Over the course of the last few weeks we have seen economic reports released that have raised recessionary alarm bells. In addition, the European drama erupted again as European bond vigilantes attacked Europe’s weakest links (PIIGS) and now the carnage is spreading to core European countries like Italy and France. In kind, global stock markets have sold off to the point where more than half of global stock markets have experienced bear markets. As to be expected, global central bankers are responding and taking action. The big question all are asking now is, will their actions be enough to turn the global economic slowdown around or will more economic and financial market damage need to be done before central bankers act more forcefully?
Global Economic Train Is Coming Off the Tracks
Back in June I made the case that past monetary actions from global central bankers were finally being felt in global economies (“Global monetary tightening taking its toll, risks mount”). The monetary tightening programs of central bankers globally that began in late 2009 and carried over into 2011 were designed to bring down inflation and overheated economies. The risk with every monetary tightening mode is that central bankers go too far and drag their economies into a recession which is often associated with some type of financial crisis. This phenomenon is made clear in the following figure of past U.S. Fed tightening cycles and associated financial crises.
Source: Jim Puplava, “The Next Rogue Wave” (12/15/2006)
The collective result of global monetary tightening over the past year has been a marked deceleration in global growth, and now it appears their actions have gone too far as leading economic indicators have not only decelerated but have dropped into negative territory. Shown below is the composite leading economic indicator (LEI) for the 34 countries of the OECD. The growth rate for the LEI has now turned negative after being positive for the first time since October 2007. Looking back over the last decade, the only false signal in the OECD LEI that didn’t lead to a recession here in the U.S. was in 2003, though that signal came after a prolonged bear market and sluggish economy. However, the current reading is coming after a strong bull market in equities and thus carries far more significance. I do not expect we are seeing a false signal.
The fact that the 34-member OECD LEI is now negative tells us risks are as high as they were in the last recession and that another global recession may be upon us. Within the OECD, the G7 block of countries shows most of the weakness with their own LEIs turning negative in April. Countries that now have negative LEI readings as of June are listed below:
The collective OECD LEI is being pulled lower by the developed countries while the emerging countries LEIs, while decelerating, are still positive. Here in the U.S., economic breadth is also deteriorating and pointing towards a possible recession occurring later in the year. While individual countries can bring down the collective OECD growth rate, individual states within the U.S. can bring down the national growth rate. Thus, it is never a good sign to see more and more states slip into contractionary mode as when enough states' economic growth rates finally roll over, eventually will the entire country also.
Shown below is the Philadelphia Fed’s Coincident One Month Diffusion Index. Readings below 50 indicate less than half of the 50 states are expanding and when only half the country is expanding economically, national economic growth takes a hit and a recession typically ensues. That has been the message over the past three decades where readings below 50% often indicate that a recession is on the horizon with a typical lead time of 4-5 months. Given May showed the first sub 50% reading, we may be entering a recession as early as September of this year. Of note, the only false sub 50% signal came last summer, when Fed Chairman Ben Bernanke came to the rescue with QE 2.
Today we were treated to the August reading for the University of Michigan Consumer Sentiment report which showed a reading of 54.9, the third worst reading in history and well below the median estimate of 62.0. This has been the case now for the past month in which economists have been way off the mark in terms of their estimates and reality. This often occurs at major tipping points (both bearish and bullish) as economists often extrapolate past results into the future and thus overshoot at economic peaks and undershoot at economic troughs. The string of overshoots in estimates from the ISM Manufacturing Index to GDP to consumer sentiment indicates we are yet at another economic inflection point in which the economy is rolling over. What is troubling about the Michigan Consumer Sentiment reading is that it often leads turns in consumption trends. First consumer’s moods change and then spending patterns follow suit. The sharp drop in consumer sentiment suggests consumers are likely to pullback sharply on spending in the months ahead.
And yet one more sign of the U.S. slipping into recession was the recent GDP report which showed real GDP on a year-over-year basis has slipped below the 2% growth mark. Going back more than half a century shows this 2% level is vitally important to hold as we have slipped into a recession within 12 months every time, no exception. Thus, the recent 1.6% growth rate is not an encouraging sign for the U.S. economy going forward.
Global Central Bankers to the Rescue
One thing that 2010 showed investors was that, while central banks may have been slow to react during the 2007-2009 recession and financial turmoil, they were more quick to react to the growth slowdown seen last summer. Here in the U.S. Fed Chairman Bernanke hinted at another round of quantitative easing (QE) in August at his Jackson Hole speech, and made good on those comments with QE2 in November 2010. Shown below, it pays to heed the old saying of “Don’t Fight the Fed.”
Since the global correction in stock markets that accelerated this month, central banks appear to be working together to yet again turn the tide on global economic growth and propping up the markets as the following Bloomberg article points out (emphasis added).
Finance ministers and central bankers from the G-7 nations, which include the U.S., U.K. and Germany, said in a statement Aug. 7 that they will “take all necessary measures to support financial stability and growth in a spirit of close cooperation and confidence...”
A scholar of the Great Depression, Bernanke said last year that among the lessons learned from the financial collapse of the 1930s is that “policy makers must respond forcefully, creatively and decisively” and that “crises that are international in scope require an international response.”
Since August 7th, here are a few of the actions being taken by global central bankers:
- Fed extends 0% rates until mid-2013
- Bank of England indicated it's ready to add stimulus
- Switzerland is intervening in currency markets by printing more francs to fight currency overvaluation
- Japan concerned over its overvalued currency
- South Korea kept rates flat two consecutive months signaling tightening may be over; the Kospi is down 11.2%
- ECB after 18 month hiatus is stepping up bond purchases, including the debt of Italy & Spain
- France, Italy, Span and Belgium introduce a ban on short-selling financial stocks for the next two weeks
Given that the global markets began to roll over materially only a few weeks ago, this has to be one the quickest coordinated responses post a significant peak in the markets in some time. What we are seing so far is the first salvo of coordinated central bank action. Various leading economic indicators are suggesting that growth here in the U.S. and globally will continue to decelerate into year end and it will be important to see how forcefully world central bankers respond. How will the U.S. markets react to a sub 50 reading on the ISM Manufacturing Index? I pose this question because one reliable leading indicator for the U.S. ISM Manufacturing index is the Australian Consumer Confidence reading which typically leads the ISM by several months and is forecasting an ISM reading near 40 by November.
Not only is the U.S. economy expected to continue to slow into year end, but so too the global economy. I highlighted back in June the report from Lakshman Achuthan, managing director from the Economic Cycle Research Institute (ECRI), who noted to his clients in January of this year that global growth would hit a wall by this summer based on their global leading economic indicators. He also said his call came before the Japanese earthquake or Middle East unrest, and so he warned not to attribute the slowdown to those events. I bring this up because in his June interview he said to expect a “dead cat bounce” which turned out to occur in July before the global economy and stock markets rolled over. Below is a key excerpt I took from an interview he did in June that I included in my June article:
This is a key point because our indicators suggested a global slowdown to hit this summer before the Japan earthquake and before the Middle East unrest. Because of these temporary economic setbacks from Japan and the Middle East we fully expect to see a quick ‘dead cat’ bounce in global activity. This will be latched on by the Fed and others to prove we were just in a ‘soft patch’ or ‘speed bump.’ However, like I said, our indicators turned down well before those events which suggests to us any sharp economic bounce will be short lived and the slow economic malaise we are calling for will be persistent, pervasive, and pronounced and any temporary reprieve will be just that, ‘temporary.”
Given the decline that occurred late in July and the horrible U.S. GDP report, the financial media all sought out Lackshman to hear his views. He was interviewed by the Wall Street Journal and he made some key points that are worth repeating, with excerpts provided below (emphasis added).
The Wall Street Journal (07/29/2011)
Lakshman – “You always have a slowdown before a recession. When that slowdown occurs there is a window of opportunity for growth to resume. When you have a shock during that window of vulnerability, it’s very risky business.”
Wall Street Journal – “In the fall of 2007, you warned that if the Fed didn’t act right then, we were heading into a recession and you were right. What are you seeing now?”
Lakshman – “One of the most troubling recent developments is the consumer. When looking at the recent GDP report, consumption essentially went nowhere. The consumer, which is 70% of the economy isn’t doing anything here during this window of vulnerability, so risks are high.
Lakshman – “You guys were just talking about 2008. Prior to Lehman, our leading indicators were at their worst levels in 30 years, THEN Lehman happened. Thus, we had a lot of vulnerability and then a shock like Lehman hit and boom ‘The Great Recession’ hits.
Lakshman – “Business cycles are about levels of risk. And right now risks are high.”
Given the likelihood of a continued global slowdown in economic growth to persist into the end of the year, it appears then that whether we avoid a recession hinges on whether global central banks can take enough decisive action to overwhelm any shocks during what Lakshman calls this “window of vulnerability.” So far central bankers have taken initial steps to help calm global markets which appears to be working. Will it be enough? Not likely given leading economic indicators suggests further erosion ahead. Thus, unless central bankers open the monetary spigots even further we will be slipping into a recession into year end. It then appears there will be a tug-of-war between global economic prospects and the world’s central banks. Below is likely to be the formula that we will see at least into year end.