Second Recession Horseman Goes Down
Recently I analyzed the ECRI recession call saying "Doug [Short] uses the 4 most important components of the economy - consumer spending which makes up more than 70% of GDP, industrial production which leads to employment and incomes which drive consumption. The chart below shows a composite index of these four major components analyzed on a quarterly change basis.
The chart above shows a group of economic indicators from the manufacturing standpoint. The STA Economic Output Composite Index (EOCI) is comprised of several Federal Reserve Manufacturing regions, the CFNAI (composed of 85 sub components), the ISM Composite Index (an average of both ISM Indexes), the Chicago ISM and the NFIB Small Business Survey. This is a very broad look at the economy from some of the major indicators.
Going back to 1967 whenever the 6-month moving average of the EOCI has fallen below 35 the economy was either in, or about to be in, a recession. That is until the summer of 2011. During 2011 there was a culmination of events that prevented the economy from slipping into recession:
- The Japanese earthquake led to a manufacturing shutdown combined with the debt ceiling debate which caused a contraction in consumer spending. This led to pent up demand that was unleashed during the last two quarters of the year.
- Further boosting consumption was a fall in oil prices which gave an effective $30 billion tax credit to consumers.
- The warmest winter in 65 years allowed construction and manufacturing to continue through the winter months which skewed the seasonal adjustments to economic indicators, like employment, to the upside.
- Due to the exceptionally warm winter utility expenses declined sharply giving another ample effective tax credit to consumers.
- The Fed engaged in Operation Twist along with the ECB which launched two rounds of Long Term Refinancing Operations which supported the financial markets and boosted consumer confidence.
Importantly, notice none of these supports for the economy was organic but rather a simultaneous collision of artificial and one-time events that prevented a recession. The problem today is that outside artificial stimulus - the "mother nature" effect is not currently available as the composite indicator is again signaling a recession through the manufacturing side of the equation."
I bring this up because the second, and arguably one the most critical as it ultimately affects consumption, component that Doug tracks, real "inflation adjusted" personal incomes, turned down sharply in the most recent Personal Income and Expenditures report for August. Before I get into my analysis here are Doug's updated comments: "The latest updates to the Big Four was today's release of the August Personal Income data (the red line in the chart below), which dropped 0.9 percent over the previous month. As the average of the Big Four indicates (the gray line), economic expansion since the last recession was flat or contracted during three of the eight months in 2012. The average for August, down 0.4 percent, is the sharpest month-over-month decline of the 2012. The data, of course, are subject to revision, so we must view these numbers accordingly. When ECRI's Achuthan made his July assertion that the indicators were rolling over, the data didn't appear to support the claim. However the latest numbers are showing some troubling signs of reversal."
Doug is correct. The downturn in both industrial production and incomes is troubling to say the least. As I said - these four data points are very important drivers of the economy. Consumer spending currently accounts for more than 70% of GDP. However, in order for individuals to spend they must have employment from which to derive income. However, in a weak economy, with high unemployment, consumption wanes putting business on the defensive. Industrial production is then throttled back as demand declines, as witnessed by the recent drop in new orders for durable goods, which leads to layoffs and firings increasing unemployment. This is the virtual spiral that the economy is locked into currently and why each component is critical to the economy as a whole. What the media tends to miss is that when one indicator begins flashing warning signals - the others generally follow.
This brings us back to real disposable incomes and consumption. In a weak economy. where there is an excessively large available labor pool. the competition for jobs keeps wages suppressed. This can be clearly seen in the chart below of real disposable incomes versus personal consumption expenditures.
Not surprisingly there is a very high, but lagged, correlation between disposable real incomes and consumption. We have spent much time discussing the impact of stagnant wage growth, and weak aggregate end demand, on both employment and the economy. However, this simple fact seems to continually elude economists and Central Planners in this country who insist on programs, such as "bond buying", which while bailing out Wall Street has no direct impact on aggregate end demand.
Real disposable incomes have fallen negative on a year-over-year basis for the first time since last November. However, at that time, the onset of the unseasonably warm winter, which allowed many construction and manufacturing jobs to continue during a period that is normally impacted by inclement weather, incomes rebounded quickly. With corporations warning of future economic weakness, new orders slowing and backlogs being drawn down, the impact to incomes could be more pervasive this time.
The chart below shows a composite index of the four major components, discussed above, analyzed on a quarterly change basis.
As I stated previously in the analysis of the ECRI recession call: "There are some very important takeaways from this type of analysis. The first is that historically recessions occur VERY quickly. This is why analysts and economists are generally caught flat footed when they occur. Secondly, the current choppiness of the economic data is very similar to what we saw just prior to the last recession as the credit induced real estate bubble was in tact. What is important to notice is that it is NOT uncommon for the underlying components of incomes, production, employment and consumption to tick up, even sharply, just before a collapse into a recession occurs.
The table shows (click to enlarge) the where the economy stood just one quarter prior to the onset of recession. In every case the economy was 'muddling' along until it wasn't. Currently the Composite Economic Indicator as shown above is at .30% with the economy growing at a very weak 1.7% annualized rate as of the second quarter. The composite indicators has fallen 50% from last quarter's reading of .60%. At currently levels neither the index or the quarterly change in the components is signaling an immediate recession. However, with history as a guide, that does not really tell us much of where we will be in the next quarter."
As I stated in the recent report on GDP and Durable Goods: "While I am not yet prepared to say that we are in a recession now, as opposed to the ECRI and John Hussman, my continued estimation is still that it is likely to occur in early 2013, however, at the current run rate of the data it could well be in the fourth quarter of this year. What is important, however, is that the evidence of the potential onset of recession is mounting."
With real incomes now dropping - two of the "four horseman" of the economy are warning of a recession. If history is any guide we are likely to see employment and, as stated above, real sales (consumption) slipping in the next couple of reports ahead. While QE programs may keep Wall Street flush with liquidity - the real economy sees no real benefit of such programs. Businesses make decisions about hiring, production, wages and capital expenditures based on "demand" - not whether the Federal Reserve is expanding its balance sheet. Likewise, the consumer makes spending decisions based on their income, availability of credit, the status of their employment, and whether the next iGadget is out. With businesses becoming more defensive due to weaker future outlooks it is only a function of time until the consumer is more deeply impacted.
As we have stated many times in the past - while QE programs may cause stock prices to detach from the underlying earnings and economic fundamentals in the short term - eventually a reversion to reality will occur. The warning signs are picking up with more consistency and it is not a time to take on portfolio risks that can lead to excessive losses. While the media, economists and Wall Street can be wrong without conseqence - for an individual it can have very real and serious consequences.