Xanax is a medication used to treat anxiety and panic disorders. Markets have been ugly since year’s end. On Wednesday, volatility was high, as the Dow Jones was down -565 points before rallying back to close down -249. Thursday’s action was a relief (+116), but markets are likely to be volatile near term. Xanax sure would help.
There are lots of worries:
- That economies, worldwide, are decelerating;
- That China will have a hard landing;
- That U.S. could fall into a recession;
- That the falling price of oil will cause a recession;
- That the Fed has made a policy mistake and that they will continue on that errant path.
Let’s take these in order.
Worldwide Growth and China
Worldwide, economic growth is still projected to be more than 3.0%. While that is lower than previous estimates, it is not a disaster. On the bright side, Europe’s data has all been quite positive. And, the European Central Bank has indicated that it will likely ease further. The concerns over China appear overdone. Their transition from an infrastructure dominated economy to a consumer led one has slowed their rate of growth, but it is still growing at a rate of 6.8%. If you don’t trust that “official” data, just ask General Motors (or Apple) – GM had their best sales year ever in China in 2015 and just opened a new plant there.
U.S. Growth
U.S. growth (recession) is another concern. 2014 GDP value added estimates show that manufacturing represents 12.1% of GDP, governments add 13.1%, and, as of Q3, consumption represented 68.4% of GDP. I put these numbers into a spreadsheet and assumed that, for the first time in years, government spending would increase (2%) noting that Congress passed a $1.1 trillion spending bill in December. I formed a matrix showing consumption growth between 0% and 4% and the falloff in manufacturing all the way up to -17%, as that is the depth it plumbed in ’09. Note that in December, 2015, Industrial Production was down only -1.5% from its September peak of 107.6; much of the decline due to low utility output because of unseasonably warm weather. Also note for reference that consumption grew 3.6% in Q2 and 3.0% in Q3.
- Results: A recession doesn’t occur unless manufacturing falls -10% and consumption growth is 1% or less. If consumption growth were to fall to 2%, the economy would still grow at a 1.3% rate (1.0%, 0.8%) if manufacturing fell -3% (-5%,-7%).
As far as consumption and consumer health are concerned, look at the following data:
- U.S. auto sales – 2015 was a record year for sales (17.5 million units);
- Home sales and starts are on uptrends; home inventories are tight;
- Labor markets are strong – government data show 292,000 were created in December, and the last 3 months of job growth in 2015 were the strongest 3 months of the year;
- Consumer credit is rising indicating that consumers are confident; in addition, voluntary quits have now reached heights not seen since before the recession;
- The Leading Economic Indicators are calling for expansion, not contraction, and there has never been a recession without a significant deterioration in this index;
- On the negative side, we have seen some deceleration in certain business indicators.
Falling Oil Prices
I question the idea that falling oil prices can cause a recession. The experience of the last 5 decades tells me that recessions may occur if oil prices rise rapidly, usually due to artificial supply restrictions by OPEC (1973, 1980, 1990), not when they fall. All of the periods of falling oil prices have spurred the U.S. economy. Falling oil prices benefit all consumers and most businesses. Today, low oil prices are due to a supply glut (demand is actually rising), partially caused by OPEC’s desire to bankrupt American shale producers. But markets worry that bankruptcies in the oil patch will metastasize to other industries. While possible, the banking system has twice as much capital as it had in ’08, and most of the lending to the marginal oil producers was done via high yield bonds which already corrected for such events in last year’s Q4.
Fed Policy
The market thinks the Fed made a policy mistake when they raised the Fed Funds rate in December. And they simply can’t digest the Fed’s projected 4 rate increases in 2016. Since December, long-term rates have fallen indicating that the markets don’t believe the Fed would dare raise rates with current market sentiment. In addition, with oil prices off sharply, the Fed’s forecast that “inflation will rise, over the medium term, to its 2 percent objective” is now a questionable assumption, and will likely keep them from raising rates again at least until the capital markets and oil prices have stabilized.
Conclusion
Volatility is likely to continue until new data calm market nerves. Let’s watch the jobs and consumption data, and see if manufacturing deteriorates further. Keep in mind that in ’87, ’94, ’98, ’02, and ’11, we had significant market corrections, but no recession. And in each of those cases, the markets rebounded over the next year. It is also possible that current market conditions represent a repricing to a less friendly Fed, but, from my lens, if that is the case, it has gone too far.
