Supply Side Recession vs. Demand Side Expansion
Deceptively Strong Economy
Some analysts continue to warn of a deteriorating US and global economy with more “negative” interest rates ahead. German 2-year government bonds have had a negative interest rate for most of the past 6 months, but yields are not just being artificially suppressed by the trillions in central bank debt buying, but also due to material “deflation” where production trends exceed consumption. These repeat offenders of gloom argue that the industrial economy is close to multi-year lows and income and employment will soon exhibit similar pain. Such a myopic perspective accords greatly exaggerated influence upon the 12% manufacturing segment of our economy (in terms of overall GDP growth) and virtually ignores the 78% contribution by the service sector. The ratios are “very” similar throughout the 1st world countries around the globe.
While factories are a minor portion of employment and income, even this weak sector is being overly maligned by a healthy cooling of the energy sector. Cheaper petroleum and commodity prices have definitely subdued the manufacturing sector, but will boost longer term consumption and provide a lower cost structure for the next spending and investing cycle. US and 1st world retail spending and employment is healthy and growing at historically robust rates, but as long as the energy sector retards capacity expansion, the overall economy will be growing in stealth mode. Even 2nd world behemoth China, which has a service sector of only 48% of its GDP, should add to the service sector tailwind of growth lurking in the global shadows once oil supply and demand moves closer to equilibrium in 2016. The canaries in the coal mine to stay cognizant of are the raw commodity dependent emerging markets.
Normally service sector activity, as represented by the non-manufacturing business and NMI composite, is consistently well correlated with manufacturing. Suddenly in late 2014 a large divergence manifested. The service sector held strong and expanded further over the past year near record rates while the smaller manufacturing (industrial) sector continued to slow toward recession levels. Why? Petroleum has been THE pivotal catalyst in this rare extreme divergence. Normally, oil declines during a recession as in 2008. During this expansion cycle countries most dependent upon raw materials like China, Brazil and Canada have been hurt severely while the UK, Germany and the US have weathered the commodity deflation storm surprisingly well due to their emphasis on consumption vs. production. Bulls and bears seem to lack a clear understanding of this dynamic and what it portends. One clue that the oil glut has perhaps artificially depressed the industrial sector can be seen in the next chart.
China’s manufacturing contraction began in 2011 which can be observed with the PMI contraction and falling copper prices. China’s managed economy has delayed the necessary capacity contraction needed to eliminate the manufacturing supply glut and stabilize deflating producer prices.
Another sign of the US Industrial weakness vs service strength is evident in the labor market. Factories are not hiring, but non-manufacturing is employing workers at very high rates with record job demand and consumer spending.
As the last vestiges of the Baby Boom generation entered the workforce in the 1980s, factory employment peaked. Ensuing decades witnessed the low tech commodity production shift to emerging markets like China and Brazil as employment in US manufacturing began its permanent descent with maturing Boomers beginning to retire.
While political leaders cry out that good paying factory and construction jobs continue disappearing overseas, the inexorable rise of the service sector continues to transform the workforce. A generation ago factory jobs were almost as common as service jobs. Now the manufacturing segment is outnumbered by almost 100 million service workers in the US! Another benefit of this long subdued economic growth cycle is that City/State/Federal tax revenues have risen high enough that government is no longer slashing its workforce, but adding workers. Unfortunately, government pays itself very well on the taxpayers dime, 33% higher than the private sector, thus aiding consumer spending trends. We may not like bigger government, but it’s another headwind that is now a tailwind.
Factory building, commercial and residential construction remain a shell of their former self pre-2008, yet service oriented consumption has surged back to new highs at the same torrid pace as previous strong expansions. Aided by aging demographics, inflation and debt service ratios that are the healthiest in decades, we now have automobile purchases (led by light trucks) near record levels. Current job growth trends should spur continued income and spending gains until inflation and interest rates rise significantly.
Some point to the dry ships index of cheaper shipping and reduced export volume as a harbinger of bad tidings. What they miss is the commodity-led global slowdown triggered by the 2014 oil glut has not spilled over to curtail overall consumption other than cheaper values of commodity related shipments.
The China Syndrome
The pivotal giant for global factory flows – especially in raw materials – is China. Amazingly, industrial production growth rates in China have fallen all the way back to the depths of the 2008/2009 global recession nadir. The industrial economy may be between 12 and 20% for the US, UK and Germany but it remains almost half of the Chinese GDP, thus this oil led commodity deflation may be even more painful for Asia than most realize.
We have been painting a theme here of a deteriorating industrial economy at home and abroad while the far more important non-manufacturing portion of the economy continues higher with surprisingly minor impedence, despite the gloom. The animal spirits of consumer and small business euphoria are tame.
Normally Contracting Earnings & New Orders = Recession
Below we can see that when US corporate earnings and new manufacturing orders both flip into contraction mode that we are already in a recession historically. How is that we can talk of 2 to 3% GDP growth this year and next when we should be in or about to stumble into a recession? Certainly a recession is possible should a country like Brazil completely default on its international debts or China fail to calm its speculators as more producers default. However, “this time is different”. This time the energy sector is skewing everything. Normally, oil and general commodities from corn to copper devalue due to slack demand. This time we have excess supply during a relatively strong expansion and rising consumption – or at least a healthy expansion minus energy. The fact is year over year earnings from the energy sector have contracted 56.6%. Overall earnings this quarter are down 2.2%. Excluding energy, actual earnings are UP 4.5%! Lower energy and general commodity price declines impair unrelated non-energy earnings to some degree, yet earnings are positive. Watch out if petroleum stocks finally approach equilibrium as everything would then pick up speed with a new tailwind.
Ocean shipping rates have fallen for almost 6 years in line with the capacity glut and deflationary spiral lower in commodity prices. The metal markets went south in 2011 and energy products joined in with a vengeance in July 2014. As would be expected, export activity is weak and ocean shipping rates for raw materials keep touching new 30-year lows. Current trends would imply shippers providing their service for free very soon. Reduced shipping capacity and/or increased demand is due in 2016. For now this is just another chart that pinpoints the global worries for producers, with service providers largely insulated. Assuming Brazil and China avoid massive debt defaults and uncontrollable panics, we expect a commodity-led industrial bottom soon that will lead to a more robust growth rate in 2016. Oil and deflation have masked furtive growth rates percolating beyond the factory walls.
When Will Wages Rise?
The aging demographics and misallocation of labor away from the higher paying but shrinking factory sector have played a large role in the worst wage growth recovery in decades. However, employment levels are improving as rapidly as ever. As these part-time and marginal workers shrink to the lows shown below we believe that wages will begin to accelerate if they haven’t already.
The huge U6 17.1% unemployment rate in 2010 is now 9.8%. In fact all year we have talked of U6 falling into the 9 to 10% zone before wage growth could begin rising faster and the 7 to 9% U6 unemployment rate before victory would be confirmed. We are closer as U6 should fall under 9% in 2016 and well under 8% in 2017 with Official Government U3 rates near 4% or less. A bottom in the energy sector over the next few months, as we have forecast, could be the trigger even faster than income gains.
3.5 to 4% nominal wage growth has been the sweet spot expected before this recovery will be declared “mission accomplished”. The October surge to 2.5% hourly earnings growth in 2015 is a new high and perhaps an inkling of a healthier labor market in 2016. It has taken longer than most recoveries for this economy to achieve the normal benchmarks of success, but the strong service sector should continue to be buoyed by the labor growth rates and commodity deflation.
About Kurt Kallaus
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