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At Recession’s Onset, There is No Bell, Bugle, or National Anthem

From my reading of the business media, there are few business economists who believe, like I do, that the probability of a recession in the next 12 months is greater than 50%.  A recession is generally viewed as two consecutive quarters of negative real GDP growth. Looking forward, a recession isn’t inevitable, as there have been ‘soft landings’ in the post-World War II era.  Nevertheless, from my lens, there doesn’t appear to be anything on the horizon that would stimulate what appears to be a very tired, tepid expansion.

The Fed’s on a Mission
On the contrary, the Fed appears to be on a mission to raise interest rates.  At the conclusion of their recent meeting, Chair Yellen said that the Fed “believes” that the “softness in the economy is transitory.”  If the “transitory” assumption proves incorrect, then the Fed risks pushing the economy into recession.  So far, the bond market doesn’t believe what the Fed believes (“transitory”), as the 10 year T-Note yield has remained in the 2.2% – 2.4% range, below its post-Trump election high of 2.64%.

Hard Data Still Soft
I continue to look for what it is that will “stimulate” this eight year old expansion.  What I find is: credit tightening, historically high levels of consumer debt, rising delinquencies, and exhausted pent-up demand (as seen from lower levels of recent auto sales and falling prices in that sector).  Home sales appear to be on an even keel only because of a lack of supply and rising demand stimulated by the fear of rising interest rates as touted in the business media.  But even there, new home construction starts are nowhere near where they were a decade ago.  The economies of Europe and the Emerging Markets are clearly on the upswing.  So, exports into these growing areas of the world would normally be a positive.  Too bad the Fed is raising rates, making the dollar stronger and reducing the demand for dollar denominated goods.

Wage growth continues to be tepid, and oil prices are now falling again putting an exclamation point on the world’s production overcapacity.  Falling oil prices are due to the rapid and large reinvestment in the oil and gas drilling sector of the U.S. economy, a sector that accounts for <0.5% of GDP.  Without such reinvestment, Q1 GDP growth would have been 0%, i.e., the other 99.5% of the economy.  (There is a good side to lower oil prices: it favors consumers; and, in this case, it leads the U.S. toward energy independence.)

Fiscal Stimulus Needed
The U.S. equity market has hoped that a Republican president and a Republican congress would stimulate business.  For sure, markets no longer need to worry about increased regulations, and there is no prospect that federal taxes, in general, are going to rise.  But, I do not think those issues alone are enough to boost economic growth much above its current 1% rate.  The Trump administration has yet to move legislation on either tax reduction or infrastructure, either of which could reignite growth.  The danger here is that by the time any such stimulation gets done, the economy will already have slipped into recession.  Indeed, it may be that the onset of recession is what is needed to get the congress to move on either or both.

No Bell, Bugle or National Anthem
The National Bureau of Economic Research (NBER), the official non-profit pegged with the responsibility of dating U.S. recessions, doesn’t necessarily use the two consecutive negative quarter rule in determining the onset of a recession.  It has its own, more subjective criteria for defining a recession.  Due to the difficulty in collecting and analyzing data, it is only with hindsight that the NBER can pinpoint the beginning and ending dates of a recession.  In addition, since it is a ‘committee’ of experts at the NBER that does this, it is often a lengthy process, as the committee must be sure it is correct.  As a result, there is always a considerable period in which the economy is actually in recession that is unrecognized by the public and the media (and sometimes by markets too).  To make this concrete, the official beginning of the last recession, December, ’07, was announced by the NBER in December, ’08; and it took until July ’03 for the NBER to declare that the dot.com recession had ended 20 months earlier (November, ’01).

The point here is that when a recession starts, there is no bell, bugle, or playing of the national anthem.  We may not know we are in one for several quarters.  That goes for the Fed, too; they won’t know either.  That is why it worries me that they continue on their tightening path, based only on their faith that the current economic softness is ‘transitory.’  Because of the dating lag, there is a real danger that they could be tightening policy right into the teeth of a recession.

It is also useful to recognize that GDP estimates are just that, ‘estimates,’ and, as a result, we often have large changes in the real GDP growth rate between the initial reading and those several iterations later.  Thus, it is not outside of the realm of possibility that Q1 real GDP growth could be negative, and that, sometime in the future, say, a year from now, the NBER dates a recession’s beginning sometime in Q1.

Employment and Productivity
Colleagues will point out that the April employment numbers were quite positive, confirming the Fed’s faith that the economic softness is transitory.  Unfortunately, you just can’t trust any particular data point.  Does anyone really believe that the economy turns off (March’s 79,000 employment gain) and on (April’s 211,000) like a light switch?  A better approach is to take a longer view, that way the machinations of weather and seasonal adjustment manipulations are smoothed out.  Looking at the last three months, a total of 522,000 new jobs were created, or at an annual rate of just over 2 million.  With 146+ million employed in the U.S., job growth over the last three months was at an annual rate of 1.4%.  That’s nothing to write home about.  Taking even a longer view and using job growth over the prior year gives almost identical results and implies that job creation is not accelerating.  Assuming that the new hires have the skills that result in average productivity, economic growth will be close to that 1.4% number.  Unfortunately, when we get close to full employment (U3 = 4.4%), those remaining in the labor pool generally have low skills and are not nearly as productive as the average.  This has been a major complaint of employers for the past couple of years.  As it turns out, and to this point, early indications are that Q1 productivity declined at a -0.6% rate.  As a rule of thumb, based on net new employment and productivity, one would expect economic growth to be about +0.8% (1.4% – 0.6%).  The first pass at Q1 GDP growth was +0.7%.

Finally, as pointed out by Wall Street economist David Rosenberg, in the last 10 recessions, beginning in 1952, there was, on average, only six months from the low point of the unemployment rate to the onset of recession; and sometimes the unemployment trough coincided with the recession’s start.  Food for thought.

Conclusions
A recession isn’t inevitable, it just has a higher probability than is currently being discounted in the marketplace.  Equity gains, year to date, have been concentrated in just a few stocks.  Many sectors have already peaked.  For investors, whatever the state of the economy 12 months hence, forward returns in that time frame starting from today’s lofty valuations levels, have, historically, been terrible.

Robert Barone, Ph.D.

Robert Barone, Ph.D. is a Georgetown educated economist and a financial advisor at Fieldstone Financial.  www.FieldstoneFinancial.com.

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