For the past three years, we have been entertained by bearish commentators on the web who have called for a U.S. recession either in 2010, 2011, and 2012 (with some making recession calls annually). In fact, many of them are stating we are in recession right now.
Their calls have been totally incorrect, with rationales lacking even the most basic understanding of what causes recessions, the market environment that is conducive to catalyzing them, and most importantly, central banking policy efficacy in terms of fighting slowdown and extending the economic cycle. I'll avoid naming names, but you all know who these Cassandras are.
I find the fact that they still have an audience, and in some cases substantial assets under management, as just more support for the truism that "a fool and his money are easily parted."
In this article, I would like to share a handful of indicators that I have accumulated over the years, which I track in order to assess recession risk. I used them extensively when making my recession call in 2007 for the hedge fund I worked, as well as in my current position, where I have been reticent in calling for recession.
Based on my indicators, I currently assess the chance of a 2012 recession in the United States as impossible, and a 2013 recession as improbable, absent a major exogenous shock. Here's why:
Reason 1: Temporary Jobs
Temp jobs have always been one of my favorite leading indicators. As you would expect, due to labor laws, temps are usually first to go at the beginning stages of recession. Thus, prior to a substantive economic downturn, we should see temp job growth shift to negative on a year over year basis, as has happened prior to the last three recessions. If I only needed one indicator to make a recession call, this would be it.
(click images to enlarge)
As of the most recent Non-Farm Payrolls report, temp jobs have increased 10.6% on a YOY basis. In fact, jobs haven't even decreased on a second derivative basis as YOY gains have accelerated since March. Another fact -- the pace of temp job growth in this expansion has been more robust than the 2003-2007 Bush expansion. Admittedly, we are coming from a much a deeper hole, but in market parlance, "the trend is your friend." Now, the bears will argue that the "quality" of jobs has not been great, but I would rebut that the fact that this job expansion has not been led by government (which continues to shed jobs) or construction (which is way below normalized rates), puts this jobs recovery head and shoulders above the prior in terms of its sustenance and further reinforces the United States as the most dynamic economy in the world in terms of its ability to readjust and realign. On this basis, it's extremely difficult to envision how the U.S. could be in recession at the moment as the bearish pundits have proclaimed.
Reason 2: Investment Spending
Go back to your Econ 101 course and you may remember that GDP = Consumption + Investment + Government + Net Exports. Any good Economist will tell you that Investment is typically the most important "delta" in GDP because Consumption and Government cannot live in a vacuum -- they are very reliant on Residential and Capital Investment (which make up aggregate Investment).
As you can see in the chart above, through the last GDP report, Investment Spending continues to rise. No doubt, one can see just how absurd the 2003-2007 expansion was, particularly with respect the over-reliance on Residential investment. But that was six years ago, and today we live in sober times. Looking at the above chart as a percentage of GDP shows both how weak the recovery has been, but also how we have overshot, particularly on the residential expenditures side. This was outlined in a previous Housing article I wrote. It also shows how inconceivable that the next recession is a) nearby and b) not going to be buffeted by continued normalization of residential investment within the context of total investment spending.
Reason 3: Global Monetary Policy
The Bears have cited on numerous occasions that monetary policy has "run out of bullets." I would argue that in a fiat regime facing contained prices, monetary policy can have incredible efficacy relative to a gold standard or currency peg regime. It is only in a period of rising prices, particularly among most politically sensitive inputs, where global monetary policy will be constrained. While admittedly food prices have risen in recent months, this will be argued as transitory by most policymakers and relatively inconsequential in the developed world, since food is a small part of the CPI. Rather, for several generations, it is oil prices which have tremendous correlation to Consumer Confidence, profit margins, monetary policy, and ultimately share prices. In my mind, the two most important Central Banks to follow are the Fed and PBOC. With respect to the Fed, we know the Bernanke put is alive and well. One reason is the moderation in CPI we have seen since the post QE/Arab Spring 2011 oil spike.
Indeed, drilling down on oil, we see that past U.S. recessions have been catalyzed by an inflationary bout. I wouldn't say it's a necessary prerequisite to have oil prices spike 100% YOY, but I do not believe oil prices down 10% YOY, as they are today, come anywhere close to being able to constrain policy. In fact, on a temporary basis, lower energy prices act as a "stimulus" to economic growth.
Furthermore, we now see the same disinflationary trend in China. China, if you will remember, took proactive steps to fight inflation and housing froth as early as 2010, and this has arguably acted to constrain the impact of Fed policy. Given the bluntness of Chinese monetary policy, M1 growth is a good way of gauging future policy response. As you can see, the recent tick-down in inflation at trough M1 growth, makes it likely we will see further policy response against any future slowdown growth. Call it the "PBOC put." The combination of unified easing from the Developed and Developing World could ignite a huge cyclical rally in global equities.
While I have derided the PermaBears in this article, I would still consider myself a pretty cynical person. Economics is about the study of scarce resource allocation and as such, I do not believe that perpetual growth is possible. Hence, to me it is clear that the next act in the global economic cycle is one which will constrain policymaker largesse. This can come in a variety of ways, but those risks with highest probability are (in no particular order):
- A War with Iran that causes a rapid spike in oil prices
- Some sort of loss of faith in the U.S. dollar, which causes a constraint on further Fed easing and tightening by the PBOC, including breaking the USD dirty peg.
- Run of the mill expansion, which tests the limits of global capacity constraints and causes a commodity super-spike like the one we saw in 2008.
Assets To Benefit:
Note that all of the above imply an increase in inflation expectations. As such, I would advocate that investors seek inflation protection in their portfolios. This can be done through commodity plays such as USO or BNO, which I wouldn't normally advocate, save for the fact that the curves have little roll yield risk, hence not overly penalizing investors in the ETFs. Protection can also be achieved through GLD and SLV, which should continue to benefit under a U.S. regime of negative real interest rates.
However, given investor sentiment toward share prices, I believe that at least for now, the shares of commodity stocks may be a better bet.
Based on these handful of potent economic statistics, I believe that recession probabilities are far overstated by the PermaBears. I have purposefully refrained from discussing Europe simply because the outcome is entirely binary. Furthermore, I would argue that if market participants truly believed Europe was problematic, we would see much poorer financial conditions, ranging from Ted Spreads, Swap Spreads to higher average levels of implied volatility.
Rather, given that we are witnessing the first unified monetary policy response by the PBOC and Fed since 2009, coupled with very poor investor sentiment, an explosive rally in share prices may be possible. I believe that such a rally will be led by cyclicals, which have become severely depressed against fixed income and defensive stocks, particularly those perceived as safe simply because they pay a dividend and offer yield. For investors willing to take a chance, higher return plays may be available in the speculative energy exploration and junior mining sectors.
The old Wall Street saying is, "Making money is better than being right." Judging by the PermaBears' performance, they appear to have achieved neither in the last two years. For them, 2012 is likely to be the hat trick.