Recession: This is the hardest world for any business economist to pen, especially when the equity market is on a tear. Nevertheless, that is the reality of a slow growth, deflationary world where not much negative must happen to push the 1% growth economy into negative territory. Post-election, markets initially rose on the hopes of economic stimulus from the Trump administration. Then, they flattened as prospects for rapid policy changes receded, followed by a renewed upswing last week based on the French elections and the long-awaited Trump tax proposals which came up somewhat short on details. But make no mistake, the beneficial impacts of reduced taxes are already priced into the market, and that will prove problematic if those benefits are delayed, as appears likely.
Currently, the consensus of business economists is that there is only a 15% chance of a Recession in the next 12 months. My reading of the data indicates that the odds are much higher than that, maybe 50%, specifically if tax reform or some other economic stimulus is delayed to 2018, and certainly if the Fed continues on its current tightening path.
The first official release of Q1 real GDP growth was 0.7% (seasonally adjusted annual rate – SAAR). While the business pundits have now set their forecasts for Q2 real GDP growth at 2.5%, March data were even more tepid than January and February, so we enter Q2 in the midst of weakness. Don’t forget, those same pundits also initially forecast Q1 real GDP growth at 3%!
- Real retail sales in March were lower than the Q1 average, and department store sales remain a disaster;
- New single family housing starts have peaked, with March’s reading 11.6% lower than the Q1 average. What is pathetic is that the peak was below 900,000 units (SAAR). In the prior decade, it was quite common to have months in the 1.2 million (SAAR) range. Yes, existing home sales were high, but that appears to be due to the highly publicized forecast for rising mortgage rates. Don’t forget, it is new construction, not the purchase/sale of existing assets, that counts in GDP;
- Average workweek hours are flat; and businesses are not hiring because they can’t find qualified candidates. As a result, they are forced to either cut production, or run costly overtime shifts which crimp profit margins. To find needed workers, firms have to raise pay schedules, and with little market pricing power, this too leads to lower profitability;
- Auto sales have peaked, and we are so far into this cycle (8+ years) that pent-up demand for autos has been exhausted. We are seeing the highest level of dealer incentives in history. As a result, the net prices of new cars are falling, and they are cratering in the used car market (-4.7% year over year (YOY), and more to come!);
- One of the most reliable indicators of consumer health is restaurant sales. The YOY trend here is down to 3%; but is negative on a month over month (MOM) basis;
- Loans originated at commercial banks have either slowed significantly or are showing negative YOY results, depending on the loan type. The Fed’s latest survey of senior loan officers gave us the first clue to this trend, and now we see from Q1 bank reporting that commercial loans at the large banks are stagnant and auto loans are falling (with delinquencies rising). Credit card and consumer loan issues are also emerging. These are all symptoms of a business cycle that is long in the tooth and quite tired;
- I am told that there can’t be a Recession because the unemployment rate (U3 = 4.5%) is near “full employment.” But a close look at the latest data indicates: 1) that employment has fallen for three straight months in the 25-54 year old demographic; 2) that more than half of the new jobs created this year were second jobs, a classic indicator of household strain; and 3) as told by Wall Street economist David Rosenberg, in all of the recessions since the 1950s, the median time from the low point of U3 to the start of the ensuing recession is a mere 6 months;
- Industrial Production remains weak. While the IP Index rose 0.5% MOM in March, if you take out utilities (which were recovering from the warmest February since 1954), the index declined by -0.4%. In addition, the IP Index itself is still nearly 6.5% below its July, ’07 peak;
- For those hoping that the economy in Q2 and beyond will be spurred by a renewal of capex spending, the reality is that capacity utilization is near recessionary levels (75%). Even if some of this capacity is obsolete, this number needs to be closer to 80% for significant capital spending to occur. The hope that a tax holiday on foreign profit repatriation will promote capex spending is also misguided because a significant portion of these offshore profits are held by a handful of tech and pharma giants lie Pfizer, Microsoft, Apple and Alphabet. And for those holding their breath for a Trump induced infrastructure boom, you will long have run out of air before the first dollar is ever spent.
A Deflationary World
The bond market, too, is telling us that, despite a Fed tightening cycle, long-term rates are falling which portends a weaker, not a stronger, economy. One would also think that if the economy were strengthening, producers would have pricing power. But quite the opposite is currently the case:
- The rate of increase in the Core CPI (less food and energy) has fallen on a YOY basis in each of the last 12 months; a phenomenon we haven’t seen in the post-WWII era. In March, the Index itself fell. Over the last 50 years (600 months), this has only happened five times;
- In the Fed’s latest Beige Book, a compendium of individual observations and comments from each of the 12 Federal Reserve Districts, it was clear that in nearly every district, there was no producer pricing power meaning that any growth in costs (i.e., wages) will simply eat into profit margins;
- Deflation, not Inflation, should be today’s watchword, and there are many good reasons for that including aging demographics, excess debt, changing attitudes toward ownership, production overcapacity, and a rapid pace of technological change that eliminates the need for human labor.
The Fed is Doing What?
Almost all of the hard data today is signaling economic weakness, as is the bond market. Yet the Fed has already tightened the equivalent of 400 basis points since ending the Quantitative Easing (QE) programs. It continues to insist that there will be two or three more rate hikes in 2017 in addition to the beginning of its balance sheet unwind as it lets its asset holdings run off at maturity. That action reduces bank reserves on a one for one basis. Such an unwind will have negative impacts on the economy similar to the positive ones QE had in stimulating it, and the economy had better be strong and buoyant, lest a Recession ensue.
What About the Equity Market?
As indicated at the beginning of this blog, a lot is riding on the as yet to be defined Trump tax reform package, and especially its timing. All market valuation metrics are stretched:
- Through mid-April, 10 stocks have accounted for 53% of the S&P 500 YTD gain, and 3 stocks for 33%. To quote Merrill Lynch trader Bob Farrell’s Rule #7: “Markets are strongest when they are broad and weakest when they narrow to a handful of blue chip names.”
- The current market P/E ratio indicates that, based on its historical mean, the S&P 500 is priced for earnings of $135 to $137. The consensus S&P 500 earnings estimate for 2017 is for $118. It is $132 for 2018. Thus, the consensus of estimates doesn’t put earnings in the $135-$137 range until 2019, which makes today’s market appear to be at least two years ahead of itself, and those estimates have no provision for Recession.
Conclusions and Other Sobering Thoughts
- The Fed’s apparent tunnel vision toward tightening risks throwing the economy into Recession;
- The expansion looks tired; pent-up demand appears exhausted; all of the hard data are quite weak heading into Q2;
- The equity markets have made large bets on a Trump induced tax stimulus package; the risk here is that it may very well arrive too late to stave off Recession;
- If the bond market is correct (and it is usually a much better indicator of economic health than is the equity market), then there is no way a flat GDP growth rate is going to coincide with a 28% rise in corporate earnings, the number that is needed to justify the level of today’s S&P 500;
- Final Thought: Investors should be taking money off the table. It is foolish to think you will know when the peak has occurred. When the bell rings and everyone heads for the exit at the same time, the little guy always gets trampled. Today, the risk/reward ratio is terrible. To stretch for the last 2%, 3% or 5% when there is a rising risk of disappointment and even Recession appears foolish.
Robert Barone, Ph.D