Gary Shilling: Recession Signals Piling Up

Recently, others are joining us in forecasting a recession, or at least entertaining a growing probability of one. Of those, few also believe it will commence this year while we continue to rate a business downturn starting in 2019 as a two-thirds probability. Instead, they postpone its kickoff until 2020, not because of specific causes but due to the expansion’s advanced age. It started in mid-2009 and is approaching 10 years in longevity, a very long life by post-World War II standards.

economic expansions


In our January 2019 Insight, we stated that “although the historic precipitators of recessions—a credit squeeze by the Fed or a financial crisis—are lacking so far, 13 recession forerunners may cumulate to kill the economic expansion:

  1. Output exceeds capacity
  2. Stocks fall
  3. Central banks tighten
  4. Yield curve inversion near
  5. Junk bond-Treasury yield spread opens
  6. Housing activity declines
  7. Corporate profits growth falls
  8. Consumers are optimistic
  9. Global leading indicators drop
  10. Commodity prices decline
  11. Downward data revisions
  12. Emerging-market troubles mount
  13. U.S.-China trade war escalates

“We put the odds of a U.S. recession that could be global this year at about two-thirds. The other third would be economic slowing but no sustained decline.”

Incoming evidence continues to support this view. Indeed, it is possible that after the smoke clears and all other data revisions are made, we’ll learn that a recession started in the first quarter of this year.

Anatomy of a Recession

Every post-World War II recession has been preceded by tighter monetary policy witnessed by a rising federal funds rate, the Fed’s historic policy instrument. More recently, this has been joined by the central bank’s reduction in its gigantic assets that were exploded by earlier quantitative easing. The aim was initially to bail out the financial sector after the 2008 financial crisis, and then to spur lending and spending by ample and cheap credit.

As we’ve noted in many past reports, QE didn’t do much to enhance economic growth, which has been the slowest of any postwar expansion. But it did flow into equities with considerable enhancing effects.

Housing activity reacts quickly to tighter credit, and normally retreats well before the peak in business activity.

housing market

Residential construction is extremely sensitive to financing costs, not surprising since it is so highly-leveraged financially. A homeowner can put down as little as 3.5% and borrow 96.5% with an FHA-insured mortgage loan. That’s a 28 times leverage, very close to very highly-leveraged Lehman with a 30 times leverage when it collapsed in 2008.

Residential construction is a small component of GDP, averaging only 4.6% over the postwar period, but its high volatility makes it a significant determiner of economic volatility. During the 2007-2009 Great Recession, the fall in residential
construction cut real GDP by 34.4%, even more than the overall drop of 4.0%. And the effect is about doubled when all the furniture and appliance costs, moving expenses, brokerage fees and other related expenditures are included...

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