5 Reasons Wall Street is Freaking Out About a Recession

As Janet Yellen testifies in front of Congress this week, it is safe to say that she is facing the period of greatest economic uncertainty since she took over the role of Fed Chair roughly a year and a half ago.

The Federal Reserve appears to be rethinking its pace of interest rate increases, which most analysts had assumed would sit at 1% by years end, after turmoil in energy and emerging markets has shaken the confidence of American investors in the health of the global economy.

Another reason folks are concerned about the American economy is that we're currently in the 80th month of this economic expansion, the 3rd longest in history. Janet Yellen has herself said that "expansions don't die of old age." And even though neither the Fed, nor most economists, are predicting a recession in the near future, it's a good bet that the experts at the central bank are taking a look at possible recession triggers. Here are five that we should watch out for.

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Oil

Why it's a problem: The collapsing price of oil had economists bullish on growth for a while, as cheaper oil should give consumers more money to spend on other things. But the magnitude of oil's collapse over the past year and a half is nearly unprecedented. As High Frequency Economics' Carl Weinberg writes in a note Wednesday to clients:

The crash of commodity prices by itself is enough to set the global economy into an irrecoverable tailspin, even in the best of times. Contemplate a world that produces 90 million barrels of oil per day, or 32.9 billion per year. Reducing the value of that production by $100 per barrel subtracts $3.3 trillion from world income, which is only $70 trillion or so to begin with. That is a big "ouch."Call that 4-4.5% hit to world income. Now consider how much oil is in the ground—maybe proven reserves are something like 30 years' supply. If so, the drop in oil prices has caused a $100 trillion cut in world wealth . . . and this is just oil. What about iron ore, coal, nickel, copper, gold?

Why you shouldn't be so worried: On the other hand, the most recent example of a similar crash in oil, when prices fell in 1986 from $30 a barrel to $15, didn't significantly affect the economic cycle at that time. The magnitude of today's drop is more severe, and the U.S. economy is more reliant on oil production today, but the '86 example is one that bears paying attention to. The vast majority of economic activity in the U.S. is in the service sector, and if anything, benefits from cheaper energy prices.

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An employee prepares to thread a bobbin of yarn as he was reloading the braiding machine on the automated braiding line at Sole Choice Inc. on September 30, 2015 in Portsmouth, Ohio.Photo by Ty Wright

Manufacturing

Why it's a problem: The warning signs of a global slowdown are not limited to oil markets. As the Chinese economy has continued to weaken, all kinds of commodities have been falling in price, and manufacturers around the globe have been forced to slash prices in order to compete with a panicked Chinese manufacturing sector that is producing at over-capacity. This has lead to what can only be described as an global manufacturing recession.

Why you shouldn't be so worried: The good news is that manufacturing these days is only a small portion of our economy. So the question for economists in recent months has been whether weakness in the manufacturing sector would spread to services, which account for the vast majority of output in the United States. Unfortunately, the most recent reading of the ISM non-manufacturing index shows growth in services slowing for the third straight month. While the services sector is still expanding, this is a trend we should all keep an eye on.

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The Stock Market

Why it's a problem: As you are probably aware, American stock investors have been irritable of late. The S&P 500 has fallen nearly 12% since last July, reflecting, among other things, investor's suspicions about the health of the U.S. economy. The stock market is a leading indicator of economic activity, as recessions are almost always preceded by falling stock values.

Why you shouldn't be so worried: But because stock markets tend to be volatile, a stock market correction can happen even absent a recession. That's why economists also like to look at the bond market, and specifically for whether or not the yield curve has inverted before predicting a recession. A yield curve inversion, in which the short-term interest rates are higher than long-term rates, indicates that investors think inflation and economic activity will be significantly slower in the future. And when you are worried about a recession, that's cause for concern.

But some analysts are arguing that central bank stimulus, which has pushed down rates across the yield curve, makes a yield curve inversion almost impossible, because it would mean that long rates would have to hit close to zero.

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Corporate Profits

Why its a problem: Even if we don’t have a real recession, we’ve already entered a so-called profit one. Earnings for the companies in the S&P 500 dropped in the fourth quarter of 2015, according to FactSet. That was the third quarter in a row earnings have fallen. What’s more, the corporate profit drop isn’t expected to end soon. On average companies in the S&P 500 are expected to see a drop in their bottom lines for the first half of the year before rebounding slightly in the second half of 2016.

Why you shouldn't be so worried: The silver lining is that profits were up a great deal coming out of the recession, and profits margins are at all-time highs, making bottom line gains, given that the overall economy is growing slowly, harder. Also a lot of the profit drop is coming from one sector: energy. Earnings of companies in the oil and gas industry dropped by nearly 75% in the quarter. But it wasn't only energy that fell. Six of the 10 sectors in the S&P 500 registered profits drops in the fourth quarter. Worse, sales were down too.

Still, a number of companies  actually ended up reporting better earnings in the fourth quarter than expected. Before companies started reporting their numbers analysts had been expecting an earnings drop of closer to 5%, worse than the nearly 4% we actually got.

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Lending

Why it's a problem: In the Federal Reserve's January survey of loan officers, an increasing number responded that they planned to tighten lending standards on corporate borrowers. It was second month in a row that a growing number of loan officers said that, and highest increase since the fourth quarter of 2009.

What's more, companies are having to pay more to borrow as well. That's particularly true for companies with lower credit ratings. In December, the difference between what companies rated so-called junk and investment grade companies had to pay to borrow rose to just over 7%. Goldman Sachs noted, at the time, that while the spread has gotten that big in the past, most of the time it has a recession has followed.

The same is true for the lending officers survey. Tightening credit doesn't alway lead to a recession. But every recession starts with a tightening of credit.

Why you shouldn't be so worried: The good news is that while the spread had risen, the fact that interest rates are still low means that companies—especially investment-grade firms—are still paying historically low prices to borrow money. What's more, many companies have taken advantage of the recent period of low rates to refinance. So it could be years before they have to pay higher rates. And when it comes consumer loans, lending officers said they were continuing to make credit card, auto and other other loans more available, not less.

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