Recent Macro Indicators Strongly Reinforce My Recession Call... Nouriel Roubini | Aug 20, 2006
The macroeconomic indicators published in the last week or so have strongly reinforced my out-of-consensus view that the US economy will fall into a recession by early 2007: quite simply most of them are headed sharply south, consistent with a sharp deceleration in growth in H2 that will lead to a recession by 2007.
First, consumer confidence is sharply down as consumers are in a foul mood. No surprise as the three bears of slumping housing, high oil and the delayed effects of rising policy rates are beating down a consumer with falling real wages, negative savings, high debt ratios, rising debt servicing ratios and mediocre job growth.
Second, all indicators of the housing sector show not just a slowdown, not just a slump but an outright rout in the housing sector. As, the Toll Brothers (the homebuilders known for the McMansions of the roaring housing bubble times) put it last week this is the worst housing oversupply slump in the last 40 years. And this is not just the self-serving view of a once high-flying homebuilder whose stock prices is collapsing along that of all Reits and other homebuilders. All the indicators from the housing sectors - including the latest housing starts and homebuilders (NAHB) forward looking business conditions - indicate a housing sector that is literally in free fall. Real residential investment already fell at an annualized rate of 6.4% in Q2; expect it to fall at rates of 12-15% for the next few quarters. And, as I have argued before, the wealth effects and the employment effects of this housing meltdown will be severe, much larger than the effect of the tech sector bust in 2000-2001.
Third, consistent with this housing rout, lending indicators - both for housing and consumer loans - are also headed south. While the supply of credit is not getting tighter, the demand for credit by firms and households is sharply slowing. Of course, the slowdown in the demand for home mortgage related to the housing slump. But now you are also seeing lower demand for C&I loans; this suggests that investment spending may be falling ahead, as already signaled by Q2 data on real investment in equipment and software. Moreover, home equity withdrawal (HEW) will be sharply down soon enough once the housing price flattening turns into an outright fall in average housing prices (such prices already starting to fall in the bubble regions of the US). And with lessened HEW, the ability of households with negative savings to consume more than their incomes - as they have been doing for two years with negative savings - will be severely curtailed.
Fourth, car sales are now falling in real terms. And as Floyd Norris pointed out over the weekend in the New York Times, car sales are one of the strongest leading indicators of US recessions. Consistent with the car dealers' doldrums, Ford now is announcing a sharp cut in production for the rest of the year. While Ford's problems - and the risk that it may eventually end up in Chapter 11 - are partly specific to this firm - as Japanese transplants in the US are doing well and gaining market shares on the Detroit Big Three - the aggregate automotive sales figures signal that the auto slump is not specific to Ford but an aggregate sector wide phenomenon. And the auto sector slump is not unrelated to the housing slump. As the FT put it on Saturday, the sharp fall in the sales of Ford's pick-up trucks is related to the housing slump as such truck are widely purchased by real estate contractors. And indeed in Q2 real consumer durables (that include both cars, home appliances and furniture all related to housing) already fell, consistent with the view that we have now have a glut in the stock of consumer durables (durables consumption has a investment-like nature to it as such goods last for a long time). Fifth, other business cycle indicators are also signaling weakness ahead: the Empire State business index, a leading indicator, is sharply softening; inventories are up and figures for May and June have been revised upward. While such revision may boost the revised Q2 figure to 3% from the initial 2.5% this is an ominous signal: with inventories of unsold goods even higher than initially estimated in Q2 and with final sales growing only a 2% rate, the slowdown in demand will force an inventory adjustment in Q3 and Q4 via a reduction in production, thus impart further downward direction to H2 growth.
This wide range of indicators clearly suggests that the economy is headed south with the growth slowdown in H2 likely to be much sharper than in Q2. Of course, cheerleading Goldilocks optimists are systematically biased towards a bullish view of the world. For example, last Friday I was interviewed by CNBC’s Squawk Box: after presenting my bearish views on the economy and on the equity markets, the cheerful anchor concluded with a totally non-consequential: “I guess this is probably a buying opportunity!†(sic!). How could have concluded with such a bullish spin is unfathomable. Of course, once a recession leads to a bearish equity markets with valuations 15-20% below current ones, we may get some buying opportunity at the bottom of the cycle; but certainly not now when P/E ratios are still high on a cyclically adjusted basis. But for perma bulls no fact can shatter their cheerful and deluded view that markets can only go up.
And what are the recent “good†news that perma optimists hold on for their bullish views? Most of them are not that “good†once you scratch the headline figure and look at the details.
First, perma bulls are cheered by the PPI and CPI figures. Indeed, as I suggested weeks ago markets are a few steps behind the curve. I argued that the coming recession will imply a slowdown in inflationary pressure and lead the Fed to cut rates in the fall or winter. But the market consensus, after the FOMC meetings, was still whether the pause will continue or whether inflation would force the Fed to hike again in the fall. The PPI and CPI figures shattered altogether the chances of a hike and made clear that the pause is a stop. But markets have not yet digested that this stop will next lead to a cut once the recession signals are clear. And the softening of the inflation pressures – save for additional energy shocks - is consistent with a softening economy and labor markets. And indeed the equity market rally in recent days is consistent with my view of a suckers’ rally following the Fed pause and future cut. After the FOMC meeting markets were still uncertain on whether the pause was permanent or a pause before another hike; it had not dawned on them that the coming recession implies that the next Fed move would be a cut. Thus, the market rally was tentative; it is only after the PPI and CPI nailed the hike scenario into a clear coffin that equity markets rallied in the typical suckers’ rally based on expectations that the Fed will come to the rescue of the economy and markets. But wait until signals of the incoming recession are stronger for markets to sharply fall when the reality of a recession leading to falling earnings and profits sinks in the mind of investors.
Second, chattering cheerleaders of an ever rising market are cheered by the industrial production data for July. But if you exclude utilities – sharply up on a seasonal basis because of the weather – manufacturing production is up a miser 0.1%, consistent with an economic slowdown.
Third, forever Panglossians are reassured by the low initial claims of unemployment benefits numbers. But low figures for such claims have been consistent for the last four months with a most sluggish labor market where a pathetic 112K jobs have been created per month on average including July when the unemployment rate started to increase. So, there is little to cheer on the labor market front. Also labor market indicators are well known to be lagging rather than leading. When demand first slows down, firm do not cut production or employment; they just let inventories of unsold goods to increase. Only after the fall in sales persists for a while firms will start to cut production to avoid an excessive pile up of unsold goods. And even then firms will tend to hold on their workers – and cut production via reduced capacity use - as losing skilled workers is costly: it is only when the fall in demand and production is significant enough that workers are fired and jobs cut. Thus, employment is a lagging indicator of the business cycle; and the fact that job growth has been dismal for four months now in spite of not being yet in a full fledged recession is an ominous signal for what the labor market will do once the recession is in full swing.
Fourth, optimists sighed a major relief when the July retail sales numbers were sharply up; the spin was that the consumer was entering Q3 with a roar. Of course, observers failed to notice that once you strip sales from gasoline purchases and once you correct nominal figure for the high rate of inflation, the real retail sales are much weaker than the headline. Also, retail sales – especially their non-durables component – are usually the last shoe to drop. In 2000 while the sharp US slowdown – that led to the 2001 recession - was underway real retail sales remained robust until Q3 and they crawled to a stop only in Q4: by September 2000 retail sales were still growing at a rate close to double digits and went into a stop only in December. Also, Q2 figure show that real durable consumption is already falling while non-durable consumption was growing at a modest 2% plus rate. The only component of consumption that was still perky in Q2 – in the double digit real annualized growth rate – was that of services. But the signals from the July services ISM leading indicators suggest that even the service sector is in a slowdown pattern, an ominous signal for the future rate of real consumption of services.
In conclusion, the “bad†news are really bad while the “good†news are only lagging indicators or actually “semi-bad†news under the disguise of “good†news. So, the flow of economic indicators from the last ten days has only confirmed my view that the economy is experiencing a sharp slowdown that will bring a significant reduction in growth – relative to Q2 – in H2 and an outright recession by early 2007. The bulls and apologists for a soft landing are clearly on the defensive as consumer confidence, housing indicators, car/auto sector indicators, credit/lending indicators and other macro measures signal that a strong growth slowdown is underway. Compared to a few weeks ago when consensus was for a H2 with 3% plus growth and the policy debate was on whether the Fed will keep on hiking in the fall, the current debate is now on how rapid the US slowdown will be, whether the landing will be soft or hard and when will the Fed start cutting rates; chatter on Fed hikes is now mostly forgotten. And indeed my Google News Barometer of Recession signals is still sharply up with over 5,500 mentions in the online press of the term “â€Recessionâ€. So, I feel comfortable in arguing that my recession call is as strong as before and I expect the economy to reach soon – by early 2007 - its recessionary tipping point.
Finally, it is also comforting to note that my out-of-consensus view that the world will not be able to “decouple†from the US recession and that we will not have a “rotation†in global growth from the US to Eurozone and Asia is now becoming a little more mainstream: Munchau in the FT has recently strongly argued that the Eurozone will not decouple from a US recession; he has also argued in his most recent column – as I did in a recent blog – that the Eurozone recovery has very weak legs. So, as I have been arguing for months now, the “decoupling†fairy tale is being peeled away by both reasoning and facts.
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