Thoughts through the cycle: W1 February ’20

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Are we in a recession yet?

  • Early in the summer of 2019, the US yield curve inverted. Quoted in the Financial Times at the time, Robert Kaplan of the Dallas Federal Reserve said, “I think the whole curve moving down, particularly at the long end, tells me there’s a lot more pessimism about future growth prospects,” adding that were the situation to continue, “it will create its own set of distortions and challenges, which may seem innocuous for a time, but I think eventually will create issues which tighten financial conditions” (“Yield curve inversion divides Fed presidents”, Financial Times, 06/09/2019).

  • While not necessarily responding specifically to the curve inversion, the US Federal Reserve entered a period of hyperactivity in H2 2019, cutting the target Fed Funds Rate three times, offering term and open-repo facilities, and resuming bond purchases to the tune of $60b per month. This qualifies as aggressive monetary easing. Following these actions, the 3m/10yr UST curve, which had been inverted from the end of May 2019, moved positive again in October 2019.

  • As a symptom, an inverted curve reflects an unwillingness of banks to lend. When short-end rates are higher than those further out along the yield curve, the ‘roll down’ for banks is negative, making the provision of new credit unprofitable since funding costs more than the lending (banks borrow short and lend long). An upward-sloping yield curve is usually the sign of healthy lending and also healthy demand for credit.

  • Through a combination of rate cuts, repo and bond purchases, the Fed acted very aggressively for what it described as just a ‘mid-cycle adjustment’ to extend the economic cycle. Despite all this expenditure of effort, the 3m/10yr curve inverted again at the end of January 2020 (see graph below). Uh-Oh.

Source: Bloomberg, 31 January 2020

  • In the same Financial Times article referred to above, Eric Rosengren of the Boston Fed was of the view that falling long term rates in the US were the result of “challenging economic conditions in much of the rest of the world”. In a week in which the World Health Organisation declared the coronavirus an epidemic, worries about global growth, especially in China, are clear. However, a glance at the graph above shows that the 3m/10yr curve had peaked and was starting to flatten from year-end 2019, well before the current health scare. This observation lends itself to the argument that it may be the US itself which is slowing.

  • The first cut of Q4 2019 US GDP came in at 2.1%. This number is a bit of an illusion, higher by 1.5% due to an inflation adjustment resulting from imports falling 8.7% at the same time as exports rising 1.4%. Falling imports suggest falling demand which is negative, (all else being equal). It may well be revised lower in time. What is most interesting is that personal consumption came in lower than expected (1.8% vs 2.0% estimate and 3.2% prior, Bureau of Economic Analysis statistics). Any doubts about consumer wellbeing ought to be taken very seriously, acting as they do as lynch-pins of the US economy.

  • On the demand side of the economy, falling imports are clearly a negative indicator. The graph below from the St Louis Federal Reserve shows US imports of goods and services heading negative in 2019. The shaded areas of the graph show previous recessionary periods.

Source: U.S Bureau of Economic Analysis, December 2019

  • Of note too is how inventories have been building from 2018 onwards (graph below). This may in part have been in anticipation of further deteriorations in the Sino-US trade war. Nonetheless, the clearing of an inventory build-up, especially if consumer demand is waning, generally means discounting and therefore lower corporate profit margins.

Source: U.S Bureau of Economic Analysis, December 2019

  • Linking these demand trends to bank credit, we see that despite Fed easing, commercial and industrial loans have been declining in 2019 (again it is worth looking at the pattern in the greyed areas showing previous recessions).

Source: U.S Bureau of Economic Analysis, December 2019

  • While some of the demand data may appear to be softening, consumer confidence remains high. The Consumer Confidence Index (CCI) administered by the Conference Board rose to 131.6% (vs 128.0% estimate and 128.2% prior) for January 2020. What is interesting though is the relationship between future consumer expectations relative to current sentiment readings. The graph below shows this data from the Confidence Board. Again, it is worth noting that future expectations are at relative lows to the current sentiment – this has been suggestive in the past of market peaks in terms of consumer outlook.

Source: Bloomberg, 31 January 2020

  • The key to US GDP is the consumer, and the key to the consumer is the job market. The graph below shows NFIB small business job openings against the overall US unemployment rate. At 3.5%, US unemployment is at all-time lows, but small businesses tend to be the most sensitive to changes in the market. The fact that small business job openings are starting to fall suggests that US employment may be reaching a cyclical peak.

Source: Bloomberg, 31 January 2020

  • There are a number of global macro indicators which are flashing as a result of the coronavirus scare. At the time of writing, copper is down 10% for the year and West Texas intermediate crude down 15%. Gold is up 4% for the year. Chinese officials are suggesting 2020 GDP growth may be 5% and not the 6% forecast due to the current disruption. This may mean that the post trade war recovery is on hold, at least in Q1 or possibly H1 2020.

  • What has to be acknowledged though is that issues in China cannot explain all of the re-inversion of the US yield curve. There is evidence of problems on the demand side of the US economy, as well as evidence of US banks pulling back from commercial lending. Average consumer credit card rates are at cyclical highs of 17% too, suggesting some reticence on the part of banks to lend there too. This would matter less were the S&P500 not trading at all-time high EV/Sales multiples of 14.3x. This would probably also matter less if this was the first time the yield curve had inverted; it is in fact the second time in 6 months, and the Fed has already tried the kitchen sink and it failed. Three rate cuts have occurred during previous mid-cycle adjustments. A fourth cut and it becomes hard to argue that it’s not a recession.


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