US: Fine Now, Not so Good Later

Dan North
Dan North Chief Economist North America

If you are looking for a good, lighthearted summer read, this isn’t it.  If you want something more like “Game of Thrones”, you’re in the right place.

The news flow is unusually heavy for August, and at the moment it’s somewhat skewed towards the negative. Our central scenario of continued, but slowing growth for the rest of 2019, followed by a significant risk of a recession in 2020 remains intact.

First, let’s start with the good news. Retail sales in July were very strong gaining +0.7% m/m, more than expected, pushing the y/y rate to a solid 3.4%.  Gains were widespread across industries, and after stripping out volatile items, “core” retail sales rose a sharp +1.0% m/m to a very strong +5.0% y/y rate. It was the latest in a string of reports showing the all-important consumer has been providing a muscular boost to the economy. It was an undoubtedly good report.

There has been other good news as well. 

  • A survey of homebuilder confidence improved as mortgage rates fell.
  • Two regional Federal Reserve surveys came out better than expected.
  • Productivity increased at an annualized rate of +2.3% in Q2, bringing the y/y rate to 1.8%, coming close to the long-term average of 2.3%.

Unfortunately there’s some unhappy news as well.

Industrial production fell -0.2% m/m in July to a barely positive +0.3% y/y rate, the weakest in almost three years.  More importantly, the manufacturing component of industrial production fell -0.4% m/m to a -0.5% y/y rate. Manufacturing productivity fell -1.6% q/q annualized to a tiny +0.2% y/y rate. Note that last month’s ISM survey was the weakest in three years and is approaching the 50 level indicating contractions. It’s fair to say that we are on the verge of a manufacturing recession.

Once again, let’s revisit the yield curve.  I am a fan of looking at the yield curve as the spread between 3month-10year Treasury yields, and it has been negative for almost three months now, strongly suggesting a recession in 2020.

However, many analysts and economist favor the 2yr-10yr spread which until Wednesday had not inverted. But it did go briefly negative Wednesday, and combined with weak data from Germany and China (see below), the stock market freaked out. The Dow fell 800 points, accompanying the S&P 500 and the NASDAQ on a thrilling 3% plunge. I’m still puzzled why so many have been ignoring the 3mo-10 yr spread, but then suddenly started panicking when the 2yr-10yr spread went down a few basis points into barely negative territory.

Here are some interesting charts from other economists I got out of the WSJ regarding the 2yr-10yr spread. Again, note that the spread only went negative during one day and has since bounced back to very slightly positive. Piper Jaffray’s model suggests that when the spread hits 0 (presumably for more than one day) there is a 91.9% probability of a recession.

Here is a model from Oxford Economics that augments the yield curve data with an economic activity index. I didn’t make the model so I can’t authoritatively speak to it, but notice that every time it passes 50%, a recession follows.  And it has never passed 50% without a recession.

The yield curve is the strongest indicator of an impending recession. But it’s not the only one. Others which suggest a recession on the horizon include the spread of consumers’ assessments between the future and the present, elevated levels of net worth / personal income, and near record high levels of corporate debt/GDP. Here’s another one, once again from the WSJ, by a firm called Gavekal Data/Macrobond.  Basically it compares a cleaner measure of corporate profits calculated by the Bureau of Economic Analysis (BEA), to corporate profits as calculated by the S&P 500 companies. The S&P 500 companies can use creative accounting to report their profits known as earnings per share (EPS). Over the long term the BEA and S&P profits grow at about the same rate. But as a recession approaches and business conditions deteriorate, corporations have more difficulty meeting EPS expectations, thus driving a need for more creative accounting. As shown in the chart, that is what’s happening now. Note that when the ratio as represented by the black line has broken above the current level, a recession has always ensued.

International news didn’t help on Wednesday. GDP in the Eurozone’s largest economy, Germany, fell -0.1% in Q2. Even though the result was supposedly expected, it was the second quarter of contraction in the past four quarters. The drop was blamed on slowing exports due to the US-China trade war. In addition recent data from China has been very weak. Industrial production rose at its slowest pace since 2009, the jobless rate in major cities returned to a record high, and figures on consumption and investment both disappointed. The trade war, which has no clear end in sight is surely weighing on the global economy.

Is it any wonder that the Fed Funds futures market is now pricing in a 100% chance of a Fed cut next month? Not only that, but the market is now pricing in three more cuts this year, for a total of four.

For now, there is a balance here between current news of strong retail sales, homebuilder optimism and regional Fed reports, vs. several forward looking indicators, especially the yield curve, which suggest a recession ahead.

This is exactly what we said it would be; good 2019, recession risk in 2020.

It’s not doomsday. Doomsday is when you didn’t know it was coming.

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