Monday, October 1, 2012

Still no sign of recession

For much of the past few years, the market has been on "recession watch." First it was the Eurozone, where sovereign debt defaults threatened to bring down the eurozone financial system, which in turn threatened the global financial system and ultimately the global economy. Then it was the slowdown in the Eurozone and Chinese economies—with several economies (e.g., Spain, Greece) entering recessionary conditions—that threatened to set off a chain reaction of slowdowns around the globe. Then a series of weaker-than-expected U.S. employment reports starting in March, followed by the U.S. ISM manufacturing index falling below 50 last June, suggested that these fears were being confirmed. Meanwhile, fears of the looming U.S. "fiscal cliff" likely contributed to a decline in capital spending, all the while the folks at ECRI have been insisting for over a year that a U.S. recession is not only imminent but inevitable. 

Some key indicators, however, have refused to follow the script.

The September ISM manufacturing index came in stronger than expected (51.5 vs. 49.7). As the chart above suggests, conditions in the manufacturing sector point to real GDP growth of 2% or more in the current quarter, comfortably above the recession levels. That's still relatively miserable growth, of course, but the important thing is that there is no sign of recession, and that's what the market has been most worried about.

Even in the Eurozone, manufacturing conditions have improved of late. The Eurozone PMI is still flirting with recession territory, but it's improving on the margin.

Perhaps most importantly, there has been a significant improvement in Eurozone swap spreads in recent months. It would be very unusual for swap spreads—a key indicator of systemic risk and a leading indicator of economic health—to improve to this degree if the Eurozone and U.S. economies were simultaneously deteriorating.

The manufacturing employment survey suggests that the outlook for the sector remains relatively healthy. If conditions were deteriorating, the employment index would be much lower than it is today.

The upturn in the export orders index—which remains relatively weak—at the very least suggests that a global downturn is not feeding on itself.

The prices paid survey of manufacturers shows no signs of outright deflation, another thing markets have been fearing.

Indeed, as the above chart of the CRB Spot Commodity Index shows, commodity prices have been firming for the past four months, yet another non-confirmation of the global slowdown story and good evidence that there is no shortage of money that might otherwise serve to hobble the economy.

When looked at from a long-term perspective, as shown in the chart above, commodity prices as well as gold prices remain very strong relative to where they were just 10 years ago. Who would have believed, back in 2002, that over the next decade gold prices would more than quintuple, and commodity prices would more than double, even as the market grew ever more fearful about the outlook for growth?

With 10-yr Treasury yields still at 1.6% and with real yields on TIPS firmly in negative territory, the market is priced to very weak or negative growth for the foreseeable future. If growth continues to run at 1-2%, instead of turning negative, I believe the equity market will have little choice but to trade higher. Holding cash that pays nothing, at a time when the earnings yield on the S&P 500 is almost 8%, utility stocks (e.g., XLU) are paying dividends of 4%, REITS are paying over 3%, investment grade bonds (e.g., LQD) are yielding almost 4%, and high-yield bonds (e.g., HYG) are yielding over 6%, only makes sense if you strongly believe that there is lots of downside risk in risk assets over the next several years—enough to outweigh their significant yield advantage. In other words, you need a recession in order for cash to beat alternative investments—slow growth is not going to do the trick. And of course, if the economy should actually improve, well then it's off to the races.

Full disclosure: I am long equities, utilities, REITS, and corporate bonds at the time of this writing.


Bill said...


Brian Wesbury said today that it's possible GDP for 3Q will be close to zero due to the drought. What's are your thoughts on this?

Scott Grannis said...

Anything is possible, of course, but I don't think zero is very likely.

William said...

Thank you again for your excellent analysis and "full disclosure".


Gloeschi said...

Agree on uncertainty of recession, but a) once you see a recession it (usually) is already over, and b), as Achutan (ECRI) points out, data gets revised downwards. Even Greenie was clueless we were in recession when asked a few days before Lehman.
Market is fearful of a recession, yes, but that doesn't mean it is priced for a recession. Consensus earnings estimates have still double-digit growth baked into Q4 2012 and 2013. Stocks "look" cheap on the basis of those estimates, but these estimates will come down. According to CAPE (cyclically-adjusted PE-ratio) stocks are valued above average.
"Cash burning a hole in the pocket": usually the argument of the bulls when everything else fails. If I have too much cash and want to invest, my cash goes to the seller of the stocks. Now he has the cash. Cash never disappears, as do stocks. The argument is nonsense.
Most of the market is owned by institutional investors anyways. Their by-laws often restrict them to hold more than 5% cash. They ride the ups and downs of the market basically fully invested. They can't leave their asset class (stocks/bonds) or even style box (e.g. domestic small cap growth) without losing their track record, so they don't. The only thing they can do is prey. And that's their investment strategy. Doesn't mean the readers of this blog are damned to do same.

Gloeschi said...

"prey" = "pray"

Ben said...


Thank you for the post. I think you touched on some very important points, including the better than forecast ISM and the ongoing improvement in Eurozone swap spreads. I also agree with your conclusion on cash, it really is a horrific asset to hold in the current environment regardless of the emotional appeal it has. I much prefer have a fully invested balanced portfolio (i.e. a mix of bonds and equities).

Finally, I am not sure I agree with the "ISM Index vs GDP" chart shown here. According to the right-hand scale, the chart does indeed suggest that the latest ISM indicates a GDP growth of 2% or more. However, I think the scale is odd as there has been some signficant divergence in this recovery between the ISM and GDP. Using the same approach, the ISM was suggesting GDP growth of 6-8% during 2010. If only that was the case!

Many thanks,
Ben (UK based portfolio manager)

Scott Grannis said...

Ben: re the ISM/GDP issue, you are right that the correlation has not been very tight in this recovery. Manufacturing has clearly done better than the rest of the economy. But things may be getting back to a better balance now. Time will tell. And as always, the chart only "suggests" what GDP might be. It's a guide, not an ironclad predictor.