Monday, August 1, 2011
The July ISM Manufacturing Index was disappointingly weak, and so was last week's GDP report. But as this chart suggests, the current reading on the ISM index does not imply a recession nor does it imply that growth in the current quarter will be weaker than it was in the second quarter. The correlation between the ISM manufacturing index is reasonably strong, but far from perfect. In any event, the level of the July ISM index is consistent with third quarter GDP in the 2-3% range; as the chart suggests, it would take a much weaker ISM index (e.g., below 47) to point to a double-dip recession.
Nevertheless, the bond market continues to behave as if we are on the verge of a recession, with 10-yr yields today falling to 2.74%, and closing in on the lows that we saw last October when the market thought a double-dip recession was in the bag (but which subsequently failed to show up). I might be more worried about the weakness in the ISM index if there were other fundamental indicators pointing towards recession, but there are none that I consider important to be found. Consider this quick recap of important and leading fundamental indicators:
This chart focuses on the monetary and bond market precursors of recessions. Every recession in the past 50 years has been preceded by a significant rise in the real Federal funds rate (blue line), and a flat or inverted yield curve (red line). Currently we have just the opposite: negative real yields and an unusually steep yield curve. This points to an extremely low probability of recession, and a high probability of continued growth. Negative real yields mean very low borrowing costs for many businesses, and a steep yield curve means very juicy profits for banks, since they can borrow at very low rates and lend out at much higher rates. A steep yield curve also means that the bond market sees stronger growth in the future.
Swap spreads are excellent indicators of systemic risk and have predicted the last three recessions. Currently, swap spreads are very low, a good sign that the banking system is sound and the market's risk tolerance is healthy. If the market sensed the approach of a recession, spreads would be much higher as investors attempted to lay off risk in general and avoid counterparty risk in particular.
Credit spreads are also good predictors of recessions. Although the first chart above shows that average credit spreads currently are at levels that preceded the past two recessions, they are far below their highs of 2008 and 2009, and show no material increase in recent months. The main reason that these spreads are so high is that Treasury yields are extremely low—spreads aren't predicting a future increase in corporate default rates, they are one way the market can express a view that extremely low Treasury yields are likely to be somewhat temporary. As the second chart above shows, spreads on long-dated corporate bonds (which are less affected by the extremely low level of short- and medium-term Treasury yields) are relatively low and show no unusual behavior. The third chart above, which compares the yields on A1 industrials with the yield on 5-yr Treasuries, confirms that the somewhat-elevated level of corporate spreads in no way reflects a material increase in corporate borrowing costs or a scarcity of money; indeed, many large corporations today can borrow at the lowest rates in many generations.
Commodity prices show no sign whatsoever of any material weakness in economic activity. Indeed, prices remain very close to all-time highs, suggesting that at the very least global demand and manufacturing activity remain robust. Strong commodity prices also signal that monetary policy is very accommodative, and thus poses no threat per se to the economy.
Commercial & Industrial Loans—a good proxy for bank lending to small and medium-sized businesses—have been growing for over seven months. This suggests that banks are slowly relaxing their lending standards, and businesses are finally reversing their deleveraging efforts. Both are consistent with an increased tolerance for risk and are thus a predictor of growth in investment and rising economic activity.
Bloomberg's index of financial conditions has declined a bit over the past month, but it is not low enough to signal any material deterioration in key financial market indicators or the onset of a recession.
New orders for capital goods are a good proxy for business investment, and they continue to rise. Business investment is an essential ingredient for healthy economic growth.
Despite all the economic weakness we've seen in the first half of this year, and despite the fact that tax rates haven't risen (payroll taxes have actually been cut this year) federal revenues have risen by almost 9%. This is fairly impressive, and suggests that this year's economic weakness likely has been caused by temporary and emotional factors (e.g., the Japanese tsunami which disrupted the manufacturing supply chain, unusually bad weather, and concerns that the U.S. government might default or Treasury debt downgraded), rather than any meaningful deterioration in the economic fundamentals.
Despite the weak economy, corporate profits are at record highs. We've never seen a recession come on the heels of a surge in profits.
All of this adds up to a picture of an economy that is weak in general, but with pockets of still-impressive strength; not an economy that is headed for a recession or even further weakness. Important measures of economic and financial fundamentals are still in good shape, and many point to improving activity in the months ahead.
Posted by Scott Grannis at 12:01 PM