I’m trying not to hold my recession story too tightly, as the Jims would say, but it’s the only one that I see cogently fits with the facts.
And those facts are that the best historical
predictors of recession have included:
- inverted yield curve for 6mths
plus
- negative YoY change in LEI
- YoY contraction in CPI-adjusted
monetary base
- 30%+ contraction in YoY housing
completions
- YoY change in employment growth
< YoY change in population growth
- Every previous time real GDP growth slipped to stall speed of 2.0% or less YoY since 1970, the Fed cut rates significantly and it was impotent to prevent recession: 1974 (cut rates 8%), 80/81 (cut over 10%), 90/91 (cut over 4%), 2001 (cut 3.5% before 9/11 and 5.5% total)
In isolation, each of these independently has been a fairly reliable recession-predictor; in combination, even just a&c, never mind all of them, as per Kasriel below, has been a perfect predictor. And we’ve seen each of these recession predictors this year BEFORE the credit crunch and before the ARM resets!
As I said before on NFP day:
No more mortgage equity withdrawal, wealth effect in reverse, YoY housing prices negative for first time since 1930s, residential investment plummeting with no end in sight to housing recession, non-residential investment lags residential and starting to turn over, auto sector also in recession, mortgage resets with much higher payments beginning in earnest over next nine months, credit tap turned off for all but those with pristine credit records, real interest rates restrictive, exorbitant TED spread, unknown/opaque bank and corporate exposure to bad debts/assets, domestically-sourced corporate profits anemic, record household debt-to-income levels and debt service ratios, inverted yield curve for last year, real monetary base retracting, and now job situation obviously deteriorating. What more do we need to see to believe a recession is likely?
But for more firepower, just take a quick look at the stuff below from Paul Kasriel, of Northern Trust, and from Comstock Partners (even if only the bolded parts)
Excerpts from Kasriel:
LEI and KRWI - It's Different This Time?
by Paul Kasriel
April 21
The bulls on the economy had better hope it's different this time because both the index of Leading Economic Indicators (LEI) and the Kasriel Recession Warning Indicator (KRWI) are sending out recession warning signals
To refresh your memory, the combination of a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base (unadjusted bank reserves and currency held by the public) and a negative four-quarter moving average of the spread between the 10-year Treasury bond yield and the federal funds rate has signaled every recession since that of 1969.
Chart:
Kasriel Recession Warning Index
Also, year-over-year contractions in the quarterly average level of the LEI usually presage recessions, as shown
Chart: Index of Leading Indicators
vs. Index of Coincident Indicators YoY
And from Comstock:
Strong Signals of Recession
Sept 13
No matter what the Fed does next Tuesday, the economy is most likely headed for recession. The August employment report was not a one-off event, but part of an overall pattern indicating a softening economy. Even prior to the latest release, year-over-year employment was already growing at a scant 1.4%, and with the August number now in the fold, growth is down to 1.2%. The following facts indicate the strong probability of recession developing in the period ahead if it has not already started.
1) Since 1953 there have been nine instances where year-over-year employment growth declined to 1.2% or less, and all nine occurred shortly before or after the start of a recession. There was not a single false signal.
2) Since 1960 there have been seven instances where year-over-year housing starts were down 30% or more, and six of the seven instances occurred shortly before or after a recession. There was one false signal in 1966 when a recession was narrowly averted [MW note: huge fiscal infusion for military buildup] and the S&P 500 dropped 25%.
3) Since 1960 there have been eight instances where the Conference Board leading indicators declined year-over-year, and seven of those instances were followed by recession. Once again the false signal occurred in 1966.
4) Of the last nine recessions, none were forecast by the consensus of economists, and even now, according to a Wall Street Journal survey, only 11 of 55 economists said there was at least a 50% chance, despite the depressed housing industry and credit market upheavals.
Summarizing the above numbers on employment, housing starts and the leading indicators, we have 24 data points, and 22 (92%) point to recession as opposed to two false signals. On the other hand the consensus of economists is 0 for 9. We see no reason why the recession signals will be false this time in light of the continuing collapse in housing and the re-pricing of risk in various markets throughout the globe.
The main bullish argument appears to be
that the economy is still growing and that the Fed will keep it that way. We
point out, however, that the economy always appears to be growing at the peak
of a cycle, and that when we really get confirmation that it is actually
declining, we are already deep into a recession. In fact, by the time the
National Bureau of Economic research pinpointed the start of the last recession
it was almost over. As for the Fed, since monetary policy works on the
economy with anywhere from a 6-to-18 month lag, any action taken now will have
little near-term effect.
No Return to Normality
Sept 6
"There can be no return to normality when the earlier 'normality’ was a freakish bubble — unless, of course, another bubble is created."
John Plenders in the Financial Times
There is a great deal of wisdom in that one simple sentence. Although the credit markets should calm down over time, where does that leave us? There is virtually no possibility of a return to the economic and financial world that existed over the last few years. First, it is doubtful that anything the Fed can do now will work, and second, the negative effect on the real economy will remain long after the immediate crisis settles down. Referring to the innovative Fed efforts to separate the orderly markets problem from the real economy, leading economist Martin Feldstein recently stated, "It is not clear whether this will succeed since much of the credit market problem reflects a lack of trust, an inability to value securities, and a concern about counterparty risks." Although the Fed can open up the discount window and make funds available, the lack of transparency causes lenders to be unwilling to lend. As long as unanticipated disclosures of new problems keep popping out of the woodwork from unlikely sources financial turmoil will continue.
Furthermore the Fed can’t bring back the subprime and Alt-A mortgage market with any conceivable weapon currently in their arsenal. Stricter lending standards have been put into place and will remain. In fact, if additional regulations are promulgated to rein in loose lending standards, as congressional leaders are proposing, the mortgage market will get even tighter. The Bear Stearns funds are not coming back and neither are all of the mortgage-related entities that have gone out of business or cut back sharply. The world credit markets are de-leveraging on a massive scale despite anything the global central banks can do.
The housing situation continues to worsen with no end in sight. Pending home sales in July dropped a whopping 12.2% to the worst level since the record began in 2001. Some contracts are not closing because mortgage commitments are falling through at the last possible moment. Foreclosures are at record highs and will get a lot worse since the peak of mortgage rate resets on ARMS are not due to peak until the 4th quarter of 2007 and the 1st quarter of 2008. An increased rate of foreclosures generally follows resets by about three-to-six months.
The housing mess is almost certain to spread to the rest of the economy. As we have previously shown, even in normal business cycles major downturns in housing almost always leads to recessions, and the current cycle is far from normal. Some softening in the economy is already evident. According to Real Capital Analytics investors in July bought the fewest commercial properties in a year. Industry sources expect commercial property price to fall up to 15% over the next year. One real estate investor said "There are so many deals falling apart.People who can get out are getting out." Despite today’s positive sales reports from retailers, consumer spending growth on a year-over-year basis is at its lowest level since late 2003. ADP estimated that U.S. employers added 38,000 jobs in August, the fewest since June 2003. This week declines were reported in the ISM manufacturing index and construction spending, while scheduled 4th quarter vehicle production has been cut significantly. Chancellor Grey Christmas reported a big increase in announced layoffs. Even the Beige Book released yesterday was not as optimistic as the headlines depicted. The report summary termed six of the 12 regions as "slowed" or "mixed", a change from the prior report that called only two regions "mixed" and none "slow".
In sum, although we think the current financial turmoil has longer to run, the real problem is fundamental as the economic expansion that started after the dot-com bust was largely based on a credit-induced housing boom that ignored risk and cannot be resuscitated anytime soon. That the stock market is a long way from discounting this probability is indicated by the current article in Barron’s titled "No Bears Here". This is likely to go down in history with the famous January 1973 article titled "Not a Bear Among Them".
Summary of the Bearish Case
June 14
Inflation fears are preventing the Fed from taking any action to save the economy from a hard landing or recession until it is too late. As we have stated previously, the Fed is paralyzed between rising inflation on the one hand and a deteriorating economy on the other, and is therefore doing nothing. Chairman Bernanke indicated that housing may get worse before it gets better, but still remains caught in a trap. The fact is that housing is a leading indicator and inflation a lagging indicator. In our view, therefore, the inflation problem will be ameliorated when the economy sinks in the second half. When the eventual rate cut comes the market will likely be far more focused on falling profits than the eventual benefits of easing.
The reported revision for 1st quarter GDP supports the view that the economy has entered the "hard landing" zone. Although the quarter was adversely affected by some temporary factors, current numbers for housing and retail sales indicate that the economy is indeed softening at a rapid pace.
The housing situation is continuing to weaken and is likely to get worse. The Case-Shiller Home Price Index for the 1st quarter dropped 0.7% from the 4th quarter and 1.4% from a year earlier, the first decline since 1990—1991. Existing home sales for April were at the lowest level since June 2003, and were down 10.7% from a year earlier. Inventories of existing homes for sale were up 10.4% from March, amounting to 8.4 months of supply as compared to 7.4 months in March and only 3.6 months in early 2005. The ratio of unsold homes to sales is at a 15-year high. The highly anticipated spring selling season never got going and, according to housing officials, home buyer traffic is minimal. In order to sell the huge inventories of both new and existing homes, prices will have to decline even more, a serious risk to the economy that was mentioned in the recent FOMC minutes. In our view this is a strong probability rather than a mere risk. In addition the tougher regulations that are coming will dampen home demand even more as mortgage approval requirements return to the rigorous standards that prevailed in more normal times. And don’t forget the resets still ahead in existing mortgages that will add additional billions of dollars to monthly payments.
We strongly believe that the subprime problem will spread to the rest of the economy. Tighter mortgage standards have only begun to be implemented and will have a significant impact. On the demand side fewer people will get financing and fewer will be in the market for new homes. Mortgage lenders will scrutinize applications much more carefully and require down payments and full documentation of assets and income. As a result fewer people will apply and of those that do, some will be turned down. In addition primary lenders know that they will have more difficulty selling off their loans as potential purchasers get more risk averse. A recent New York Times article showed that even in the New York City area mortgages have become harder to get—and this is still one of the strongest markets in the nation. All of this means that demand for new homes, already down 30% from a year ago, is almost certain to drop further.
Even in normal economic cycles when subprime lending was not a major problem housing has been the conduit through which tighter credit conditions has been transmitted to the rest of the economy. In the last 47 years there have been seven occasions when housing starts declined 30% or more year-to-year. In six of these instances a recession followed. The only exception was in 1966 when the economy had a hard landing that barely avoided recession and the Dow Industrials dropped 26%. As of February housing starts were down 30%. With the addition of the subprime problem in the current cycle, the probability of a recession ahead is even greater than usual.
We have long argued that the housing malaise would spread to consumer spending which accounts for about 70% of GDP, and that appears to be happening now. April same-store sales for 51 leading retailers tracked by the International Council of Shopping Centers were down an average of 2.3%, the worst showing since the organization began tracking the data in 1970. In three decades there have been only two previous negative readings. The Council’s Chief Economist stated that falling home prices were weighing on consumers more heavily and that mortgage equity withdrawals had dwindled. Wal-Mart added that shoppers expressed concerns about their personal finances, the cost of living and high gasoline prices.
With factors making up over 70% of GDP now slowing down or declining it is difficult to see where any economic rebound will develop. Typically capital spending does not pick up after consumer spending growth drops. In fact, capital expenditures, on average, trail consumer spending by two quarters, while exports are too a low a percentage of the GDP to make much of a difference. The most likely outcome is either a hard landing or recession. The latest FOMC minutes continue to show that the Fed is paralyzed between the risks of inflation on the one hand and further economic decline on the other. This makes it highly likely that they will not cut rates until it is too late to matter. Although the stock market is still fixated on the favorable forecast of a benign soft landing and eventual cut in interest rates, in our view the time is fast approaching when the incoming data renders that outlook no longer tenable.
The employment market, too, is weaker than it seems on first glance. Even the dubious figures supplied in the establishment payroll report show a year-over-year jobs increase of only 1.4%, [MW: now 1.2%] a number usually preceding economic recessions. In the first five months of the year average monthly jobs rose by only 132,000, compared to 201,000 in 2006. In addition the increase of 157,000 jobs in May showed construction jobs virtually unchanged. However, the BLS birth/death adjustment added a mythical 40,000 construction jobs to achieve that figure. Given the condition of the housing industry, we find that hard to believe.
In addition there is even more reason to doubt the accuracy of the monthly payroll report. The BLS also does a retroactive adjustment of the payroll data based on a much more inclusive state-by-state calculation that does not include a birth/death adjustment. Unfortunately, that data is about nine months behind, but here is what the BLS has reported. The original BLS reports showed that payroll employment increased 500,000 in the 3rd quarter of 2006, including positive growth in construction jobs. However, the recently released state-by-state data for the same period showed a rise of only 19,000 jobs and a 37,000 drop in construction employment. Given the recent weakness in the economy there is a good reason to believe that current payroll employment is being significantly overstated as well.
Adding to the case for continuing housing weakness is the strong prospect of tightening by the leading home lending regulators. According to ISI’s Washington office, John Dugan, Controller of the Currency, strongly criticized so-called "stated income loans". These are loans that are made without documentation of income or assets by the borrower. The prospective borrower merely states his income and gets the loan. Dugan states that studies show that income is inflated by 50% or more in 60% of stated income loans and that 43% of mortgage brokers know that the borrower wouldn’t otherwise qualify for the loan. It is not without reason that the trade refers to these as "liars loans". Regulators believe that loans with little or no documentation are not appropriate in the sub-prime loan market or in the alt-A market as well.
Until relatively recently the inability of so many borrowers to meet their periodic payments was masked by the big appreciation in home prices. Now, however, the regulators are beginning a strong crackdown that is certain to reduce the availability of credit as well as the number of people who qualify for loans. The downward pressure on home sales and prices is therefore likely to continue for some time. As we have previously shown (please see archives for past comments) the housing mess is already having a negative effect on consumer spending and will probably spread to the rest of the economy. The peak in industrial production usually lags the peak in real consumer spending by one quarter, while the peak in capital expenditures lags by two-to-four quarters. Even in normal residential building cycles a sharp decline in housing sales has almost always led to a hard landing or recession. Given the recent speculative boom in housing we see no reason why this time will prove to be an exception.
The market is living in a low-probability
world that assumes a benign soft landing in the economy, a stimulative
second-half Fed rate cut and continued economic strength from the rest of the
globe. While possible, we think the odds of this favorable outcome are
low. First, if history is any guide a hard landing or recession is highly
probable. In the past recessions have occurred under the following
circumstances:
1) Whenever GDP growth was below 3% annualized for 5 consecutive quarters.
2) When the Fed tightened monetary policy (8 of the last 10 times).
3) When the yield curve was inverted (6 of the last 7 times).
4) When the Conference Board Leading Indicators were 0.5% or more below a year earlier (9 of the last 10 times).
5) When new building permits were 25% or more below a year earlier (7 of the last 9 times).
6) Whenever payroll employment growth dropped to 1.4% over a year earlier.
All of the above has now occurred.
On the other hand the consensus of economists has never predicted a recession in advance—NEVER. Although anything can happen in the world of economics and financial markets, we would rather go along with a group of indicators with a high probability of being correct than with a group that has never gotten it right.
Second, as for the beneficial effect of Fed rate cuts on the stock market, we have to take the context into account. It’s true that with the exception of the rate cut in January 2001, Fed decisions to ease have almost always resulted in rising markets following the move. However, it is extremely important to note that the upward moves only happened because the market declined significantly prior to the rate cut. In fact, of the ten Fed moves to ease in the last 50 years, the Dow Industrials dropped by an average of 23% prior to the first cut, and declined in every instance. So the chances are that the market will move up after the first rate cut—whenever that occurs—but only after a damaging major decline.
The third argument being made is that any softness in the U.S. economy will be largely offset by a strong global outlook. According to Northern Trust Chief Economist Paul Kasriel, this is not likely. He points out that the weakening segments of the U.S. economy—consumer spending, housing and capital expenditures—account for 85% of GDP, compared to exports accounting for 11.5%. In addition domestic demand as a percentage of GDP is declining in the EU, China and Japan, meaning that exports are accounting for most of their growth at the margin. He estimates that U.S. consumer spending accounts for 29% of the rest of the world’s GDP, and is, in essence, their locomotive for growth. It is therefore unlikely that global growth prospects can be split off from the growth outlook in the U.S.
In our view, therefore, a hard landing or recession is probable; a Fed rate cut won’t help unless the market declines significantly beforehand; and global economic growth is not likely to provide enough offset. Since this is virtually the exact opposite of what most investors are counting on, we think that the current risks in the market are extremely high.
