Economy Knocking At Recession's Door

Includes: SPY
by: John Early


Real economy poised to stall into recession.

Apparent strength in financial economy will not save real economy.

There is no pent up demand because pent up desire lacks the money to be pent up demand.

Growth in several measures of the real economy has fallen to levels normally associated with recessions. Measures associated with the financial economy like the stock market and interest rate spreads look very healthy. This apparent strength in the financial economy will not save the real economy.

Weakening Real Economy

Below is a look at the year over year growth rates of: wages, real personal income, real retail sales, housing starts and new orders of capital goods. Then we'll take a look at annual growth for jobs compared to GDP.

The amount paid to employees in wages and salaries only grew 2.05% from Q4 2012 to Q4 2013. Growth in aggregate compensation of employees has never fallen to this level without the economy already being in recession. In four of the last 10 recessions, the weakest growth rate did not get this low.

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Real personal income grew 2.2% in the 12 months ending in February. Often the economy is already in recession by the time year over year growth gets this low. The 2.2% growth is probably a bit distorted to the high side from the wild fluctuation in personal income from November 2012 through February 2013. The fluctuation came from the effort to recognize income in 2012 at lower tax rates and avoid income in 2013 at higher rates. The biggest distortion was in December's year-over-year growth of -1.9%.

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Real retail sales are up only 0.37% from a year ago and are down 1.2% from the November 2013 high. This level is consistent with a recession starting within a few months.

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Housing starts have dropped 6.4% in the last year. Usually starts need to drop by a bigger percentage to signal a recession. Also this indicator leads growth by several months. This is more of a sign that the risk of recession will be elevated in about 6 months.

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On the other hand, the number of housing starts at 2.86 per thousand people is smaller than the lowest number of starts at the bottom of any recession since data began, except the great recession. Starts may be stalled at the January 2013 level.

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New orders of capital goods are up 2.17% from a year ago February. This looks good compared to being down 1.4% in January. However, the improvement is more a case of the tail wagging the dog, or volatility in the year-ago numbers. New orders are down 3.4% from the June 2013 high. This weakness is consistent with the economy on the verge of recession.

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Employment data was released the morning I am writing this. While job growth typically lags economic growth three to six months, a discrepancy between the household survey and the establishment survey makes it worth taking a look. Annual growth in non-farm jobs, which is the establishment survey, was 1.71% or the best growth rate since 2012. The household survey had annual growth of 0.62% which is only the best since September.

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The monthly data points for new jobs in the household survey are much more volatile than the establishment survey; often hundreds of thousands above or below the establishment survey. Yet, the establishment survey is much more volatile than the household survey in the annual growth rate (which takes the growth of the average of the last 12 months from the growth of the average 12 months before). In the last 25 years the household survey has tracked the economy better than the establishment survey. This differs from the 1980s when the establishment survey tracked better. In the chart above, the red growth rate axis for jobs is scaled to show the correlation between GDP and the household survey.

Even though jobs are a lagging indicator, the weakness in the household survey may suggest GDP weakness. Eight of the last nine times annual growth was down to 0.62%, the economy was already in recession or about to go into recession. However, since the household survey showed 476 thousand new jobs in March and the annual growth rate has ticked up slightly for three months, it could turn out more like 1996 where growth fell to this level and then rebounded.

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The tale of when the economy falls into recession will likely be told by leading and coincident indicators before it is repeated in the job numbers.

Financial Strength not a Savior

The strong stock market, record corporate profits and a healthy yield curve do not mean a recession is not at hand.

In normal times the stock market leads the economy about 6 months. However, the lead can be a year or turn into a month or so lag. In the last 10 years, the lead time with the best correlation is roughly concurrent. So a recession could start with no advance warning from the stock market. It could be like 1990 or 1929 when the recession started the same month stock prices peaked. Of course, since it often takes a year for a recession to become official, stocks would have fallen before we knew the official recession start date.

Corporate profits have risen to a record high, but the growth rate is pedestrian and does not preclude a recession beginning at any time.

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Profits usually start shrinking before a recession, but they don't have to. In 1973 profits grew 26%, but a recession started that December. Profits continued growing for 9 months into that recession. In the 1990 recession, profits never did shrink although stock prices did.

In normal times the yield curve and other yield ratios start giving warning signals as early as 18 months before a recession. However, an elevated monetary base and short term interest rates held below 2% may mean those warnings don't come. At least they didn't warn for the four recessions between 1936 and 1955 when the monetary base and interest rates were similar to today. There is more about that in this article. In the last few years, the monetary base is an even bigger percentage of GDP than it was from the 1930s into the 50s and short-term interest rates are also lower. We can't count on the normal warning of an inverted yield curve.

No Pent Up Demand

Pent up desire requires available money to be pent up demand. While pundits on CNBC and here on Seeking Alpha have claimed pent up demand will lead to a strengthening economy this year, the people with pent up desire probably don't have the money for it to be demand. Typically during an economic downturn people pull back on purchases and increase savings. When confidence begins to return, there is money available to spend. Almost five years into a recovery/expansion, there is not pent up demand.

The personal savings rate has trended down since the end of the great recession. If it were not for the aberration of income around the tax hike in 2013, the last four months of the savings rates would be the lowest since the great recession.

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With the savings rate lower than at the beginning of six of the last eight recessions, people are more likely to find reasons to pull back on purchases than to ramp up spending. Those at the top of the income / wealth spectrum probably have no significant unsatisfied demand. Those who depend on wage and salary income have had very weak growth in income as noted above and may not trust their income enough to satisfy more of their desires.


Fed action and strength in the financial economy have not translated into strength in the real economy where actual goods and services are produced. Growth in the real economy is at the point where it often stalls into recession. Growth has been bouncing up and down the last few years and the highs in the bounces have been trending down. While a recession could be starting now, it is likely a few months away and there may be another bounce before it does. Those confidently looking at financial measures and claiming there is no chance of recession in the next two years should keep a close eye on the real economy. Ultimately growth in the real economy backs value in the financial economy. When the real economy turns down, stocks (NYSEARCA:SPY) will tank, even if they don't lead the way this time.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: There is no guarantee analysis of historical data their trends and correlations enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.