In this article I explain why I have come to the conclusion that a late-2016 recession is likely. While the Federal Reserve is predicting another solid year of growth, as if the U.S. economy are in the middle of the business cycle, in fact we are near the end of the cycle. Considering the U.S. economy is approaching the seventh year of the growth cycle, it would be unprecedented for the economy to still have several years of growth as that would make it one of the longest expansion periods ever. Using the historical length of past expansion periods Citi has come up with a probability of a recession after each year of growth. Currently this chart shows the economy having a 65% chance of recession in 2016.
The initial reason for my concern came from the decline in oil prices which I have, in the past, been over-anxious in calling a bottom in. Although oil-related jobs, excluding those at gas stations, represent less than 1% of total employment, this sector has led our recovery. As you can see below, there was a 55% increase in these jobs since 2007. The total effect on the economy from this sector turning negative is difficult to precisely determine. There are many states such as North Dakota that have built their entire economies on fracking development. There are towns in Wisconsin built on the jobs created from frac sand mines. Even though the total percentage of jobs in this industry is low, there can be wide reverberations throughout the entire economy.
The oil sector layoffs are still in the early phases, as employment is a lagging indicator. Most fracking firms had some sort of oil price hedging in place. If oil prices don't recover in 2016, these hedges will roll off and more layoffs will take place. I am predicting a big pickup in M&A activity in the oil and gas sector, spurred by these hedges coming off. A fracking firm that is seeing earnings decline and has debt coming due in the next few years will be more motivated to sell than last year where the concept of a V-shaped recovery in oil was prevalent. This M&A activity will spur even more layoffs as the acquiring firms 'circle the wagons' when deciding which parts of the newly acquired firms are worth keeping. The chart below shows how far the number of employees in the industry has to fall over the next few quarters.
It's important to find out why oil prices have declined rapidly as we try to unravel the story of what global economic growth will look like in 2016. There are three arguments for why oil prices have declined. The first argument is the one often cited by the media, which is excess supply brought about by the North American unconventional drilling. As oil prices declined it encouraged OPEC nations to cheat by drilling more than their agreed upon quota in order to make up for budget constraints caused by low oil prices. OPEC countries that have kept oil high in the past have lost their control over the market. There are conspiracies that Middle Eastern nations want to destroy American drillers by drilling more to maintain market share. This doesn't make sense to me; if the fracking firms went bankrupt, they would come back stronger once oil went back to triple digits. Having oil in the $30s is not what OPEC nations imagined a few years ago. It's unsustainable unless budget cuts are made.
The second and third arguments are more complete because they explain the reason why the Bloomberg's commodity's index is at its 22-year low. It's not that supply isn't a critical factor in determining the price of oil, but it would be wrong to claim it as the only factor.
The second argument is potential future weakness in Chinese demand. China had been one of the most important drivers of the in demand for all commodities as its government historically spent money on infrastructure as a form of an economic stimuli. The story given on the reason for this shift is the transformation from an economy driven by exports to the U.S. to one driven by the Chinese consumer. While this transformation is certainly occurring, I think the narrative that the Chinese government is in complete control of the economy and will produce a 'soft landing' is wrong. The Chinese government simply couldn't keep borrowing at the rate it was as its debt-to-GDP ratio is 208%. I think the commodities market is dealing with the reality that China stopped spending because it couldn't do so anymore. Whether this is a managed decline or not, the Chinese PMI was 48.2, which was the 10th straight month of decline shown in Chinese manufacturing.
The third argument is the Fed's recent hawkish policies have caused a strong dollar that has caused deflation. The Fed ended QE and raised interest rates in December, while central bankers around the world have been cutting rates. In a sense countries around the world are in an infinitely long currency war that America is losing as the strong dollar is hurting its multinational firms. Keep in mind the dollar will increase further if there is a recession in 2016 as a flight to safety occurs.
The Fed's policies also had an effect on the supply of oil, showing how each action has an impact on the global economy in ways that are akin to a ball of yarn. When you untangle one piece, another one comes undone. The Fed's low interest rates and quantitative easing program caused over-investment in risky assets such as the unicorn companies like Uber (Private:UBER) and in fracking firms that took on huge amounts of debt to expand drilling. This drilling is what caused the oversupply, which I mentioned earlier. Since the Fed introduced QE 3, U.S. oil production increased 70%. Of course, this production would have increased because of the new drilling methods pioneered by EOG (NYSE:EOG) (Pad drilling, high frac sand intensity), but low rates encouraged more investment than there would have otherwise been as investors chased risky assets to drive returns they weren't generating from bonds. Low rates allowed fracking firms to borrow more money for their projects.
The weakness in the Chinese (NYSEARCA:FXI) economy has had far reaching impacts on commodity producing nations such as Brazil (NYSEARCA:BZF), Australia, Canada, Russia, and the oil-producing Middles Eastern nations. Chinese demand for products has played a part in Australia avoiding a recession for 24 years. This boom cycle is near its end as China lowers its demand for commodities. While the emerging markets economies do not have large economies as a percentage of the total global economy, they have, up until recently, powered a disproportionate amount of global growth. As you can see, 2015 was the first year in the past four in which emerging markets drove less global growth than developed markets. The economies that drove the global economy out of the recession in 2008 are now dragging the global economy lower.
I think economists have tunnel vision when they make forecasts. They think just because China has never driven the U.S. economy into a recession before, it means it can't happen now. The housing market in 2007 was deemed too small to have an impact on our economy until it caused the collapse in the economy. China is now being deemed to be in a similar category. I think this will prove to be foolish as economists are ignoring the important role it has played in the first few years of the recovery. Every year, for the past few years, the 'soft landing' phrase is thrown out, but every year economic activity slows. Economists and rarely forecast sharp recessions, but I think there is a strong possibility for one to occur at the end of 2016.
Getting back to the Fed's policies, because I feel 2016 will be recessionary, the Fed is doing the exact wrong thing. It should be cutting rates instead of raising them. Raising rates could flatten the yield curve as short term rates rise relative to long term rates. The differential between the 10 year and the 2 year yield has been an excellent predictor of past recessions. As you can see, I analyzed the chart of the differential when I was preparing for a YouTube video where I predicted a recession in December. The metric has support at its previous low of 1.19. As of January 6th the metric is 1.21. I think the market is trying to determine if the U.S. will go into a recession right now as the market typically tries to forecast what the economy will do 6 months in advance.
Besides the flattening yield curve, declining developing economies, and massive decline in commodities, there are a few other indicators which are flashing warning signs. I will go over them now. This slide is from Hedgeye. It calculates the rate of change of S&P 500 earnings (NYSEARCA:SPY) by comparing S&P 500 TTM EPS with the TTM Average. As you can see, when the TTM EPS falls below the TTM average it is a great indicator of a recession. The term 'earnings recession' is the same type of phony term as the 'soft landing' in China. An earnings recession is a leading indicator for the economy because firms start firing workers when their profits sink.
The M&A activity, which I predicted happening in the oil sector, correlates perfectly with the unemployment rate bottoming by the end of the year. As you can see from this chart from Hedgeye, after the jobless claims number drops below 300,000 it takes an average of 19 months for the U.S. economy to go into another recession. The Fed should have been raising rates 2 or 3 years ago as the jobless claims were falling. This rate increase in December was too little, too late.
It doesn't make sense for the Fed to raise rates into a declining profit environment, but currently there is about a 52% chance the Fed will raise rates at the March meeting. If this does occur, it only bolsters my recession call.
Buybacks are typically viewed as a favorable way to return capital to shareholders as ones that are substantial are able to shrink the number of shares outstanding. Unfortunately, the timing of buybacks tend to be awful as firms buyback stock at the peak of the profit cycle when stocks are high and stop buying back shares when the shares go down during a recession in order to preserve capital. Therefore, when buybacks increase it is a sign of a potential top in the market. The chart below shows the amount of firms which have TTM buybacks which exceed their net income. A firm spending more money on buybacks than it has in earnings is a recipe for disaster. As you can see from the chart, the number of firms in this category is not yet at the height reached before the recession in 2008, but it is the highest since the recession ended. This is a negative indicator for the market.
There are 3 more indicators which I am following which have a negative signal for the overall U.S. economy. The first is the spiking junk bond yields. As investors anticipate a future recession they become more conservative and start demanding higher rates of returns for risky securities such as junk bonds. I think the skyrocketing junk bond yields correlate with the bubble popping in the unicorn private firms as investors once again demand profits from businesses they own. We may have seen the beginning of this with Fidelity lowering its valuation of Snapchat (CHAT) by 25% from $16 billion to $12 billion. Keep in mind Snapchat is only earning $50 million in revenues this year.
The slide below is also from Hedgeye. It shows the rate of change in consumer sentiment turning negative as it is below its 12 month moving average. As you can see, this indicator has predicted the past 3 recessions. Anyone paying attention to the news of Macy's (NYSE:M) closing 36 stores because of poor sales wouldn't be surprised by this metric. While some will blame Macy's poor performance on unseasonably warm weather, I don't buy this excuse. If Macy's believed this decline was temporary, it wouldn't be closing stores.
The final chart shows the increase in inventory to sales ratio. This can signal a recession because an increase in inventories signals a decline in demand. The excess inventory needs to be discounted in order to be sold, thus lowering the profits of firms. This correlates with the possible decline in profits shown in the chart I referred to earlier. There is a concern that this increase has to do with ecommerce firms keeping more inventory on hand, but I don't believe this to be a valid excuse because the ratio was flat from 2010 to 2012, while online sales grew.
In conclusion, the biggest risk investors have to avoid is listening to the Fed's predictions on where the economy is going. We are at the end of the business cycle, not in the middle. The Fed missed the last recession and will miss this recession until it is even more obvious than it is now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.