The review of American Economy: Should the Fed cut rates?
For the emergence of real crisis conditions and a protracted change in the trend on the stock market, a fundamental change is necessary. It may be a recession in the economy or the arrival of the "black swans", that is, the onset of rare events with little predictability. It makes no sense to guess ahead of time about “rare birds,” but it’s been the first month that they have been talking about the upcoming recession in the USA. In recent days, world media headlines have been filled with scary messages about a new round of inversion of the Treasuries “yield curve” and the possible consequences of this phenomenon.
Despite this, the American stock market is not far from historical highs. Mid-term correction may be just around the corner. However, there is no talk of a bear market yet. Investors are hoping for support from global central banks, especially the Fed. In July, the regulator lowered its key rate. Jerome Powell noted that such a move is not the beginning of a cycle to reduce rates. At the same time, room for maneuver was left, and the derivatives market is more likely to lay 2 more stages of reduction before the end of the year.
Should the Fed cut rates? In our new review, we will assess the situation in terms of economics and other factors.
What do the matching indicators say?
Recession is understood to mean a reduction in GDP for 2 or more consecutive quarters. The recession in the United States is officially announced by the National Bureau of Economic Research (NBER). Organization economists determine at what point the economy is in recession or growing, based on four indicators: employment, personal income, sales in the retail sector, and industrial production.
The last recession in the United States ended in 2009. Recently, we have had about 2-3% of the quarterly GDP growth – not too much, but still not stagnation. Let's go over the main components as part of the NBER assessment.
Employment in non-farming. sector. In July, it increased by 164 thousand people. The graph shows that on average since 2011 +200 thousand growth per month has been observed. This is a moderately positive value, which allowed to reduce the unemployment rate to 3.7%. So we have a labor market in a state of so-called “full employment”. The Fed regularly notes strong labor market performance. I note that the dynamics of over +200 thousand is a fully strong value. In the past 3 months, payrolls have been growing less, but it’s too early to talk about breaking the trend.
- Personal income. For four consecutive months, we have a dynamics of + 0.4% month-to-month. Everything is within the norm of recent years.
- Retail sales. In July, annual dynamics slowed to + 3.4%. Regular fluctuations are noticeable on the chart. So, no dangerous signs are clearly observed.
Industrial production. In July, growth compared to the same period a year earlier was 0.5%. In recent months, the dynamics are increasingly weakening. In the US, they began to talk about proximity to the industrial recession. This idea is reinforced by the proximity of the business activity index (PMI) in the US industry to 50 points, separating growth from slowdown.
Conclusion 1: coinciding indicators in the medium term do not indicate a particular weakening of the US economy. An alarming moment is the industrial segment. It makes up only about 15% of US GDP, however, a negative influx into the wide economy is possible due to the multiplier effect.
A look into the future
Having received information about the recession, we have a delayed process. When a recession officially becomes a reality, the economy has collapsed for a long time, and with it the financial markets. So from a practical point of view it is much more useful to try to look into the future and evaluate the recession scenario in advance. Let's go over these indicators and assess the risks of a recession in the United States on the horizon of 1-2 years.
Treasuries’ Profitability Curve
This is perhaps the key recession indicator. The “yield curve” of Treasuries (the difference between the performance of various issues) and other government bonds are a good market benchmark and allow us to assess the situation in the economy of the country as a whole and its future prospects. The more smooth (flat) the US government bond curve becomes, the more its economy slows down. Long bond yields are inflation-dependent and fall when the economy weakens. Meanwhile, short yields are more affected by changes in the Fed's key rate.
Compared to the situation a year earlier, the curve noticeably changed its appearance, and not for the better. It is almost completely inverted in the middle segment. If you look at the key segment – the difference between the returns of 10- and 2-year-olds, we have a menacing signal in the form of the spread leaving the negative zone in recent days. In the time span since 1955, a similar alignment was preceded by 9 recessions in the States. The time lag between the spread in the negative zone and the onset of the recession ranged from 6 to 24 months (data from the San Francisco Federal Reserve).
Leading Indicators Index
Conference Board Leading Economic Index is calculated based on 10 indicators, some of which are known from earlier releases. These are initial applications for unemployment benefits; sub-index of new orders from ISM; the number of permits issued for housing construction; S&P 500 index; the difference between the yield of 10-year-old Treasuries and the Fed key rate; consumer sentiment index, etc. The Leading Economic Index shows the expected development of the US economy in the next three to six months, and in some cases predicted the onset of recessions and the way out of them. Over the period from 1959, peak values of the index in most cases were observed 10–20 months before the onset of the recession.
Corporate profits
According to estimates of the research organization FactSet, over the past 60 years, the average period between the peak values of the total profit of US corporations and the onset of the recession was 49 months (about 4 years). False signals are also possible. As an example, the recession of corporate profits at the end of 2014-2015. was not accompanied by a recession in the US economy.
A recession of corporate profits could already come to America. According to FactSet estimates, in the second quarter, consolidated earnings per share (EPS) of the S&P 500 could fall by 0.7% compared to the same period a year earlier. If the forecast materializes, then this could be the second quarter of a decline in a row. About 30% of the reporting companies mentioned the topic of customs duties, mainly commenting on the negative impact or fears of this effect on financial performance. The largest number of companies concerned about this issue is observed in the industrial, consumer and IT sectors, due to the high share of international revenue. FactSet predicts a return of consolidated EPS to growth (+ 3.9%) in the IV quarter, however, the forecast may not materialize due to the problems of the global economy and trade confrontation between the US and China.
Number of delinquencies and defaults
The rise in the number of delinquencies and defaults on loans is a sign of excessive credit expansion, in particular in the substandard segment. In the event of a slowdown in the economy, this alignment is a warning signal anticipating the coming recession.
The level of arrears on all loans (all commercial banks in the USA) is now about 2.3% (data as of May 2019). The indicator is slowly growing, however, it is much lower than the values of 2006-2007. Risks lie in the field of student loans and substandard car loans (for borrowers of a low category).
The ratio between copper and gold
Copper received the title of Doctor Copper, since for a long time it had a good reflection of the situation in the global economy. This is one of the key industrial metals, which is in high demand during times of economic expansion. Gold, by contrast, is a defensive asset popular during periods of economic slowdown. That is why the ratio between copper and gold (copper / gold ratio) can be considered an indicator of the state of the economy, as well as crisis conditions. In precession periods, the ratio decreases (copper falls, gold rises). I note that in recent years the importance of the indicator has decreased. Copper is under pressure from structural changes in China, which reduces the use of metal.
The current picture is alarming. Since May, the ratio has noticeably subsided. The problems of the global economy put pressure on industrial metals. Gold, meanwhile, has already updated its 6-year highs, signaling a way out of the risks.
Conclusion 2: we have warning signs in terms of leading indicators. However, talking about the imminent start of a recession in the United States is clearly too early. Apparently, this is a matter of prospects for 1-2 years. The June forecast by the Fed suggests the US economy will grow by 2% in 2020 and by 1.8% in 2021. Based on this, the regulator has not yet expressed intentions to aggressively reduce rates. However, this basic forecast may well turn out to be overly optimistic.
What else the Fed is looking at
Inflation. Consumer inflation data released this week generally does not contradict the idea of lowering rates. The total CPI in July accelerated growth from 1.6% to 1.8% per annum. At the same time, the target guideline for the inflation regulator is 2% per annum. Even more important are inflationary expectations, everything is much more sad here, forcing the Fed to react. According to the inflation-protected bond segment (TIPS), inflation expectations in the USA for 5 years are about 1.4% per annum, and for 10 years - about 1.6% per annum.
Foreign risks. The aftermath of the trade wars of the United States and China affected the whole world. Activity in the secondary sector has been slowing down over the past 18 months, and in recent months has begun to decline in a number of cases. Corresponding PMI indices fell below the base 50 points. An outsider for this indicator is export-oriented Germany. German GDP in the II quarter fell by 0.1%. Europe's largest economy is shrinking for the second time in a year. Meanwhile, China's industrial production in July grew by 4.8% year on year, the dynamics became minimal for 17 years.
An interesting point - according to the yield spreads of 10-year-3-month government bonds, the “yield curves” of government bonds are upside down not only in the USA, but also in Germany, Canada, Japan, Hong Kong and a number of leading countries.
Do not forget about the currency factor. In recent days, the dollar has strengthened on the world stage, including against the renminbi. If the Fed does not reduce rates, the "American" will continue to grow, which will hit US exporters.
Recession models. The Federal Reserve Bank of New York publishes model data that predicts the likelihood of a recession on the horizon of 12 months in relation to the inversion of the “yield curve”. Now its model says that the probability exceeds 30%. Investment bank models give a wider spread, but the overall picture is similar.
Conclusion 3: The problems of the world economy and the strengthening of the dollar indicate the need to reduce the Fed rates. An additional factor in favor of such a decision is the ECB's willingness to lower interest rates as early as September. Donald Trump has repeatedly criticized Powell for his lack of action, which, in the opinion of the US president, puts US exporters at a disadvantage. Weakening inflation expectations and mathematical models confirm the increased recession risks.
Final conclusion
The recession in the distant future seems quite justified, because it will fit into the framework of the business cycle. The economic expansion in the USA lasts since 2009 and is the longest in the history of the country. Along with the economy, the US stock market is also growing, which is heated by relatively “cheap money” from the Fed. Apparently, the States have already entered the late stage of the cycle, and the likelihood of a recession in the next 1-2 years is quite high. “Foreign” risks worsen the picture.
The weakening of the US economy can bring down the American stock market, which often does not fall during the recession, but on the expectations of such an event. More than 50% of Americans invest in stocks, including retirement savings. The increased stress in the financial markets can hit consumer sentiment, and therefore further worsen the economic situation due to the multiplier effect.
That is why the Fed will be forced to respond in advance. The regulator can not deceive the expectations of the market, which pledges an early reduction in interest rates. In the future, a return to the quantitative easing (QE) program cannot be ruled out. This alignment is able to support the American stock market. The dividend yield of the S&P 500 is now about 2% per annum, which is much higher than the yield on 10-year-old Treasuries (1.55%). This makes US stocks generally more interesting than government bonds. It should be understood that the Fed has limited room for maneuver in terms of lowering rates. The key rate is low by historical standards and is only 2-2.25%.
