1/2 Full: Not Throwing in Towel on Recession Probability
Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
August 29, 2011
Key points
- Double-dip recession chatter is highly elevated, but I think we'll scrape by without one.
- Leading indexes are giving conflicting signals.
- Recession or not, growth will be weighed down by debt and lack of confidence.
Let me state right up front that even though I'm not in the recession camp, risks that there will be one have risen markedly. A good deal of that risk relates to the breakdown in confidence triggered by the debt ceiling-related political antics, the subsequent downgrade of US debt by Standard & Poor's, the ongoing debt crisis in the eurozone and a highly volatile stock market.
The lack of confidence can turn into a self-fulfilling prophecy. But formal recessions require a big drop in many segments of the economy, and let's not forget that several segments—housing, automobiles and small business—really never exited recession in the first place. As a result, the likelihood of major drops from these levels is low.
The most recent trigger for elevated recession chatter was the extremely weak regional measure of activity put out by the Philadelphia Federal Reserve (Philly Fed). It dropped to -30.7 in August from +3.2 in July—its lowest reading since March 2009, and a level that's always been historically recessionary. Caveat: It's only for the Philadelphia region and is extremely volatile, but its warning is worth heeding nonetheless.
Since the last recession ended in mid-2009, we have had the view that the recovery would likely be square root-shaped (a "V" initial recovery followed by flat performance) versus shaped like a "W" (double-dip recession). We're unquestionably past the "V" and are now growing very, very slowly (the flat part of the square root sign). As we've noted countless times, the ability of the economy to grow at anything resembling a healthy pace is severely limited by massive debt as a percentage of US gross domestic product (GDP), exacerbated by many structural impediments to jobs growth.
However, there are several recent bright spots:
- Consumer spending surged in July.
- Oil prices have tumbled in the past five months, providing a boost to consumers and energy-intensive businesses.
- Mortgage rates have dropped to record-low levels, allowing some homeowners to refinance.
- The trade-weighted dollar hit a new low in August, down 10% year-over-year; benefitting US exports and multinationals.
- Initial unemployment claims have ticked back down toward the critical 400,000 level.
- Stocks are rallying again.
- Corporate insider buying versus selling (transaction volume) is at or near record levels compared to recent history.
- Durable goods orders rose by a greater-than-expected 4.0% in July (driven by autos).
- Monetary policy remains extremely accommodative.
- Negative effects from Japan's disaster(s) are abating.
GDP growth … or lack thereof
I want to start by providing a little more insight into the recent weak GDP reports and the large downward revisions to earlier growth. With last week's revision to second-quarter growth, real GDP growth was now only 1.0%, following a paltry 0.4% in the first quarter.
As a result, year-over-year GDP growth is now at a level that has nearly always signaled a recession (though there have been some exceptions, as you can see in the chart below).
GDP Growth Dips Below 2%
Source: Bureau of Economic Analysis and FactSet, as of June 30, 2011.
One positive caveat, however: For the first quarter of 2011 and the recession period, it was only "real" (inflation-adjusted) growth that was revised downward. What many don't realize is that "nominal" (not inflation-adjusted) GDP growth was actually revised higher in the first quarter.
So it was a greater amount of inflation that pulled down real growth. Nominal GDP is most highly correlated to corporate top-line (revenue) and bottom-line (earnings) numbers and helps explain why, in conjunction with the downward revisions to GDP growth, corporate earnings were revised up by a whopping 15%.
According to Barclay's, historically the average peak in annualized trailing earnings came five months prior to the beginning of recessions. In only two cases—the 1974 oil shock-induced recession and the 1981 monetary policy-induced recession—were earnings still rising when the recession began. We're nearly 90% through the second-quarter earnings reporting season and earnings are beating consensus estimates by 5.7%.
That said, earnings growth rates are decelerating, which is quite normal at this point in the economic cycle. By this year's fourth quarter, it's expected that reported earnings growth will fall below 20% for the first time since the fourth quarter of 2009. This is only the ninth time in the post-World War II era that earnings growth stayed above 20% for four consecutive quarters or more.
Let's look at what this deceleration might be saying about the likelihood of recession and/or market action going forward. As you can see in the chart below, courtesy of Ned Davis Research (NDR), earnings growth decelerations below 20% have neither been necessarily recessionary nor caused trouble for the stock market.
Performance After EPS Growth Falls Below 20%
Source: NDR, Inc. Further distribution prohibited without prior permission. Copyright 2011© Ned Davis Research, Inc. All rights reserved. Growth/Value=Russell 1000 Growth Total Return Index/Russell 1000 Value Total Return Index (data only available beginning in 1979). Earnings growth has been greater than 20% for at least four quarters and then falls below 20%.
As you can see, stocks haven't followed earnings' lead, having risen a median of 13% over the following year. The two cases in which the market declined were during 1956 and 2000—after both cases, a recession began within the following 18 months.
So if history has rhyming qualities, if a recession is avoided, the market stands to perform fairly well even as earnings decelerate. As NDR notes, earnings deceleration stories appear to be more about leadership themes than about the broad market's performance. When earnings growth decelerated in the past, investors tended to put a premium on companies that continued to deliver; in other words, growth stocks (you can see this illustrated in the table's fourth column above).
LEI says no recession
Most regular readers know I keep an eye on the leading indicators, specifically The Conference Board Leading Economic Index (LEI) and it was the decisive turns in those in 2007 and early 2009 that gave us the heads up that the recession was beginning and ending, respectively.
Since the LEI low in March of 2009, it has moved up with only one monthly downtick in May, after which it resumed its ascent, with its latest reading for July up well more than expected. As you can see in the chart below, we've never experienced a recession (since 1948) when the LEI was making new highs.
LEI on High
Source: FactSet and The Conference Board, as of July 31, 2011.
There are a couple of caveats about the LEI worth noting, however. The two primary drivers of recent strength in the LEI are the yield spread and M2 money supply. The yield curve has inverted (short-term rates higher than long-term rates) prior to every recession in the past 60 years, while today the curve remains relatively steep. Some argue, and rightly so, that with the short end of the yield curve pegged at a zero percent rate, the only way for the yield curve to invert is for the Fed to raise short rates (not happening any time soon) or long rates to go negative (also highly unlikely).
Prior to 2001, a narrowing yield curve spread would have been a negative contributor to the LEI, but the Conference Board changed this indicator so that it's only a negative contributor if the curve inverts—again, not possible with short rates at zero.
As for money supply, much of the increase in M2 is because investors, consumers and businesses have moved toward cash holdings given the market and economic volatility. Some suggest this is a negative from a macro perspective, but I'd argue it means there's a lot of fuel on the sidelines. If you eliminate the positive contributions from the yield curve and M2 supply, the index would have been down in three of the past four months and in a pattern that ultimately led to recession in late 2007.
WLI says recession
Another popular leading index is published by the Economic Cycle Research Institute (ECRI): its Weekly Leading Index (WLI) can be seen below.
WLI Much Weaker
Source: ECRI, as of August 19, 2011.
The WLI has just generated a contraction signal based on an NDR model, confirming that the risk of recession has risen. The indicator was heavily influenced by the recent stock-market correction, but the signal should be heeded, as the WLI has been fairly accurate in calling turns in the business cycle since 1968.
The short-lived contraction signal it generated last summer, again due to falling stock prices, was not confirmed by other indicators. This time around, with consumer sentiment returning to recession lows, state coincident indexes pointing to a slowdown and most regional activity indexes declining, evidence is mounting that the soft patch of this year's first half could turn into contraction in the near term.
NDR also has a model that predicts recession based on state conditions, as you can see below. Although the risk has risen, you can see it remains below 15% and likely reflects the better revenue stream (via tax receipts) states are experiencing and the fact that much of the budget-related spending austerity is largely behind them.
Still-Low Recession Probability
Source: NDR, Inc., as of July 31, 2011. Further distribution prohibited without prior permission. Copyright 2011© Ned Davis Research, Inc. All rights reserved.
Mixed picture, less conviction
I know what I've presented in this report paints a mixed picture for the economy, and frankly that's a valid assessment in our opinion. Back in the fall of 2007, when I wrote a report titled, "Recession Watch," we felt that a recession in short order had a very high probability. In the spring of 2009 when we wrote many reports suggesting the recession was coming to an end, those were backed by a high conviction rate as well.
Today, it's murkier. It's with limited conviction that I feel a recession will be avoided. I also think it's a game of semantics more than anything at this point, because the bottom line is that growth is likely to be constrained in this era of deleveraging.
Copyright © Charles Schwab & Company, Inc.
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