Category: Economy

Analysis of the global economy

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Predicting recessions with payroll and unemployment data

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm devised the Sahm Rule, using changes in unemployment levels, as a more timely predictor of recessions.

Sahm rule: US Data

But the signal repeatedly lags the official start date of recessions by several months, limiting its usefulness for investment purposes.

In previous articles I observed that payroll growth is a good predictor of recessions. But payroll growth has been declining for decades; so it has been difficult to devise a one-size-fits-all-recessions rule. Until I turned to using momentum.

Twiggs Momentum is my own variation on the standard momentum formula and I applied this to monthly payroll data to arrive at a 3-month TMO.

Sweden: Sahm rule

The orange band on the above chart reflects the amber warning range, between 0.5% and 0.3%, where recession is likely. If TMO crosses below the red line at 0.3%, risk of recession increases to very high.

When the TMO falls below 0.5%, a recession is likely, but there is one false reading at 0.49% in 1986. So I treat 0.5% as an amber warning level.

There are no false signals below 0.3% in the last 50 years. So I treat the 0.3% level as a red warning — that recession risk is very high.

Some of the signals (e.g. 1975) are late but the TMO has a far better record, than the Sahm Rule, at giving timely warning of recessions.

The August 2019 TMO reading is an amber warning of 0.5%.

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Sahm Rule: Sweden tips into recession

Sweden: Sahm rule

What is the Sahm Recession Rule?

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm uses the following rule as a timely indicator of recessions:

Sahm RuleSahm RuleSahm Rule Graph

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NY Fed conducts first overnight repo in 10 years as rates surge

The last time that the New York Fed had to inject liquidity into financial markets via overnight repo operations was during the 2008 global financial crisis, when concerns over Bear Sterns and Lehman Bros were threatening to bring the financial system to its knees. From The Street:

The New York branch of the U.S. Federal Reserve said Tuesday that it was prepared to add as much as $75 billion in cash to broader markets in order to hold the Fed’s key rate inside its target range.

The so-called Repo operation, during which twenty four Primary Dealers in the Fed system can exchange eligible collateral, such as U.S. Treasury bonds or mortgage-backed securities, for cash. The move comes amid a massive surge in the price of what is known as ‘general collateral”, which is normally the cheapest batch of securities that banks use to pledge against cash, or other assets.

The costs for borrowing general collateral, often referred to as GC, spiked by 2.5% on Monday, and was followed by a 6% surge today, taking the price to as high as 8.75% at one point, some 6.5% higher than the upper-end of the Fed’s target rate range.

The Fed’s announced operation, however, pushed that overnight rate back down to 0% shortly after it was launched….

Steven Bartholomeusz at The Age suggests that the liquidity squeeze may be an anomaly:

There was an unusual confluence of events in the past few days that may have exacerbated underlying structural problems within the market.

US companies paid their quarterly taxes on September 15. They often prepare for the payment by parking the funds in short term money market fund accounts to generate a return.

The payments of those taxes, estimated at more than $US100 billion, meant a large amount of cash was withdrawn from those funds, which are a source of the cash for repo deals.

At almost the same time there was a settlement of auctions of about $US78 billion of Treasury bonds. With only about $US24 billion of bonds maturing at the same time that meant about $US54 billion of net cash was drained from the market to pay for those bonds.

The Financial Times’ Alphaville blog posited another strand to the explanation for the dollar shortage, albeit one it described as “highly speculative,’’ suggesting that the severe spike in oil prices after the drone attacks on Saudi Arabia’s most important oil processing complex might have triggered margin calls in oil futures markets, forcing a frantic scramble for US dollar-denominated cash.

Quarterly tax payments are a regular occurrence and the markets are accustomed to dealing with them as part of the quarterly cycle. Large fiscal deficits causing a net issue of $54 billion in Treasuries is a more likely culprit. The first rule of margin calls is never meet a margin call, so that seems an unlikely cause, but the spike in oil prices may have impacted elsewhere on financial markets.

We need to be on the lookout for a repeat. Demand for cash is surging. The graph of broad money (MZM plus time deposits) below shows a surge in broad money ahead of the last two recessions. And another worrying rise this year.

Broad Money: MZM plus Time Deposits

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Tectonic shift threatening the global reserve currency system

As Mark Carney observed at Jackson Hole: the global reserve currency system is broken — it has been since Nixon defaulted on gold backing for the Dollar in 1973 — and there is no fix. We have to find a replacement along the lines of Carney’s suggestion. On Macrovoices, two experts on the EuroDollar system, Jeffrey Snider and Luke Gromen discuss the massive tectonic shift facing the global financial system.

https://www.macrovoices.com/683-macrovoices-184-luke-gromen-jeff-snider

This is a complex topic but it is important that we grasp the implications before a tsunami appears on the horizon.

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S&P 500: Upside limited, while downside risks grow

Corporate profits (before tax) ticked up slightly in the second quarter of 2019 but remain below 2006 levels in real terms. The chart below shows corporate profits adjusted for inflation using the GDP implicit price deflator.

Real GDP and Hours Worked

Growth in production of durable consumer goods remains week, reflecting poor consumer confidence.

Durable Goods Production

The chart below shows growth in bank credit and the broad money supply (MZM plus time deposits). Credit growth (blue) remains steady at around 5%, slightly ahead of nominal GDP growth (4.04% for 12 months ending June); a healthy sign. Broad money (green) surged upwards in the first three quarters of this year. Not an encouraging sign when there were similar surges in broad money before the last two recessions.

Broad Money & Credit Growth

The S&P 500 is testing resistance at 3000. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Expect a test of support at 2800. Breach would flag a reversal, with a target of 2400.

S&P 500

The cyclical Retailing Index displays a similar pattern, with resistance between 2450 and 2500.

Retail

Our view is that upside is limited, while downside risks are growing.

On the global front, the outlook is still dominated by the prospect of a prolonged US-China trade war. More great insights from Trivium China:

Tariff delays may be aimed at creating warm, fuzzy feelings before the next round of talks in early October, but……These small gestures do nothing to resolve the underlying trade conflict. We’re still pessimistic on prospects for a deal.

Zhou Xiaoming – China’s former top diplomat in Geneva – expressed the same view in a recent interview (Guancha):
“The two sides disagree too much on the objectives of the negotiations……It is almost impossible to reach an agreement in the short term.”

Zhou urged Chinese officials to be clear on the US’s objective:
“Economic and technological decoupling is the objective of the entire US government.”

Zhou said that officials must prepare for that potentiality, even if it is not their desired outcome.

So should we.

Dow Jones – UBS Commodity Index found support at 76 before rallying to 79. Rising troughs on the Trend Index reflect increased support. Consolidation between 76 and 81 is likely but we maintain our bearish long-term outlook for commodities.

DJ-UBS Commodities Index

On the global front, weak crude oil prices flag an anticipated slow-down in the global economy. Trend Index peaks below zero indicate selling pressure. Breach of support at $50/$51 per barrel would be a strong bear signal, warning of a decline to $40 per barrel.

Nymex Light Crude

We maintain our investment in quality growth stocks but have reduced equity exposure to 40% of (International Growth) portfolio value.

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China: Exports fall despite weaker Yuan

Reuters says that export orders are falling and the contraction is expected to worsen in coming months:

Beijing is widely expected to announce more support measures in coming weeks to avert the risk of a sharper economic slowdown as the United States ratchets up trade pressure……

On Friday, the central bank cut banks’ reserve requirements (RRR) for a seventh time since early 2018 to free up more funds for lending, days after a cabinet meeting signaled that more policy loosening may be imminent.

August exports fell 1% from a year earlier, the biggest fall since June, when it fell 1.3%, customs data showed on Sunday. Analysts had expected a 2.0% rise in a Reuters poll after July’s 3.3% gain.

That’s despite analyst expectations that a falling yuan would offset some cost pressure and looming tariffs may have prompted some Chinese exporters to bring forward or “front-load” U.S.-bound shipments into August, a trend seen earlier in the trade dispute…..

Among its major trade partners, China’s August exports to the United States fell 16% year-on-year, slowing sharply from a decline of 6.5% in July. Imports from America slumped 22.4%.

Many analysts expect export growth to slow further in coming months, as evidenced by worsening export orders in both official and private factory surveys. More U.S. tariff measures will take effect on Oct. 1 and Dec. 15.

Banks are suffering a liquidity squeeze:

The PBoC says the new cuts will release RMB 900 billion of liquidity. That’s more than the RMB 800 billion and RMB 280 billion released by the January and May cuts, respectively. (Trivium China)

Consumer confidence is ebbing.

Google Searches for Recession

China’s response to tariffs has annoyed the Trump administration, making prospects of a trade deal even more remote.

China’s response to U.S. trade actions appears to reflect a cynicism about the efficacy of democracy. Beijing’s strategy appears calibrated to exploit the fact that the American people elect the head of their government, by attempting to influence how the American people will vote. In effect, it seems to be gambling on its ability to turn American democracy against itself.

At the center of China’s responses are the tit-for-tat tariffs intended to hurt American farmers, a constituency that tends to support President Donald Trump and to live in crucial swing states. These tariffs appear designed to deliver political pain in the U.S., not to produce any economic benefit for China. China’s other political meddling, as Vice President Mike Pence recently laid out, includes attempts at interference in the 2018 U.S. midterm elections. Recent targets of Chinese Communist Party influence campaigns also include state and local governments, Congress, academia, think tanks, and the business community. (The Atlantic)

A massive increase in stimulus is the likely eventual outcome, focused on housing and infrastructure. That would fuel demand for raw materials such as iron and steel.

If not, expect a sharp drop in imports to impact on China’s major trading partners.

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Time to be defensive

Bob Doll at Nuveen says he does not expect a recession (for the next few quarters) but remains neutral towards stocks:

“Although stock prices have advanced over the last couple of weeks, investors remain focused on downside economic and policy risks and are increasingly concerned about a possible recession. The latest manufacturing readings hurt economic sentiment, while trade issues, turmoil in Hong Kong, the increasing likelihood of a messy, no-deal Brexit and a downturn in European growth are increasing worries.”

The Institute for Supply Management August Report points to an economic slow-down, with the Purchasing Managers’ Index (PMI) falling to 49.1 percent, from 51.2 percent in July. The New Orders Index also declined, to 47.2 percent from 50.8 percent in July. Readings below 50 indicate contraction.

“…The 2020 U.S. elections linger in the backdrop, offering potential to produce either a dramatic shift in economic policy should the Democrats retake the White House, or continued policy uncertainty should President Trump win reelection.

Against this backdrop, investors are struggling to position their portfolios. Consensus appears to say that it is time to turn more defensive, but U.S. Treasuries and other government bond yields appear to offer little if any value. Indeed, government bond markets are pricing in a high likelihood of a recession and a prolonged period of sluggish growth. At the same time, equity markets have been range bound over the last several months (and, by some measures, since the start of 2018) and are providing unclear signals.

In our view, the preponderance of the evidence suggests that growth will remain sluggish but a recession will be avoided, at least for the next few quarters. In other words, we think the signals coming from the equity markets are more accurate than those coming from government bond markets. Nevertheless, we continue to have a broadly neutral view toward stocks, and think investors should remain selective, focusing on such themes as companies that offer compelling value and those that have the ability to put relatively high levels of free cash flow to work.”

The wild card is the impact that high levels of uncertainty may have on business investment and employment.

Google Searches for Recession

This is a time to be defensive.

Bonds, traditional dividend-paying blue chips, and growth stocks all appear over-priced at current levels. Small caps are high risk in the current volatile environment and we are focused on large cap stocks with strong cash flows and defensible market position in non-cyclical industries. Some cyclical sectors may present value but investors need to be selective because of vulnerability to a potential down-turn.

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S&P 500 buying pressure but payrolls disappoint

August labor stats, released today, point to low real GDP growth for Q3. Growth in weekly hours worked came in at a low 1.09% and GDP is likely to follow.

Real GDP and Hours Worked

While inflation is not the primary concern at the Fed right now, rising annual hourly wage rate growth (3.46% for total private) flags an increase in underlying inflationary pressure. This may make the Fed more hesitant about cutting rates despite Donald Trump’s tweet storm.

Average Hourly Wage Rate

Most important is the continued decline in annual payroll growth. At 1.38% for August, further weakness is likely and a fall below 1.0% would warn of an economic slow-down.

Real GDP and Hours Worked

The S&P 500 is headed for another test of resistance at 3000. The Trend Index oscillating above zero for the last 9 months indicates buying pressure but I expect strong resistance at 3000. Upside is limited while downside risks are expanding.

S&P 500

Semiconductors are doing better than expected, despite the trade war, but I suspect will weaken when the surge in orders ahead of tariffs tails off.

Semiconductors

Retail has stalled since late 2018 and bearish divergence on the Trend Index suggests selling pressure.

Retail

Automobiles, in a decline since 2017, have rallied over the last 6 months. But, again, further weakness is expected.

Automobiles

On the global front, weak crude oil prices flag an anticipated slow-down in the global economy. Breach of support at $50/$51 per barrel would be a strong bear signal, warning of a decline to $40 per barrel.

Nymex Light Crude

We maintain our bearish outlook and have reduced equity exposure for international stocks to 40% of portfolio value.

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Australia: The elephant in the room

June quarter real GDP growth slowed to an annual 1.4%, the lowest since the 2008 global financial crisis (GFC). Major contributors to growth are household consumption, public demand and exports; while the biggest handbrake is investment.

Australia: GDP

A quick look at the RBA chart shows that consumption is slowing but at a slower rate than disposable income. Households are dipping into savings to support consumption, with the savings ratio (savings/disposable income) declining to near GFC lows.

Australia: Disposable Income, Consumption and Savings

Gerard Minack warned of the danger that households will dramatically increase savings, and cut consumption, if employment prospects grow cloudy.

That brings us back to investment. Low investment is a drag on employment growth.

Australia: Job Ads

Low interest rates, on the other hand, are a tailwind at present. They seem to have shored up housing prices,

Australia: Housing

And states are taking advantage of ultra-low interest rates to boost infrastructure spending.

But low interest rates are a double-edged sword. Bank net interest margins are under pressure.

Australia: Bank Net Interest Margins

And credit growth is plunging.

Australia: Credit Growth

The housing recovery will be short-lived if there is not a dramatic increase in loan approvals.

Australia: Housing Loans

AMP chief economist Shane Oliver believes that:

“growth will remain soft and that the RBA will have to provide more stimulus – by taking the cash rate to around 0.5% and possibly consider unconventional monetary policy like quantitative easing. Ideally the latter should be combined with fiscal stimulus which would be fairer and more effective. While Australian growth is going through a rough patch with likely further to go, recession remains unlikely barring a significant global downturn.”

But that ignores two factors:

  1. increased pressure on bank net interest margins from lower interest rates; and
  2. the elephant in the room: China.

China: Activity Levels

China’s economic model is built on a shaky foundation and trade war with the US is likely to expose the flaws.

Chinese leaders are growing increasingly worried about the economy. Premier Li Keqiang said at this week’s State Council meeting:

“The current external environment is increasingly complex and grim.
….Downward pressure on the domestic economy has increased.”
(Trivium)

Twitter: Simon Ting

BEIJING, Sept. 5 (Xinhua) — Chinese and U.S. chief trade negotiators agreed on Thursday to jointly take concrete actions to create favorable conditions for further consultations in October.

The agreement was reached in a phone conversation Chinese Vice Premier Liu He, also a member of the Political Bureau of the Communist Party of China Central Committee and chief of the Chinese side of the China-U.S. comprehensive economic dialogue, held upon invitation with U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin. (Xinhua)

…Extend and pretend. Neither side wants a full-blown trade war. But they are miles away from an agreement.

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Interest spreads hold sway over the global economy

An inverted yield curve is a reliable predictor of recessions but it also warns of falling bank profits. When the spread between long-term Treasury yields and short-term rates is  below zero, net interest margins are squeezed.

Yield Differential (10y - 3m)

In a normal market, with a steep yield curve, net interest margins are wide as bank’s funding maturity is a lot shorter than their loan book. In other words, they borrow short and lend long. Few bank deposits have maturities longer than 3 to 6 months, while loans and leases have much longer maturities and command higher interest rates.

When the yield curve inverts, however, the spread between long and short-term rates disappears and interest margins are squeezed. Not only is that bad for banks, it’s bad for the entire economy.

When their interest margins are squeezed, banks become risk averse and lending growth slows. That is understandable. When interest margins are barely covering operating expenses, banks cannot afford credit write-downs and become highly selective in their lending.

Slowing credit growth has a domino-effect on business investment and consumer spending on durables (mainly housing and automobiles). If there is a sharp fall in credit growth, a recession is normally not far behind1.

Bank Loans & Leases

Right now, the Fed is under pressure to cut interest rates to support the US economy. While this would lower short-term rates and and may flatten the yield curve, cutting interest rates off a low base opens a whole new world of pain.

Quartz this week published a revealing commentary on the damage that negative interest rates in developed economies are doing to bank net interest margins :

The problem for commercial banks is that government bond and mortgage interest rates keep going lower, but it isn’t as easy to cut deposit rates — the rate at which banks themselves borrow from customers — at the same pace. After all, it’s tough to convince people to keep deposits in an account that returns less than they put in (even though this already happens, invisibly, through inflation).

Bank Net Interest Margins in Developed Countries

Ultra-low interest rates are likely to squeeze bank margins in a similar way to the inverted yield curve. And with a similar impact on credit growth and the economy.

If I was Trump I would be pleading with the Fed not to cut interest rates.

Footnote:
1. The NBER declared a recession in 1966 when the S&P 500 fell 22% but later changed their mind and airbrushed it out of history.

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