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How you could spot an economic recession

We take a look at some indicators you could use to assess the health of the economy.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

A downturn is difficult to predict accurately, many economists try and fail. But we think that there are some indicators you can look out for to help you gauge the health of the economy. It’s been a great time to be invested over the last ten years. We’ve experienced one of the longest bull markets in history. And if you were brave enough to invest back in 2009, you would have received some handsome returns. Between the start of 2009 and June 2019 the FTSE All-Share Index rose by 168.4%*. However, please remember that past performance is not a guide to the future.

Some academic studies have indicated that the stock market can be a useful leading indicator of future economic activity. So as we might expect, these stock market gains have also been accompanied by GDP gains too, albeit at a much slower rate. In the UK GDP rose by 17.7%* over the same period.

But the party can’t last forever, and while it’s difficult to predict the future consistently, there are some indicators that you can look at to get a feel for how the economy is holding up. This article is not personal advice. If you’re unsure if an investment is right for you, seek advice.

Inflation

In the UK the Bank of England is responsible for setting our monetary policy and they have two key aims. They set the base rate of interest to try and achieve a target annual inflation rate of 2%, and encourage economic growth and financial stability. Inflation is currently 1.7%, slightly below the 2% target. If inflation is persistently below target it’s usually a sign that demand in the economy isn’t very strong. If prices are rising very slowly or even falling, consumers delay buying things, exacerbating the slowdown in demand and eventually impacting employment levels.

The Bank of England’s interest rate decisions can be a good indicator of how healthy they think they economy is. When they’re cutting rates it’s usually because they think the economy needs a boost to carry on growing and the extra activity should help them achieve their objectives. But if they’re raising rates, it’s with the intention of reining the economy back in. This may be because inflation is above their target or to counterbalance powerful growth.

It’s worth remembering though any interest rate changes usually take 12-18 months to filter through and have an effect on the economy.

Yield Curves

The yield curve shows the interest rates available to investors willing to lend their money for different periods of time.

In August the yield curve for two year and 10 year Treasuries in the US inverted for the first time since the run up to the financial crisis in 2007. This means that a 10 year bond yielded less than a two year bond. Normally, you’d expect that the longer the period you lend money to the government for, the more you’d receive because of the greater risks involved.

Generally the longer the period, the higher the chance of the government defaulting and not being able to pay off their debts. But where inversion occurs, investors are in the unusual situation where they’ll get lower returns for lending over a longer period of time.

This usually means lower economic growth and interest rates are expected in future. But an inversion has previously been an indicator of an approaching recession. However, the one thing it’s hasn’t been so good at is predicting when it might happen.

Any potential recession could be months or years ahead, or might not even happen at all. It could just be a sign of investor nervousness and given the unprecedented support central banks have given to markets through their monetary policy, it’s possible normal market signals may have been distorted.

Confidence Surveys

It’s hard time for investors to know where to put their money. The headlines seem increasingly off-putting whether it’s a deterioration in the US-China relationship or another twist or turn in the Brexit process. And for businesses who export to other parts of the world or for workers worried about the potential impact on their jobs it creates uncertainty, stifling economic activity.

The Hargreaves Lansdown survey of investor confidence shows investors are still feeling cautious about investing in the UK, with confidence levels having fallen below the levels seen even after the Brexit referendum.

Confidence is an important barometer because it affects decision making. Consumers and businesses who are confident in the direction of the economy are happier spending more, anticipating that good times are ahead.

But when people are unsure they cut back on spending and save a bit extra each month, in fear of losing their job or an unexpected event. This lower spending drags demand lower and can tip an economy into recession if it persists.

Purchasing Managers Index (PMI)

PMI is an economic indicator which measures the health of a particular sector within an economy. In the UK PMI data is collated for the manufacturing, services and construction industries. A PMI score of 50 or above indicates an expansion, 50 indicates a constant level of activity and a score of less than 50 shows a contraction.

Recent PMI surveys have shown shrinking manufacturing sectors in many countries across the world, including the UK and Germany. This isn’t usually good news for the wider economy. It often means demand for goods is falling and can result in companies having to lay off workers to keep labour costs under control.

But the effect doesn’t necessarily end there. A worker who’s been made redundant now has less income to spend on other goods and services in the economy. They may cancel their leisure club membership or eat out less frequently, which can be a drag on other areas of the economy, like the services sector.

What should investors consider ?

We think one of the best ways you can reduce the impact a recession can have on your portfolio is to diversify your investments. By holding investments with different drivers of returns you can reduce the chances of them all performing in exactly the same way should an event like a recession occur.

The mix of investments that will be right for you will depend on your objectives and attitude to risk. Remember no matter how diversified your portfolio is it can always fall as well as rise in value, so you could get back less than you invest.

Learn about the benefits of diversification

Read more

*Source: Thompson Reuters to 30/06/2019

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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