By John Mauldin | July 2010
The Risk Of Recession
The Leading Indicators Are Starting to Turn
Terms of Trade and US Real GDP
Bernanke at the Crossroads
Some Really Dismal Numbers
Unemployment Went Down?
Earnings Take a Hit
Money Supply Concerns
A Central Banker's Nightmare
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The Risk Of Recession
I am on record as saying I think there is a 50-50 chance we slip back into recession in 2011, as I think the economy will soften in the latter half of this year and a large tax increase in 2011 (from the expiring Bush tax cuts) will tip us into recession. This was not based on data, but rather on research which shows that tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. If you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases. Christina Romer, Obama's head of the Council of Economic Advisors, did the research along with her husband, so this is not a Republican conclusion.
If the economy is growing at less than 2% by the end of the year, then a tax increase of more than 1% of GDP could and probably would be the tipping point. Add in an almost equal amount of state and local tax increases (and spending cuts) and you have the recipe for a full-blown recession— at least the way I see it. I was asked at my recent speech in Milan, what sorts of things could make me wrong? There are a few. First, it could be that tax increases and cuts don't matter. Some very smart people (like Paul McCulley) feel that tax increases on 'the wealthy' don't really figure into Romer's analysis.
Or maybe bank lending starts to pick up and the economy is actually growing at 3-4% by the end of the year— although the chart below suggests that bank lending is still in freefall. Notice that if this trend continues just a little while longer, bank lending will have fallen by 25% in about two years. This is a truly scary chart. It is unprecedented in modern history. Also notice that after the 2001 recession bank lending continued to fall for over two and a half years.
Or perhaps Congress decides to extend the Bush tax cuts or phases in the increase over time. That would be better and maybe not push us into recession. Maybe they vote for more stimulus, although that does not look likely. If Congress cannot extend unemployment benefits, as happened this week, then other stimulus is unlikely.
The über-Keynesians that are in control of our economic policy clearly do not think that large tax increases matter, or if they do think so they are not speaking out about them. They are conducting an experiment on our economic body without benefit of anesthesia. Here's a prediction about which I can feel confident: if we do slip back into recession, they will blame some factor other than the tax increase and call for massive stimulus.
In fact, they will probably say that the lack of stimulus was the problem in the first place. Paul Krugman will be the head cheerleader. (For a quick, fun, and instructive read, go to Joshua Brown's web site [The Reformed Broker] and read about the Econ Gangs of New York, where Joshua describes the various groupings of economic thinkers. Seems I am in the gang led by my friend Mohamed El-Erian, the 'New Normalers'. Krugman, of course, is the leader of the 'New Jack Keynesians', a most vicious and pernicious gang, in my opinion.
Going into the last two recessions we had an inverted yield curve (where short-term rates are higher than long-term rates), which made it easy to predict a recession. Let's look at a graph of the yield curve from my e-letter of February 16, 2007. Notice that the 3-month T-bill is about 45 basis points higher then the 10-year bond, which is what the studies use as the basis for their analysis.
The curve had been like this since before September of 2006, when I was predicting a recession about a year out. (An inverted yield curve is the best predictor we have of a recession one year out that. A yield curve like the one below has always been followed about one year later by a recession.)
Here is today's yield curve. It is normal (if you can call anything in a 0% Fed rate environment normal), and while not as steep as it used to be, it is still quite steep. (Bloomberg)
We are not going to get an inverted yield curve when the Fed is holding rates at 0%. The curve we have today is not signaling a recession. It suggests that those who see continued recovery are right.
I am not so sanguine. I was on a panel with Martin Barnes (of Bank Credit Analyst, and one of the best economic minds I know) at David Kotok's shindig in Paris last week. Martin and I are very good friends, but we do tend to go at one another. It makes for a very interesting panel for the audience.
I posited that I think the chances are better than even that we have a recession in 2011. Martin said (insert deep Scottish brogue), "John, double-dip recessions are very rare". And he's right. The last (and only) one we had was because Volker was stamping on the brakes trying to bring inflation under control in the '80s.
My rejoinder was along these lines: We are not coming out of a normal business-cycle recession. We went through a debt crisis and a balance-sheet, deleveraging recession. The old data that we used to judge recoveries by just does not apply here. At best, it is misleading. It wasn't just a bubble in housing, it was a bubble in debt. And now we are reducing that debt.
We are coming to the end of the Debt Supercycle (a term coined long ago by Bank Credit Analyst). We now have a bubble in government debt that is getting ready to burst in one country after another. What is indeed a very rare thing (a double-dip recession) is a very real possibility. Since we don't have the yield curve to guide us, let's look at what we do have.
The Leading Indicators Are Starting To Turn
Even while I was on vacation in Italy, I had to regularly feed my addiction for economic and investment information. Over the course of a few days I ran across several studies on the Economic Cycle Research Institute's (ECRI) Index of Weekly Leading Economic Indicators. The index has turned down of late. Chad Starliper of Rather & Kittrell sent me the following charts and analysis. (I love it when someone else does the work for me while I'm on vacation!)
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Jonathan Tepper (coauthor of the next book I am working on) sent me this piece from a group called EMphase Finance, based in Montreal. They wrote this back in April, as the Weekly LEI was beginning to turn over. They have found a bit of data that seems very good at predicting the economy of the US 12 months out. Let's take part of their work:
Terms Of Trade And US Real GDP
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Their Conclusion?
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And while we are on leading indicators, let's end with this note from good friend and data maven David Rosenberg of Gluskin Sheff (based in Toronto).
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My take is that Bush cut taxes in 2001 and again in 2003 in the face of weak economic circumstances. Unless something changes, we are going to enact the largest tax increase in US history. That will be matched by equally large tax increases and spending cuts by state and local jurisdictions.
And we are going to do it at a time when the above research suggests that growth may be in the 1% range and unemployment will still be in the 9-10% range. Extended unemployment benefits will be long gone for many people. Housing will still be in the doldrums (more on that in next week's Outside the Box) and housing prices are likely to fall from here.
Growth in the first quarter was revised down (again!) to 2.7%, or about half that of the 4th quarter of last year. Much of what passed for growth [then] was inventory rebuilding and stimulus. The underlying economy may be weaker than the headline number reveals. And by the 4th quarter, there is very little stimulus.
Given the above, I think we have to increase the odds of a 2011 recession to 60%, and those odds will rise and fall based on the economic performance of the next two quarters. Do tax increases matter? We are about to find out.
And if I am wrong, I will be spectacularly wrong. And I hope I am. But you have to call it as you see it.
Bernanke At The Crossroads
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If I am right about the potential for a recession, it is going to bring Ben Bernanke and the Fed to a very serious crossroads. Recessions are by definition deflationary. But inflation is already as low as it has been in a very, very long time. Core CPI is less than 1%. The Dallas Fed's Trimmed Mean Inflation Index is down to 0.6% for the last 6 months.
If we enter into a recession, it is quite possible that the US could go into outright deflation. That is what M3 is saying. Take a look at this chart from John Williams of Shadowstats, who still tracks M3. But all the measures of money-supply growth are turning down. This is signaling deflation.
Albert Edwards of SocGen noted this week, "We are now walking on the deflationary quicksand." Treasury markets seem to be pointing to a deflationary outcome. In the next recession, we could all become Japanese, unless…
You have to understand that when you become a Fed governor you are taken into a back room and given a DNA change. Henceforth, you become viscerally and genetically opposed to deflation. Well, except for Tom Hoenig, president of the Kansas City Fed. His DNA change did not take. He wants to raise rates now, and is the lone dissenter at the Fed meetings.
(On a side note, when you Google Tom Hoenig, you get six pictures of him. Five are clearly of him, and one is moldy bread. I am not sure what that means. By the way, Tom, my invitation to Jackson Hole got lost again this year! And I would be happier with Hoenig as Secretary of the Treasury, for what that's worth.)
What's a central banker to do? Bernanke gave us the road map back in 2002 in his famous helicopter speech. As a last resort, you print money. But the Fed already has a very pregnant balance sheet. Can they push another $2 trillion into the economy to combat deflation? Will they?
Deflation is the enemy of debt, and especially those who are over-indebted. Great Britain seems to be purposefully pursuing a little inflation to make its debt burden easier. Will the US do the same? If we slip into recession and deflation, I expect the Fed to react with more quantitative easing. They will start to take down longer-dated paper as they move out the yield curve. Could they expand the Fed balance sheet? Oh yes. We are in uncharted territory, gentle reader.
Some Really Dismal Numbers
The recent unemployment numbers were just bad, even though the spin doctors were out in force. Of course we knew that because of census workers being laid off the number would be negative, and it was, down 125,000. But the "bright spot" we were told about was that private payrolls came in at 83,000 new jobs. Let's look at what you did not see or hear.
First, last month's dismal (there's that word again) private job-creation number was revised down from 41,000 to 33,000. So in two months, total private job creation is 116,000 jobs. We need 125,000 jobs per month just to keep up with population growth. But it is worse than that. The headline number we look at is from the Establishment Survey. That means they call up existing businesses they know about and ask them how many people are working for them, etc. One of the first things I do when the employment numbers come out is look at the birth/death assessment on the BLS (Bureau of Labor Statistics) web site.
For new readers, the birth/death assessment has nothing to do with people dying, but rather is the BLS's attempt to estimate the number of new businesses that have been created or have "died" within the last month, and they use these numbers to 'adjust' the employment total. They use historical, seasonal numbers to create a model from which they make these estimates. There is nothing conspiratorial about the numbers— they have to make an attempt at such an estimate, otherwise the employment number would be badly off. But the birth/death number can skew the totals a lot more than is typically realized.
Take the last two months. Using the birth/death model, the BLS assumes that 362,000 jobs were created 'somewhere'. That is over four times the number of jobs in the headlines we just read. Those extra jobs were added into the total because that is what the model told them to do.
Over a complete business and employment cycle, those numbers will average out to be pretty close to right. But as I said, they can also be misleading in the short term. Let's look closer at some of the details.
Click Here, or on the image, to see a larger, undistorted image.
The B/D adjustments say that we added 65,000 construction jobs in the last two months, over half the total number of jobs created. Really? US single-family homes set an all-time low sales number [in the latest] week. Mortgage applications are way down. Home construction is way off. Commercial real estate construction is down. Where are those construction jobs?
158,000 new jobs have supposedly been created in the hospitality and leisure industry in the last two months. And that is consistent with what normally happens in summer time. Typically, these are lower-paying jobs. (I worked a few myself while in college.) In the actual numbers, as surveyed, they estimated only 33,000 new jobs in L&H, so the B/D adjustment accounted for almost the entire positive number.
But what happens is that most of those L&H jobs go away in the fall, so then the B/D adjustment goes negative. Further, I am not sure we can assume a typical cycle here, to base the B/D number on. (One more thing to complicate all this. The headline number we see is seasonally adjusted, but the B/D assessment isn't. But we just won't go there. That's way too much "inside baseball" sort of trivia.)
But look at this chart from my favorite data maven, Greg Weldon. It shows that the number of people planning vacations is way down, dropping by over 35% in the last three years, for the second lowest number ever. Ever.
That is not consistent with a typical hospitality and leisure job-growth pattern. I have three kids working in that field, and the talk is not [the usual summer talk] of robust job creation or lots of overtime. (By the way, my Tulsa readers should go to Los Cabos for some good Mexican food and leave my daughters Abigail and Amanda some really big tips! And make sure they get your name and address.)
Unemployment Went Down?
We were told that the unemployment number dropped from 9.7% to 9.5%. That's a good thing, right? Well, no, not really. The number dropped because the number of people counted as being in the labor force dropped.
If you haven't looked for work [in the last] four weeks, you are not counted as unemployed. If you add those who were taken off the rolls back in [to arrive at the pre-Clinton calculation], the unemployment number would have risen to 9.9%. In the past two months nearly one million people have dropped out of the labor market.
If you counted all the people who would take a job if they could find one as unemployed, the unemployment number would be closer to 11%. As an aside, if I have any real beef with the BLS over how they create their data, it is this last point. If you would take a job if you could get one, you should be counted as unemployed. Period. [[Add in the number of people in part-time jobs who would like full-time, and the number approaches 20%!: normxxx]]
The Household Survey was rather dismal. (This is where they call households and ask about their employment situation.) The survey showed a loss of 301,000 jobs, or 363,000 jobs if you 'adjust' it to match the Establishment Survey. Not pretty.
Maybe a better way to look at unemployment is to look at the percentage of the total population that has a job. That number has been rising off and on for almost 50 years as more and more women have moved into the labor force. But notice the large drop over the last year— almost 5% of working people in the US have lost their jobs.
The initial unemployment claims 4-week moving average stubbornly refuses to go down any further. It has essentially gone sideways for over 6 months.
If you go back and look at the data from the last 45 years, the current level is typical of recessions.
Earnings Take A Hit
No, not business earnings, which seem to be holding up, but personal earnings. Average hourly earnings dropped 0.1% in June, something that David Rosenberg notes is a 1-in-50 event. The trend is downward, with annual growth of less than 1.7%. Average hours worked were also slightly down.
My friend and Maine fishing buddy Bill Dunkelberg, chief economist at the National Federation of Independent Businesses, has produced his monthly survey, and there was not much to cheer about from a future employment perspective. Over the next 3 months, 8 percent of the businesses surveyed plan to reduce employment (up 1 point), and 10 percent plan to create new jobs (down 4 points), yielding a seasonally adjusted net 1 percent of owners planning to create new jobs, unchanged from May and only the second positive reading in 20 months— but just barely so.
From Dunk's email:
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A few more data points and then let's look at some of the implications. The numbers from the Conference Board survey were weak. The total of people planning to buy a major appliance is at an almost 16-year low.
Car sales were low last month, and the survey says they may go lower, as plans to buy a car are down from 6% to 3.7%. In fact, in almost all categories plans to buy were down. Which makes sense, as 17% of people say their incomes are decreasing.
New home inventory is back up to 8.5 months of supply. As noted above, single-family sales hit an all-time low, as anyone who wanted to buy a home did so in order to get the government incentive. Just as with Cash for Clunkers, all we did was bring buying forward; we did not create actual new buyers, at least not in any significant numbers.
Money Supply Concerns
After the explosion in the money supply by the Fed in the depths of the Great Recession, growth in the money supply has gone flat. We recently looked at the fact that M-3 (the broadest measure of money supply) has turned negative for the first time in many decades. Look at the adjusted monetary base, below.
And now let's look at MZM, or Money of Zero Maturity. MZM is a measure of the liquid money supply within an economy. MZM represents all money in M2, less the time deposits, plus all money market funds. MZM has become one of the preferred measures of money supply because it better represents money readily available for spending and consumption. This measurement derives its name from its mixture of all the liquid and zero-maturity money found within the "three M's" (Investopedia). Notice that it too has gone flat, for over a year now.
These charts suggest that deflation is in the wind.
A Central Banker's Nightmare
Let's recap. Unemployment is high and is in reality going higher if you count those who would take a job if they could get one. Incomes are weak. Plans to purchase discretionary items are falling. Housing is likely in for a further drop in prices. The stock market is not exactly booming.
Treasury yields are falling, not from a credit crisis or a flight to quality, but because of 'economic conditions' (deflation). Money supply is flat or falling. Prices are under pressure. The list goes on, and all factors are indicative of deflation.
As noted last week, the data suggests we could see weak growth in the last half of the year. Over two-thirds of the past quarter's 2.7% growth was from inventory rebuilding. [And] surveys seem to show [that that source of 'growth'] is abating as inventories begin to stabilize.
I was on Larry Kudlow's show (links below) last Tuesday, and he gave me some time to air my views. My main concern, as readers know, is that we may have a weak economy in the latter half of the year and then introduce a large tax increase, which my reading of the economic studies on tax increases suggests will throw us into recession. Recessions are by definition deflationary. (Not to mention what another one would do to unemployment and the stock market!)
With inflation at less than 1%, could we see the central banker's nightmare of outright deflation? We very well could. I think that is what the bond market is saying.
How would the Fed react? For an answer, we need to go back to Ben Bernanke's famous 'helicopter' speech of November 2002, entitled "Deflation: Making Sure 'It' Doesn't Happen Here." (By the way, I have always been convinced that his remark about printing presses and helicopters was an attempt at 'economist humor', which is why we don't get many offers from comedy clubs.)
I did a fuller assessment of that speech in my weekly letter. But I want to pull out a few quotes from the speech. Let's sum up the 'helicopter' section: 'You can [always] create inflation by printing a lot of money.' But that is not the interesting part of the speech. Quoting from my letter:
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(And now, in 2010, that question might become more than academic.)
With the above as background, we can begin to look at what I believe is the true import of the speech. Read these sentences, noting my bold-faced words:
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Now let us go to his conclusion:
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And there you have it. All the data pointing to a slowing economy? It puts us [much] closer to [outright] deflation. [But] [i]t is not the headline data per se we need to think about.
We need to start thinking about what the Fed will do if we have a 'double-dip' recession and start to fall into deflation. Will they move out the yield curve, as he suggested? Buy more and varied assets like mortgages and corporate debt? What will that do to markets and investments?
Note that last bolded line: "For this reason, as I have emphasized, prevention of deflation is preferable to cure." If he is true to his words, that means he may act in advance of the next recession if the data continues to come in [sufficiently] weak and deflation starts actually to become a threat. That is the thing we don't see in all the economic data— the potential for new Fed action. Let's hope that, like the deflation scare in 2002, it doesn't come about. Stay tuned.
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Normxxx
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