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Synchronicity or not here we come…

There is a real fight going on over the assessment of the state of the economy. In his recent professorial 'chalk-talk' Chairman Bernanke told his class that he was not sure that the US economy has the strength in domestic demand to continue the expansion. But district bank President Richard Fisher, said that the economy is doing well enough that he is against any more QE. At the St. Louis Fed, President James Bullard is beginning to ponder a turning point in the economy talking about a possible rate rise in later 2013 (heresy with the Fed pledged to hold rate steady into 2014, but a very minor heresy). However, Bullard has, in a more strongly critical way, wondered if such a turning point is on the way if any further Fed stimulus would be ill-conceived.

So, within the Fed itself we have a bevy of opinions.

Thursday's LEI was up strongly, and while the folks at ECRI claim to have built a better mouse trap, their index is saying that we are hell-bent on our way to recession.

Well boys and girls, it is exactly these sorts of differences of opinion that help markets to function but it is being on the right side of the argument and of the trade that will make you money.

While we debate these things here at home others want to settle the issue under the rubric of synchronicity. The argument is that the world's economies are tied together and that there is some slowing in China and lot of it in Europe. Japan is still struggling. So the argument is that the US cycle will be dragged down by trends elsewhere. So is this view true? What does history have to say about it?

US-Europe Connection: To look at this we have looked to the relationship between Germany's MFG Industrial production and that in the US. If you peruse a chart of these two co-plotted indices you will see a strong co-variance in the two. The statistical R-Square between the two series is only 0.45, with a coefficient mapping IP growth from one country onto IP growth of the other of 0.5. This means when one country's IP changes, the other's changes about half as much; and with that, the co-variation which is statistically explainable is just under half (R-Square=0.45).

If we ask this question differently by looking at changes in the speed of IP growth by correlating Y/Y changes in Y/Y growth rates. That R-square relationship zooms up to 0.69 still with a coefficient on the 'change in' growth term of 0.5 . Once again about half the growth for country is transmitted to the other but now changes in growth one place explain nearly 70% of changes in the other.

However, a plot of these changes reveals that the largest variation with a very tight correlation comes from this last crisis. If we re-execute the correlations stopping at mid-2007 the R-square relationship between changes on this abbreviated horizon drops to 0.25 and the coefficient mapping changes in growth from one country to the other falls below 0.5 to 0.33.

And therein lies the real answer…

That answer is that there is more 'sin' in synchronicity than you might expect. When you do these sorts of "correlation experiments" there is always a question of whether 'A' causes 'B,' or 'B' causes 'A'. But there is the other possibility that some common factor 'C' causes both 'A' and 'B.'

The financial crisis is one such 'C'. The whole world suffered that crisis at the same instant. It was not a US IP drop causing a German IP to drop or vice versa. It was a crisis in which banks stopped lending - globally and locally. As interbank markets froze up, a credit freeze ensued.

In truth, when we take out the post-2007 period, there is still evidence of global connections but the lower coefficient that maps growth onto one place from another and the lower statistical correlation overall suggest that Europe's downturn may impact the US but that it may not derail our recovery.

The clear message here is that establishing a weak synchronicity is not enough for us to jump into the camp of growth naysayers. There have been plenty of times when German growth dipped or spurted and the US simply did not go along.

On balance, if the situation in Europe gets very bad and widespread and if it shows a severe decline in output we should expect noticeable and perhaps even severe contagion.

Intra Europe: It is interesting to note that if we calculate the IP growth rate change, R-Square for a group of EMU countries (France, Spain, Ireland, Greece, and Portugal) and for EU member, the UK, we find positive correlations between each of them and German IP. If we look at correlations before the zone was formed vs. afterward we see that the correlations rise sharply. If we exclude the period after mid 2007 then only Italy and the UK show stronger post EMU correlations (the UK is not a member of EMU). And only Italy shows a high correlation on changes in growth rates with Germany when we compare the before-EMU with the after-EMU and leave out data from after July 2007.

On balance, all this number crunching suggests that even in the same currency zone there is a great tendency for countries to go their own way. The single unifying factor for the business cycle this last time around was the financial crisis. So, if there were a severe global recession, we would see correlations rise. The recessions in 1979-82 were caused by the US reacting to an inflation rate it had let get out of hand. The policy shift was draconian; its effects were widespread.

Unless Europe experiences a severe financial crisis, I don't think that Europe will derail the US expansion. Remember that Germany will do better than other EMU members because at any given rate for the euro, Germany is about seven percent more competitive than EMU on average. While Greece is about 19% less competitive than the average and Spain is about 12% less competitive. The Zone members may share the same nominal exchange rate but countries have vastly different real exchange rates. These metrics also will come to bear on how correlated IP will be across the Zone. The Zone is far more heterogeneous than it looks.

The real culprit in the tightly synchronous business cycle is the common third factor that affects everyone: a financial shock, an oil price shock or something of that nature. We still have candidates for that kind of event. But a run-of-the-mill European recession where various euro-members will experience downturns of differing degrees of severity does not threaten the US. The bigger question for the US is whether we really have built enough of a foundation for our own growth to endure and that is still under debate even within the FOMC.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: How Tightly Correlated Are U.S. And Foreign Growth Rates?