Monday, August 1, 2011

Manufacturing weakens, but it's not a death knell

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.


brodero said...

Lost in all the falderal is the strength in exports. Since 4th qtr 2006 the structure and residential
components of GDP have lost 441billion while the export component
has grown 588 billion....

Anonymous said...

Scott (and anyone else),

Another good indicator I follow is federal withholding tax receipts. After adjusting for recent tax changes, the y-o-y growth rate lately is about 8% over last year. Even without adjusting for tax changes the growth rate is about 4.25%. I follow all this at the following website, which is well worth the $200 yearly member fee:

Benjamin Cole said...

Another tour de force by Scott Grannis.

BTW, I strongly, strongly, strongly, urge Scoot Grannis to read Martin Feldstein's op-ed in today's WSJ.

I emphasize the word "strongly."

brodero said...

Unknown do you subscribe?? and
secondly do you think Dailyjobs
update had adequately adjusted
for what has been some major
payroll changes this year??

Anonymous said...


Yes I subscribe. Adjusting for the tax changes is an imperfect science, but as far as I can tell they do as good a job as is possible.

Basically what they (actually, a "he") tries to do is replicate what TrimTabs does with its monthly jobs estimates. In this case they don't actually come up with a monthly jobs loss/gain number, but they show what withholding tax receipts do on a daily basis, then also do 21-day running averages, monthly averages, etc. It's very good for seeing trends as they unfold.

Scott Grannis said...

Re Feldstein's op-ed: I have never been a big fan of Feldstein, and I have a fundamental disagreement with his belief that a weaker dollar can lead to a stronger economy without a debilitating rise in inflation.

Benjamin Cole said...


Well, thanks for reading the Feldstein piece.

He does cite the low inflation rates of the last several years, even as the U.S. dollar has migrated to exchange rates that favor US exports.

I'd hate to look at the GDP numbers now without the export boost--we would be plain dead in the water.

mmanagedaccounts said...

I especially love the government revenue chart and the corporate profits as a % of GDP. I hear congressman say "we've got to get to the business of creating jobs."
That means we've got to have better than 0.4% and 1.3% GDP growth.

One of the biggest drags on the economy is housing. Ed Yardeni has proposed a solution on his blog (

He recommends the federal government provides a $20,000 matching subsidy to any homebuyer who puts an equal amount of cash into the purchase of a single family home (up to 2 million houses). The cost would be $40 billion.

He proposes paying for it by reducing the tax on repatriated foreign earnings from 35% to 10%.

A third part of his recommendation is that anyone who purchases an existing single family house as a rental property (no matching subsidy) would receive tax-free rental income for 10 years.

Here's wondering if Scott Grannis thinks this makes sense. Is it a good idea. I generally do not like government interference in the economy, but government policy was a major contributor to this deep housing depression. Government should help get us out.

Or do we wait and let housing prices find their own bottom and have a self liquidation of excess inventory?

McKibbinUSA said...

US manufacturing employment now stands at pre-World War II levels -- more at:

The future of the US is not manufacturing -- far from it -- when can we start talking about how to export healthcare services, training, and education for a premium (?) -- when can we start talking about exporting anything and everything else except manufacturing (?) -- herein lies the central problem -- too many people yearning for some vision of the "good old days" that probably never existed during their adult lifetimes...

John said...

MManaged Accounts:

One of the things eating the housing market is job insecurity. Why would anyone sign a mortgage contract when they don't have a job contract?

Benjamin Cole said...

John, William and Managed Accounts-

We now have two conservative economists, Greg Mankiw and Martin Feldstein, suggesting we have to have a stimulative monetary policy and cheaper dollar. Mankiw suggests the Fed targets 2 percent inflation, and sticking with that--meaning if we fall below trend (as we have) then gunning the engines.

There is also a school of conservative monetary economists, evidently loosely congregated around a Scott Sumner, who call for a Fed program of QE, announced inflation targets and targets for nominal GDP growth. Some of these guys write for CATO, National Review etc. If they got any more right-wing they would have little mustaches and involuntary arm spasms when they heard martial music.

Sadly, too much of the "right-wing" today remains encrusted into positions more useful for the last century or the 1970s. It doesn't help that we have Obama for President, which means the right-wing will espouse tight-money and fiscal austerity with extra fervor. The partisan bile is at flood tide, on both sides.

However, as someone who thinks Bush was a failure, and Obama is too, I support monetary stimulus at this time.

The only place worse than where we are is Japan. And right now the Dems, GOP and Bernanke-san are leading us there.

Scott Grannis said...

Re Yardeni: I have great respect for Ed Yardeni, but I disagree with him on this. The problem with housing is an excess inventory problem. That is being solved with lower prices, but it takes time. Subsidizing the price of homes interferes with the market's natural correction mechanism and introduces more distortions to a market still suffering from previous distortions.

Cutting corporate taxes is a good idea, as long as there are no conditions attached. The government must stop meddling with the economy. Too much meddling got us into this mess in the first place.

Anonymous said...

Do you mind briefly explaining the real fed funds rate? Thanks

Scott Grannis said...

Re real fed funds rate: The Federal funds rate is the Fed's target overnight interest rate, and is currently set at 0.25%. The real rate is found by subtracting inflation from this rate, and I am using the year over year change in the Personal Consumption Deflator, currently 1.2%.

Benjamin Cole said...

" I am using the year over year change in the Personal Consumption Deflator, currently 1.2%."

And this is debilitating inflation? We have run a QE program that helped stimulate the economy, and resulted in no increase in federal debt (monetary stimulus, not fiscal stimulus), and the inflation rate is 1.2 percent, a rate that is arguably too low, in anything.

What is about inflation that making otherwise sane and intelligent people go koo-koo?

mmanagedaccounts said...

California sold 38,000 houses in June but there was an additional 43,000 in foreclosure filings.

Scott Grannis is right that the solution to the dismal housing excess inventory is JOBS. As more people find permanent work, household formations will increase and the demand for housing will go up.

Where are the jobs? Manufacturing? Agriculture? Technology? An article in National Affairs pointed out new job opportunities will be found in education and healthcare.

Arnold Kling and Nick Schulz argue that the potential for job growth and innovation in both industries is being repressed by government policy. Both industries are heavily influenced or controlled by the federal and local government. These two industries especially need to be opened up to competition and entrepreneurial reform.

Stripping out government control of these industries will be tough. Liberals will resist with a passion. Reform and renewal will take time and lots of it.

In the meantime, energy could be a hotbed for new job opportunities, well paying jobs. Unfortunately, there's a muzzle on energy companies in this country.

I love manufacturing but it is not the answer to our jobs problem. According to the Bureau of Labor Statistics, 27.5% of employment in 1948 was manufacturing production workers. As of 2008 that figure had dwindled to 6.9%. Sadly, machines are cheaper, more efficient and more dependable than people.

I say there should not be a "jobs program." Unleash business from the shackles of regulation, tax uncertainty and excess taxation, and the jobs will come.

Along with the jobs will come a new demand for housing, and more jobs in housing as new construction kicks in.

I'm worried about our future. I'm afraid we're headed for a New Deal without naming it such.

John said...

"energy could be a hotbed for new job opportunities, well paying jobs. Unfortunately, there's a muzzle on energy companies in this country."

Fact is, domestic crude production is up over the past 2 years, reversing a long downward trend. A chart from Index Mundi:

mmanagedaccounts said...

John, we are consuming less oil too, but we could become less dependent on foreign sources by using more of our own resources. We may also see increasing exports of coal going to China. I would love for us to sell more to China.

septizoniom said...

you have officially turned boring

Jeff said...

I just saw my third corporate layoff announcement this week of 30,000+. The list of charts showing no recession on the horizon is impressive. But who cares if the economy is growing at 2% or contracting at 1% when every dollar in your pocket is losing value at 5% to 10% annually!

This debt deal really does nothing to actually cut spending. We will still add $7 trillion in new debt over the next 10 years. The decline in the dollar that started in 2001--interrupted by the subprime crisis and European debt crisis--is continuing.

For some to post here that this is good (e.g. increased exports) is foolishness. For others to say that we need more government subsidies to prop up the housing market is simply insane! Sure some benefit from these policies. But the cost is spread to all.

The economy is doing its best to climb back despite the relentless attacks on the private sector. What is needed is a freeze on spending, a freeze on tax rates, and a freeze on more regulation. If that would have been the debt deal, Katie bar the door on the economy! We could grow our way out of this. The debt deal just slowed the didn't change it.

I am not as optimistic as Scott. In 5 years the US debt will be $20 trillion. 10yr Treasuries will be 7%+ making interest expense over one third of the budget. That I fear will be the point of no return for the dollar.

Benjamin Cole said...


A cheaper dollar means more US exports, more tourism here. What's wrong with a cheaper dollar?

Benjamin Cole said...

News Flash:

For the first time in history, the Daily Treasury Real Long-Term rate has fallen below one percent.

See here:

This is inflation?

Scott Grannis said...

Low real yields are typically associated with rising inflation. Real yields are low because monetary policy is very accommodative and the economy is weak. High real yields are the method the Fed uses to reduce inflation. High real yields make borrowing very unattractive, and this slows the growth of money and inflation. Low real yields make borrowing very attractive, and this fuels inflation.

Benjamin Cole said...


Agreed--but with nominal yields on five-year notes at 1.30, and core inflation rates dropping below 2 percent, and a very slow economy, it seems to me we are doing a Japan.

Investors say no inflation ahead.

Meanwhile, today's nosedive on the DJIA is not what I expected following a debt deal. Ouch.

Oil may be vulnerable. We are seeing seaborne tankers filling up, and there is no more available storage space at Cushing. If oil starts sinking, we go back to out-and-out deflation.

Benjamin Cole said...

PCE price index -- "The price index for PCE decreased 0.2 percent in June, in contrast to an increase of
0.2 percent in May. The PCE price index, excluding food and energy, increased 0.1 percent, compared with
an increase of 0.2 percent."--fresh fro BEA.

Prices are dead in the water--and oil looks weak.

Finding inflation now is like snipe-hunting.

John said...

When I read this blog, I get the impression that supply siders really do believe we are re-living 1979 and the cure to the problem is to simply cut taxes and regulations and let the cornucopea of private sector prosperity spill into our laps.

In 1979, interest rates were high. Now they're low.

In 1979, inflation was high, now it's low.

In 1979, oil was high, but would soon be $10/barrel.

In 1979, the boomers were growing their in their careers, raising families, and consuming like crazy. Now they're downsizing.

In 1979, government debt as a percentage of GDP was minimal, due to the revenue enhancement effects of tax bracket creep. Fiscal hawks should build a shrine to honor Carter. Reagan had room to cut taxes AND spend big on defense, which he did, for awhile. But he was hated debt even worse than taxes, which he eventually would raise.

Stockman was on CNN last night and had a very interesting perspective. There's no growing out of this debt. We'll need to raise taxes. If you don't get that, you're living in a dream world.

Scott Grannis said...

Your comment tempts me to reply:

This is not a replay of 1979, but allowing the private sector to grow is the best solution to our problems. Government is much bigger today than it was in 1979. 25% bigger, in fact: 24% today vs. 19% of GDP then. We need a smaller (relatively speaking) and less intrusive government. The experiment in Big Government has failed.

Interest rates were high then because the Fed was fighting inflation. That will be the challenge for tomorrow's Fed.

Inflation is much lower now, but it is rising. The Fed has been making a lot of the same mistakes in recent years that it did in the 1970s, by keeping interest rates too low for too long and weakening the dollar.

Today the boomers are beginning to retire, but they are being replaced by hordes of Chinese and Indians eager to work hard and boost their standard of living. It doesn't matter if they live on the other side of the world; they have no choice but to buy more from us.

Government debt was indeed a lot smaller then: around 30% of GDP, vs. 62% now. But don't forget it was well over 100% of GDP after WW II, and we solved that problem by lowering taxes (from a maximum of 85% in 1950 to 70% in 1980) and shrinking government (from almost 45% of GDP in 1945 to 20% in 1980). In fact, that gigantic shrinkage of government coincided with an incredible boom in economic activity in the late 1940s and 1950s.

Don't forget that only Congress has the authority to spend money, not the President. Reagan had room to cut taxes because they were way too high and we were on the wrong side of the Laffer Curve. JFK was actually the first president to realize that taxes were too high.

Stockman squandered his reputation long ago in my estimation.

Jeff said...

Benjamin, sure, a cheaper dollar helps exporters and tourism. It also hurts everyone else who holds dollars, including exporters and tourist operators. I am neither of these and hold lots of dollars. A cheaper dollar is simply a hidden tax on everyone who holds dollars.

John, it is not 1979. More like 1974…on the cusp of higher inflation and interest rates. What is the annual interest payments on $20 trillion at 8%??

Jeff said...

John, actually I am wrong. It's probably more like 1936!

John said...

Corporate profits: record high.
Parked on the sideline: $2 Trillion.
Consumer confidence: 52-week low.

Not one great idea, nor the best of human effort is supported by "investment" in gold.

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