By Eugen von Böhm-Bawerk
In The Coming US Recession Charted (June 20, 2015) we argued that the US economy is heading toward recession, not escape velocity as the sell-side and Fed officials have been telling us. Today we will revisit the possibility of the US entering a recession in 2016 and by extension substantiate our argument for NIRP, and not lift-off, as the most likely next move by FOMC.
One of the most reliable predictors for the business cycle is the yield curve. Unfortunately, due to Federal Reserve manipulation, whereby the short end of the curve have been permanently pegged to zero, an inverted yield curve is more or less impossible. However, if we look at the relative change from trend we can construct an equally good predictor. The blue line in the chart below depicts difference in the 10/5 term spread vs. its underlying trend. Historically, a breach of 50 basis points have indicated an upcoming recession. While the current trend deviation is not giving a clear signal yet, it is close enough to suggest we are heading straight into another recession.
The growth rate in real GDP for 2015 goes a long way to validate what we see in the picture above. Sup-par performance, even by a lacklustre post-crisis standard, is the most likely outcome for the year. Recent data point to a very weak third quarter, with growth probably coming in less than 1 per cent SAAR; supported by the prescient Atlanta nowcast model. The annual run rate for GDP suggest growth below 2 per cent, thus entering 2016 on slowing momentum.
Why do we believe the second half will weaken from an already dismal first half? One reason stems directly from the outcome of the so-called residual seasonality debate that raged after the catastrophically poor first quarter. In what, by now, have become a sell-side embarrassing ritual, first quarter GDP ruin all preceding year-end forecast of impending escape velocity.
This year they had enough of it and demanded from the BEA to remove any residual seasonality that had to still be left in the data. The BEA complied and revised the first quarter as requested. The problem with such myopic thinking is that it obviously comes back to bite you when you least need it. We are sure the Atlanta Fed model does not account for the fact that GDP “given” to the first quarter must be “taken”, most likely from second and third quarter, since seasonal adjustment cannot (or should not) change the average growth rate for the year as a whole. If BEA shifted GDP units into the first quarter, they must revise down second and third quarter correspondingly as shown by our “second round” seasonal adjustment in the chart below. In other words, there should be downside in the already downbeat Atlanta Fed nowcast.
The FOMCs lift-off debate will thus do a one-eighty quicker than most people think possible.
In addition, as we pointed out in our update from June 20, time is getting ripe for another down cycle. Historically the trough to peak last around 40 months, while the current expansion has been ongoing for 75 and is by that the fourth longest on record (actually third, as the second world war was not a time of prosperity in the US, but the statistics measure it as such).
As we should expect in a mature expansion, business sales stalls and have actually started to fall; this is not something that just tend to happen now and then. The chart below clearly shows what falling business sales means – recession.
Inventories, as witnessed in the latest wholesale sale report, are rising fast with the inventory to sales ratio clearly in recessionary territory. As ZeroHedge recently pointed out, the dollar value of inventories over sales have never been higher.
In this environment, we should expect imports to slow down, but due to a strong dollar, it makes more sense for Americans to import goods than buy from local suppliers. We calculate the non-oil trade deficit to be at a record while the overall deficit is flattered by increased domestic oil production and oil product exports. As the shale-gale settles down, domestic oil production will fall; probably 400 – 600kb/d in 2016. Imports will obviously rise accordingly. The total deficit will converge with the non-oil deficit, creating another GDP headwind.
As a side-note regarding the strong dollar and how the Fed has become the global central bank. In times of QE, dollar liquidity has improved, which includes the all-important Eurodollar market. With increased confidence that actual dollars will be there if needed, money flows back out pulling the dollar value down. However, as soon as the Fed stops the flow of fresh dollars, the dollar value spikes wreaking havoc to global dollar liquidity. What is interesting to note is how QE3 completely failed to lift confidence in the global dollar market and the mere taper crushed the remaining confidence leading to a scramble for actual dollars, thus bringing the EM down with it.
But we digress, with higher inventories and more goods flowing in from foreign markets US industrial production growth has fallen (to a large extent tied into reduced activities in shale oil development) and will soon cross the zero line as production need to be realigned with demand.
The factory order report confirms our view. Both “core” and headline factory orders are pointing to tougher times for US manufacturing.
Excess capacity leads to another round of deflationary pressure; exacerbated by the dramatic change in EMs FX reserve accumulation. We showed yesterday that even Norway is on the brink of becoming a net seller of financial securities. Bond markets agree with that assessment witnessed in the rapidly falling 5Y/5Y, in both Europe and the US.
We end with an update to our cumulative goods sales vs. cumulative inventories chart derived from the GDP report. There can be little doubt that the massive, unprecedented surge in inventory accumulation (which counts positively to GDP) will eventually be liquidated. When it does the US enter recession, global dollar liquidity crashes, the value of dollar surges even higher, pulling EM further down and a world recession will be upon us again. In this scenario central banks panic; NIRP, QE4 and helicopter money is the only thing they know and they will stick to it.
The statements, views, and opinions expressed in this article are solely those of the author and do not necessarily represent those of EMerging Equity.