International | Jun 24 2019
Richard (Rick) Mills
Ahead of the Herd
As a general rule, the most successful man in life is the man who has the best information.
Dancing closer to the exits
When Americans elect or re-elect a president in the fall of 2020, there is a very good chance the closest thing to their hearts – their wallets – will be top of mind.
That's because many are predicting the longest-running economic expansion in US history is about to slam on the brakes. It's been over a decade since The Great Recession of 2007-09 plunged the world into monetary despair. That downturn was particularly bad because it combined an economic slowdown with problems in the financial system, rudely exposed by the sub-prime mortgage crisis.
In this article we are asking, what is the best indicator for predicting the next recession? What does the current data say about a recession?
We've become so used to the stock market being in the green, we barely notice when the Dow, Nasdaq or S&P 500 have a bad day. Stocks have become like real estate – keep buying them because over time, they will always go up.
But key economic indicators are blinking "caution" for investors.
US unemployment is at record lows but the job numbers are indicating a shift. The country created 75,000 jobs in May, well off the expected 185,000. President Trump likes to take credit for near-full employment but in fact the jobless rate has been falling for several years, shown in the FRED chart below; it reached 10% during the Great Recession, second only to nearly 11% in 1980, and has fallen steadily, under the watch of President Obama, who was first elected in 2008.
President for life, Xi Jinping, will meet with President Trump at the upcoming G-20, to try and make progress on the trade war, which is far more serious than a year ago when the first tariffs, on aluminum and steel, were enacted. Tariffs now encompass over half of the roughly $500 billion in goods that China exports to the US, and almost all American goods imported by China.
The US has banned large tech companies like Intel from doing any more business with Huawei, one of the world's largest smartphone makers, and builder of 5G networks. The federal government is pursuing almost two dozen criminal charges against Huawei and its chief financial officer over its dealings with US-sanctioned Iran. In retaliation, China fined Ford $23.6 million for anti-trust violations, and is investigating FedEx for "wrongful" deliveries, Automotive News said. The country is also threatening to blacklist foreign firms that damage the interests of Chinese companies, and has warned its citizens against traveling to the US.
Uncertainty over the trade war is having an effect on business leaders who are deferring strategic decisions and in some cases, rejigging their supply chains. Google has already shifted production of its motherboards to Taiwan to avoid a 25% tariff, and is looking at adding Nest thermostats and server hardware. Taiwan-based Foxconn, which assembles iPhone and iPads for Apple, said it's prepared to move production out of China if necessary.
On Friday (prior week) Morgan Stanley reported a rapid deterioration in US business confidence. The investment bank's gauge of business conditions fell 32 points last month, the biggest drop since the financial crisis.
Orders for durable goods are down and the Purchasing Managers Index (PMI) of the countries that count are sucking wind; Wolf Street called the US PMI figure of 50.2, "the cleanest of the dirty shirts." Germany, Japan and China were all lower. (China's National Bureau of Statistics published signs of a sluggish economy on Friday – notably, lower industrial output and investment).
The PMIs for US services and manufacturing in May were the worst since recessionary 2009 – adding to the sentiment that US economic growth is slowing.
As for the US Federal Reserve, its board of governors is hinting that a rate cut is being considered as a way to bolster the flagging economy – a complete 180 from six months ago when the US central bank was looking at raising interest rates.
Why? Because the Fed is concerned about low global growth, especially the Chinese economy, and disturbing signals that we are heading into a recession.
50 years of recessions
What is this thing we are calling a recession? In a nutshell a recession is what results when an economy stops growing. The National Bureau of Economic Research (NBER) is the group entrusted to call the beginning and end dates of a recession. NBER defines it as "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales."
Economists agree that a recession is defined as two consecutive quarters of decline in GDP, which is the total value of all goods and services a country produces.
Results from a recent poll showed nearly half of CFOs surveyed, expect to see negative growth by the second quarter of 2020. Two-thirds of economists predict a recession by the end of 2020, citing trade policy as the greatest risk, while another 10% believe the contraction will start this year.
Jeffrey Gundlach, the so-called "bond king", is equally bearish on the economy. He puts the odds of a US recession within the next six months at 40-50%, and 65% over the next year. Marketwatch reports Marko Kolanovic, JP Morgan's chief quant strategist, saying that President Donald Trump's trade battles have cost U.S. companies trillions, and could trigger a downturn that would end up being known as the "Trump recession."
If the above-mentioned analysts and surveys are right, and a recession is around the corner, it would be extremely helpful to know, what are the signs? Also, one shouldn't get lulled into thinking that because we've enjoyed a decade of strong growth, that the next slowdown will be gradual or soft. History proves otherwise.
Expansions don't die, they're killed
There's an old saying in economics that "expansions don't die of old age." Meaning there is always an event, or sometimes more than one, that causes a long period of economic growth to end. Investopedia does a nice job of naming the causes all the US recessions going back to the Roosevelt recession of 1937-38. Unfortunately, it skips the Great Recession, widely known to be caused by a housing crisis in the US (due to sub-prime mortgages), which resulted in a credit squeeze, bank failures and subsequent government bailouts.
We learn the main triggers for the last three recessions before 2007-09 were, in reverse chronological order: the pop of the dot-com bubble and 9/11 attacks (9/11 recession); Iraq's invasion of Kuwait, causing the oil price to spike (Gulf War recession 1990-91); and the regime change in Iran which also caused an energy crisis (Iran/energy crisis recession 1981-82), forcing the US to invoke drastic fiscal tightening – culminating in an interest rate spike to 21.5%.
In fact, Investopedia reveals the common factor throughout nearly all US recessions is oil market turbulence; a sudden increase in the price of crude oil has preceded nine out of 10 post-WWII recessions.
Let's get back to basics – most recessions, nine of the last 10, are caused by energy crises. Not surprising, considering our dependence on fossil fuels. While the amount of renewable energy capacity is increasing every year, global consumption of energy is still dominated by fossil fuels and hydro-electric power. The latter require the construction and upgrading of dams, itself a fossil-fuel-intensive endeavor.
Oil price shocks send ripples through the Canadian and American economies, since both are significant oil producers. For example, at the end of 1998, crude oil was priced at just $11 a barrel. By late 2000, it had tripled to $34/bbl. High oil prices combined with the dot.com crash and Enron, resulted in the 2000-2001 recession.
An oil price shock puts pressure on other prices to increase (like transportation costs), which hikes inflation. Businesses put expansions and hiring on hold, or lay people off. Gradually GDP growth slows, unemployment rises, as does the cost of living. Costs are rising but the dollar is worth less. People have less to invest, or invest more conservatively, moving their money out of stocks and into safe havens like bonds, foreign currencies and precious metals. Sustained selling crushes the stock market. A recession ensues.
Oil prices, shaded areas are recessions
In a typical healthy market, the yield curve shows lower returns on short-term investments and higher yields on long-term investments. More importantly, yield curve inversion has come before every recession since World War II.
The yield curve between long-term and short-term Treasury note yields has been inverted since May 23. In other words short-term yields like the three-month, one year and three-year Treasury notes, turned higher than long-term yields. That's unusual because it means bond investors prefer to park their money in bonds that will pay them back their money, plus interest, in one month to three years, versus investing in a bond with a term of 10 to 30 years, in which case they would demand a higher yield for tying up their money so long. A yield curve inversion shows low confidence in the long-term performance of the US economy, among bond investors.
However on Monday (last), yields jumped. The 10-year Treasury is at 2.101% and the three-year yield at 1.815% as I write. The market is focused on the Federal Reserve's meeting on Wednesday when it will announce its interest rate policy. Investors are anticipating the Fed to hold its overnight lending rate – the interest rate at which banks loan money to one another – unchanged at this meeting and possibly signal a cut to the federal funds rate later in the summer. [As was the case – Ed]
Remember, up until Monday the yield curve was inverted – showing a negative spread between long-term and short-term T-bill yields, meaning investors had more confidence in short-term than long-term bonds.
Yield curve inversion + oil prices
So far, we know that yield curve inversions are a very strong indicator of a coming recession. All of the post-WWII recessions except two were preceded by an inversion. We also know that nine out of the last 10 recessions saw oil prices spike immediately, or very close before the recession.
At Ahead of the Herd we decided to compare two charts – the historical price of oil and historical yield-curve inversions – to see if there is any correlation. In fact, the two charts match very closely.
The first chart below shows all the yield-curve inversions from the last 50 years, along with the recessions that followed – the gray bars. The second chart is the historical price of West Texas Intermediate (WTI) – the North American crude oil benchmark.
The "U.S. yield curve steepness" chart below, courtesy of JP Morgan Asset Management, is very interesting. It shows when the yield curve inverts, a recession is very likely to follow, on average, 14 months after the point when the curve inverts, ie. The curve goes under the horizontal line demarcating 0%. This has been the case for the last 50 years.
As an article in Advisor Perspective reports, this yield curve recession indicator is so reliable, it cannot be argued. Author Erik Conley writes: "I don't know of any economists who dispute this assertion; history is history and not theory."
Taking a look at the chart, there was a recession every time after the yield curve inverted, for the last 56 years, except for two times when there was an inversion without a recession. How's that for odds?
Now take a look at the oil price chart, reproduced here for easy comparison. In all of the recessions there was a preceding oil price spike. For example, before the "oil crisis recession" of 1973-75, the inversion occurred in 1973, and continued to fall to -2%, as the Fed tightened short-term rates to try and tame inflation, caused by spending on the Vietnam War. During this period oil prices tripled, beginning with the OPEC oil embargo in 1973.
Or the 1990-91 "Gulf War recession". The yield curve inverted in 1989, about a year before the recession caused by Iraq invading Kuwait, whose actions threatened more oil price shocks, began. Oil was gradually rising from 1985 to 1990, when it makes a rapier-like slash up to nearly $80 a barrel from around $25/bbl.
The financial crisis of 2007-09 is even more demonstrative of the connection. Here we had the inversion occurring in 2006, which few people recognized as a daunting signal to sell their stocks. The recession began in the fall of 2007 and by 2010 the spread between short and long-term T-bill yields had grown to about 2.5%. Meanwhile WTI made an incredible run in a very short time, from under $20/bbl in 1998 to an all-time high of $163.80 in 2008.
Finally, consider that the two times the yield curve didn't go into recession, it was when the oil price was dropping. Comparing the two charts for the last time, look at the red dots in 1966 and 1998. These inversion-point anomalies, ie. happening without a recession coming an average 14 months later, occur when the price of oil is falling = no recession.
To us, being the keep it simple kind of folks we are, this proves 1. That yield curve inversions are excellent recession indicators – basically acting as energy price spike warnings and 2. That energy prices can both start recessions, and prevent them.
A lot of forecasters consider the housing market to be a reliable indicator of a coming recession. Economist Edward E. Leamer declared in 2007 that "housing is the business cycle" (recessions are considered part of the business cycle, along with expansions and contractions) – a statement he was proven right on, when the housing crisis that presaged the Great Recession began that same year.
According to the St. Louis Fed, housing downturns have preceded every post-war recession. Warning signals include rising mortgage rates, a dip in home sales and lower house prices.
We would expect housing starts to be a good predictor of a recession, since they signal the confidence of home builders in financing projects and being willing to sell them to eager home buyers. If developers and builders think a recession is coming, they are unlikely to take on new work.
The St. Louis Fed research found a strong recession indicator in lower housing starts for the last four months before each downturn began. It refers to this scenario as a "housing starts inversion". If a housing starts inversion occurs, there is around a 50% likelihood that a recession will start in the next three months. Not bad odds.
U.S. homebuilding starts fell in May, dropping 0.9% to 1.269 million units, but data for the prior two months was revised higher.
High household debt
We're going to go a little out on a limb here in presenting our next recession predictor – unsustainable household debt.
In 2015 the Federal Reserve started raising interest rates, thinking the economy was making a full recovery following the Great Recession. But as we've pointed out, it was a false recovery based on a very shaky foundation. Still, in 2018 it was hard to argue with 4.1% growth in GDP during the second quarter; the Fed continued their raises, predicting four more in 2019.
Now they've changed their tune. With GDP growth falling and all the other aforementioned economic storm clouds blowing in, rate increases are off the table and we are now looking at another rate cut, maybe even reprising the infamous quantitative easing (QE). It would be the first rise since 2015, and the stock market, businesses and consumers would all love it.
If the economy is faltering and with the Fed having raised interest rates, from close to 0% in 2015 to the current 2.5%, we should expect consumer spending to tank. In fact this is not what we are seeing. It's true people are buying less houses, but they are lining up to spend on just about everything else.
How do we explain this rash of spending? People are making purchases on credit.
Consumer spending makes up 68% of the US economy. If most businesses are doing well, and they appear to be from the statistics, employees should theoretically have more to spend on goods and services. People are keeping their jobs and their wages are going up.
This in fact is what we find. The Balance reports that consumer spending increased by 1.2% in the first quarter of this year, and notes that "Strong consumer spending is the main reason the GDP growth rate has been within the 2-3% healthy range since the Great Recession."
Consumer spending has gone up steadily since the first quarter of 2018, when it was $12.7 trillion, to $13 trillion in Q1 2019. US car sales have leapt from 16.4 million in April to 17.3 million in May.
That got me curious, as to where people are finding the money to spend $13 trillion in the first quarter. The answer appears to be… Uncle Visa. A Bloomberg article reports that US credit card debt skyrocketed to $870 billion in 2018, a new record.
Americans have more money in their bank accounts but what they make they're spending – maxing out their credit cards and dumping balances on lines of credit. The US savings rate skidded from 7.5% last December, to 6.2% in April. It's a far cry from the parsimonious Americans of 1975, who put away a record 17.3% of their income.
Freedom 55? Forget about it. Most workers in the US will be toiling away at their work stations into their golden years. Marketwatch reported on Friday that the gap between what people should have socked away for retirement and what they actually have, was $28 trillion in 2015. It only gets worse. By 2050 that number is expected to swell to $137 trillion according to the World Economic Forum – or a $3 trillion increase in the gap every year.
Canadians like to think of themselves as less materialistic than Americans but in fact what we see is Canucks heading to the malls and giving their credit card numbers to e-commerce platforms with reckless abandon.
Wolfstreet.com reports that, despite rock-bottom interest rates and the highest-ever disposable income, the percentage that Canadian households spend paying principal and interest on mortgages and other debts reached 14.9% in the first quarter, matching the record reached in 2017.
In Canada, debt to disposable income was a whopping 175% in 2018, one of the highest rates in the world and rising, versus 103% in the US and falling. Why are US debt levels coming down? Wolfstreet notes that a lot of home owners defaulted on their mortgages and credit cards after the financial crisis, which skewed the numbers. Another issue is the "fear factor" of getting too far into debt. A lot of Americans are gun-shy of holding uncomfortably high mortgages, knowing that is what caused the Great Recession. They have watched interest rates climb and they don't want to be saddled with higher payments.
Wolfstreet adds that continued low interest rates have created two of the world's biggest housing bubbles, in Vancouver and Toronto. Many Torontonians and Vancouverites have such large mortgages that even a small rate increase would make monthly payments a hardship. They are truly debt slaves to the banks.
Like household debt, government debt is getting more and more unsustainable. The problem for the central bank as it considers how it will handle interest rates at its next Federal Open Market Committee meeting, is how to stimulate the economy and trigger real economic growth rather than just creating asset bubbles in corporate debt and financial markets.
In February the US national debt hit a record $22 trillion. According to NPR, that means over the next 10 years, annual federal deficits are expected to average $1.2 trillion, which is 4.4% of GDP, much higher than the 2.9% average over the past 50 years.
Snatching defeat from the jaws of victory
Donald Trump rolled into the White House on a promise to "drain the swamp" in Washington of corruption and to put the pedal to the metal on America's economy by bringing back jobs lost to out-sourcing, and tearing up "horrible trade deals", not only with the US's strongest competitor, China, but its so-called friends as well, like Canada and the EU.
It came apparent a few weeks into his term that Trump would be a do-er, not a thinker. In December 2017 his administration passed new legislation implementing $1.5 trillion of corporate and individual tax cuts.
By the following summer the effects of those cuts started to be felt in the economy – although they mostly benefited corporations due to billions of profits that were repatriated from overseas and plowed into stock buybacks.
Nonetheless, the 4.2% quarterly growth in GDP was real, and something Trump could crow about. Since becoming president in 2017 Trump has consistently bragged about the stock market bull that, despite pulling back last fall, continues to run. He's even said that, if he loses the 2020 election, the stock market will crash. Same with impeachment.
"The Trump Economy is setting records and has a long way up to go…. However if anyone but me takes over in 2020 (I know the competition very well), there will be a Market Crash the likes of which has not been seen before! KEEP AMERICA GREAT," Trump tweeted Saturday.
The truth is that Trump has very little to do with the strength in the US economy. In fact, one could argue the economy has done well despite his economic leadership. As the chart below shows, gross domestic product was growing when Obama was elected for a second term in 2016. However, even Obama's charm couldn't stop the economy from sliding to just 1.9% growth in 2016. When Trump was inaugurated in January 2017, it was at 1.8%, then jumped to 3% by July. Between July 2017 and January 2018 it was all downhill. The spike to 4.2% the following July was short-lived; six months later growth had slumped to 2.2%, and it now sits at 3.1%.
All Trump had to do was sit back and do nothing, maybe get into a regular golf routine with his buddies at Mar-a-Logo, and the economy would have hummed along just fine. Instead we have the tweeter-in-chief picking fights with all his trading partners, passing a massive tax cut that benefited the wealthy and corporations, thus exacerbating the divide between rich and poor, putting America's "exorbitant privilege" in jeopardy by snubbing its allies and forcing them into the arms of the enemy, as Mexico has indicated by holding high-level talks with China. The dollar is under threat as the reserve currency. Italy has joined China's Belt and Road Initiative. Trump refused to shake hands with Angela Merkel, and is now threatening to slap tariffs on auto imports from the EU.
But the scariest part in all of this is what could happen in Iran. After two oil tankers were recently attacked in the Strait of Hormuz, Trump and his secretary of state, Mike Pompeo, were quick to blame Iran as the culprit.
Whether or not that's true, America going to war with Iran right now would be very bad news for the economy. Let's consider the likely fallout of an attack on ships in the extremely narrow and shallow Strait of Hormuz; over a third of the world's oil flows through the strait. If there's war, Iran will close this vital choke point
Now the sudden tightening of oil supplies, similar to what happened in the 1970s, would immediately push up the price of crude. Interest rates would rise, further damaging business confidence and putting the squeeze on corporate and consumer borrowing. The dollar would plummet, making imported goods more expensive. Americans' standard of living would fall as costs stay the same, or become inflated along with energy prices, but the dollar is worth less. The US dollar's already questionable "exorbitant privilege" of being the world's reserve currency would come into sharper focus. Trade in gold and other safe havens besides US Treasuries would increase.
The Guardian reminds us of the fragile state the world economy is in, having not fully recovered from the financial crisis of 2008, and getting slammed by tariffs, thereby slowing down growth. Imagine what $80, $100 or $140 barrel oil could do?
The global economy is struggling to regain momentum after the tit-for-tat trade tariff battles initiated by the Trump administration. A slowdown in trade over the past 18 months and a collapse in investment spending will push down GDP growth to 2.6% this year after several years above 3%, the World Bank said in its most recent forecast. Fears of a slowdown in the demand for oil are one of the main factors keeping a lid on prices at the moment. If a deal was struck between the US and China when the two countries' presidents meet in June – one that prevents an escalation of the trade war – economic prospects would receive a boost. Higher global demand and further tanker bombings in the Gulf would probably push oil prices back up towards $80.
As we have proven, oil price spikes are nearly 100% correlated to recessions. Right now, we also have the other recession indicators we've outlined: yield curve inversion, real 10-year yields, high levels of indebtedness, low housing sales, etc. It wouldn't take much, like a war with Iran, to tip the boat over.
In fact, the only thing that appears to be keeping the current economy from falling into recession is low oil prices. And that is precisely what Trump's threats on Iran are putting at risk. Ever the bully, Trump is literally snatching defeat from the jaws of victory, concerning the US economy.
Real yield correlation
The Federal Reserve Bank of St. Louis looked at all the post-war recessions that the yield curve had predicted. Then they compared the 10-year Treasury yield at the precise beginning of inversion, to the length of the subsequent recession, taking into account two variables, the duration of the recession and the unemployment rate. The results were astonishing: lower real rates (10-year yields minus inflation) at the onset of a recession correlated with worse downturns.
What's the connection? According to the researchers, there is a clear correlation between real interest rates and the severity of a recession; the lower the real interest rate, the longer a recession that follows a yield curve inversion. The real 10-year rate also tracks unemployment, suggesting there may be causation between real rates and economic output.
"Low levels of real interest rates capture early warnings of future slowdown in economic growth," the report said. In other words, the lower the real 10-year bond yield, the more likely it is that the economy will go into recession. Lower real rates at the point of yield curve inversion also correspond to longer recessions.
Extrapolating that idea to the current data points to an ominous result. From the graph below, the current real 10-year yield (nominal rate minus 1.8% inflation) is 0.35%, which would plot the vertical line far to the left of where it was in September 1978 during the worst post-war recession. That means the next recession, if the correlation holds true and the real 10-year rate doesn't change much, is likely to last longer than 32 months, and be characterized by more than 4.5% unemployment.
In an article on Project Syndicate, Nouriel Roubini says, "a severe enough shock could usher in a global recession, even if central banks respond rapidly. After all, in 2007-2009, the Fed and other central banks reacted aggressively to the shocks that triggered the global financial crisis, but they did not avert the "Great Recession." Today, the Fed is starting with a benchmark policy rate of 2.25-2.5%, compared to 5.25% in September 2007. In Europe and Japan, central banks are already in negative-rate territory, and will face limits on how much further below the zero bound they can go. And with bloated balance sheets from successive rounds of quantitative easing (QE), central banks would face similar constraints if they were to return to large-scale asset purchases.
On the fiscal side, most advanced economies have even higher deficits and more public debt today than before the global financial crisis, leaving little room for stimulus spending. And…financial-sector bailouts will be intolerable in countries with resurgent populist movements and near-insolvent governments."
What pushes the US into recession? War with Iran, or anything else that causes an oil price spike. This article started with the question, which is the best indicator for predicting a recession? We presented five. It should be clear by now, that while the other four indicators have some bearing on whether we enter a recessionary downturn, it is energy prices that are the underpinning of our entire global economic system. Mess around too much with oil prices, and the fallout will be immediate and likely, severe. That goes for both dramatic oil price jumps and death-defying falls. The health of the world economy is predicated on oil prices somewhere north of $50 a barrel and south of $100/bbl.
The yield curve is the most reliable recession indicator – it has shown remarkable ability to predict energy caused recessions.
We've proved this graphically, and it makes sense. The global economy still runs on fossil fuels, only 9.3% of global electricity generation (excluding hydro) in 2018 was from renewables.
We normally think of the price of energy that keeps an economy in check; when oil and natural gas prices are too high, businesses that depend on those fuels get hit, passing their higher costs onto consumers. And in 2014 when the oil price crashed, consumer and businesses were happy, but it was governments that suffered – in terms of depreciated currencies and a big hit to resource revenues.
But what if we thought about it a different way. Right now, energy prices are low, so the economy should be humming along. But it's not. We've outlined all the negative indicators showing signs of a sick patient of an economy. Lower energy costs are like the IV hooked up to that patient; they are keeping it alive. Raise oil prices now, and the economy will be in for a shock. Interest rates will go up, employment will crash, housing starts will crash and the level of consumer debt will take on a whole new meaning – consumer spending is 70% of the US economy. The economic patient may even stop breathing – the equivalent of GDP growth stopping – and go into a recessionary coma.
Predicting a recession is hard. If anyone is able to do it, they would surely deserve a Pulitzer Prize in Economics. As retail investors we obviously don't know if it's to be war with Iran or not, but we know what happens if it occurs. Having this knowledge can help guide our investment decisions.
Like dancing a little closer to the exits.
Richard (Rick) Mills
Richard is the owner of Aheadoftheherd.com and invests in the junior resource/bio-tech sectors. His articles have been published on over 400 websites, including:
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