. 

When the yield on the 3-year Treasury is higher than that of the 10-year, the yield curve is said to be inverted. An inverted yield curve has preceded the previous eight recessions, Lau said. He favours this indicator because it’s based on real-time market data rather than economic data, which can lag anywhere from one to two months.

The curve inverted in October. Lau said a recession usually follows within a year, but the timing has ranged from nine to 23 months in the past.

All three indicators suggest a recession, Lau said, but the question is when.

“It does seem to point to somewhere in the second half of 2023, perhaps the first quarter or the first half of 2024,” Lau said.

The indicators give investors some foresight, Lau said, and allow them to position accordingly. 

Within credit markets, Lau has a preference for non-traditional fixed income, such as asset-backed securities and non-government guaranteed commercial and residential mortgage-backed securities. In these sectors, Lau said high single-digit yields and low double-digit yields are still available, while remaining in investment-grade securities.

For investors willing to step outside of the investment-grade arena, Lau said yields can rise quickly from there. However, he cautions loading up solely on credit in today’s environment. 

U.S. Treasury securities also have yields not seen in years and can offset credit risk, Lau said: “That can be quite an attractive parking spot for those who are waiting to deploy cash.”

Longer-dated Treasury bonds mean giving up some income but could provide protection against adverse moves in riskier assets, such as the aforementioned credit sectors, Lau said. 

For this reason, Lau recommends a mix of credit and Treasuries to balance the risk. “If you have both of those sides in your fixed income portfolio, you have offsetting risk and return,” he said.

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