Is A Global Recession Approaching?

Thursday, September 3rd 2015, 1:27PM

by Andrew Hunt

Despite this evidence of a new global malaise, there are still those that continue to expect the US economy to “ride to the rescue” over the next few months, particularly following what, at first sight at least, appeared to be not only firmer employment data but also an apparently reasonable retail sales report earlier this month.

Since those data points, it has been be relatively easy for many to talk about the US’s “second half economy” gathering pace once again. If we observe the retail sales data in levels terms, though, we can see that the data has downshifted quite significantly over recent months and that, relative to its post-GFC trend, the data is now almost as weak as it has been at any time since the crisis.

Moreover, both the latest GDP data and, more importantly, the industry-specific series point to the existence of what has become a significant inventory overhang within the economy that will likely reduce rather than boost growth in the second half of the year.

We calculate that it is quite possible that the inventory term could knock a full percentage point off the second half of the year’s growth rate.

Elsewhere within the US data crop, we find that despite the ongoing and clearly visible strength in the construction sector (that is perhaps due to foreign home buyers?), much of the production data has softened of late. For example, the level of non-aerospace durable goods orders has fallen by 1% so far this year, that exports are struggling, small company business sentiment has softened, industrial production growth remains essentially very modest and even the latest commercial credit data has looked a little softer.

In addition, we also find that, away from the hoopla and noise that accompanied the monthly jobs report, employment growth has in fact shifted down a gear and real disposable income growth has slowed to around half the rate that was witnessed at the beginning of the year.

Finally, even the long-awaited fiscal boost does not seem to be occurring – the budget deficit seems remarkably constant at this time. Therefore, even within the current round of US data, we can see little that makes a compelling case for there being a further acceleration in the economy in the near term and instead we find many reasons to believe that the soon-to-be revised and heavily inventory-dependent second-quarter GDP number may in fact have represented the peak in this year’s growth profile. It is not only the US economy that seems to be facing new headwinds, though – trends elsewhere amongst the world’s largest economies seem to be somewhat worse.

If China’s economic data has been at all accurate over the last decade, then we can report that a quarter of global economic growth since 2009 was accounted for directly by China’s local government spending boom and that China’s economy in its entirety probably both directly and indirectly accounted for at least one-half of global growth between 2008 and 2013.

As to how much of this growth was warranted, efficient or even sustainable remains to be seen but what is clear is that China is now the world’s second largest economy and therefore we find it hugely significant that we find that it is bordering on a recession at this time.

Unfortunately and quite simply, the latest economic data from China – and its economic satellites – has been remarkably weak.

For example, the June industrial production data was originally described as stronger than its immediate predecessors but, following a number of important revisions to the individual constituent series, even this data now appears to have been notably soft, while the recently released July industrial data was quite simply awful. Our measure of industrial production (IP) – compiled from “the bottom up” shows IP down 1.7% year-on-year in July and the sequential data since March/April has been notably negative.

Consequently, we suspect that China’s industrial complex is firmly anchored in a recession and, if this is the case, then we can suggest that even if the service sector is expanding at a 4-5% rate (and even this seems optimistic), overall GDP growth may well be below 2% year-on-year currently.

For China, this would seem to represent an effective, if not technical, recession that will likely prove difficult to arrest, given not only the existing private sector debt overhang (which is itself very reminiscent of the West in 2007) but also the large existing budget deficit (which is actually larger than those that existed in the West during the GFC). Contrary to popular misconceptions, we suspect that China does not have a limitless ability to stimulate its economy.

Elsewhere in Asia, we find that in levels terms, Japanese real domestic demand has now fallen back to 2005’s level and that any benefits that might have occurred as a result of Abenomics for the economy seem to have long-since passed.

Moreover, we must also note that Japan’s economy is suffering something of a supply-side productivity “bust” at present which, from a longer term perspective, is even more worrying than the weaker demand side/expenditure data. For an economy in which the working population is shrinking, the fact that average levels of productivity are falling must represent something of a crisis.

In previous reviews, we have attributed the revival that occurred within the German economy earlier this year to the boost to its income terms of trade that it received when commodity prices fell by more than the external value of Euro at the end of last year.

We have further argued that this terms of trade effect had already begun to dissipate over the course of the second quarter and that, with domestic credit growth remaining relatively weak in an absolute sense, it has always been likely that German growth would tend to erode over the latter part of 2015 unless domestic capital spending trends improved in the meantime.

It has therefore not been surprising to find that we have recently witnessed not only the release of a relatively lacklustre GDP report but also weaker employment figures, notably weak domestic orders figures, softer production and sales data from the economy and therefore we are continuing to hold the view that, despite the ECB’s seemingly aggressive (but ill-conceived) quantitative easing programme, Germany’s economy is unlikely to be able to sustain its first quarter momentum – particularly now that it seems that real disposable household income growth has ebbed away once again.

Elsewhere within the Eurozone, some of the data from France has begun to look a little better but we would note that France reports its data relatively late: some of the “revival” that we have witnessed occurred several months ago and we lack a clear “read” on the economy’s true position at present. Both Spain and Italy have produced better data over recent months but we would argue that these have been “special cases” in which last year’s terms of trade benefits have been augmented by one-off tax cuts (Spain) or a surprisingly resurgent, if perhaps unsustainable, credit cycle in Italy.

In summary, we remain of the firm opinion that Europe’s better showing in early 2015 was simply the result of the one-off effects of the terms of trade boost that occurred despite the weaker Euro. As such, Europe’s growth was probably rather fortuitous and unlikely to be sustained unless a new domestic capital spending cycle begins. Unfortunately, there are at present few signs that the latter is occurring: Germany’s domestic capital goods orders data has been softening, although more promisingly, the level of foreign orders for capital goods has maintained some upward momentum.

Faced with such weak trends within the major economies, it has also not been surprising to find that income trends within several of the commodity producing countries have been compromised quite severely but, perhaps more worryingly, we also find that there are signs of damaging revisions to people’s permanent income expectations occurring, with the result that there are increasing prospects for domestic balance sheet recessions occurring within these economies.

Having been subject to over-investment in their commodity sectors and varying but often significant levels of Dutch Disease during the previous commodity price booms, growth in these economies now seems inherently fragile and at risk now that their export revenues and terms of trade have declined. (Dutch Disease is the situation under which overly strong commodity producing sectors in an economy can crowd out and degrade the other sectors of the economy, such as manufacturing.)

Therefore, we find that many of the commodity producing economies such as Brazil and Australia are already flirting with or already experiencing recessions at a time in which the legacies of their previous over-exuberances are blunting policymakers’ room for manoeuvre and effectiveness. New Zealand’s economy also seems at risk, although the continuing stimulus from the Canterbury Quake may allow the economy to avoid an outright recession in the near term.

Finally, we find that the data from the emerging markets (EM) continues to look notably – if not extremely – problematic and the authorities in many of these countries are being forced to revise down their expectations for economic growth very significantly. In terms of our favoured “canaries in the coal mines”, Singapore’s production and export data remains soft, Mexico’s production data has also deteriorated and the data from both Korea and Taiwan’s economies has deteriorated sharply of late. The last three or four months have been very poor ones for these economies – which now account for a much larger share of global GDP than they did during the previous EM Crisis in 1997-8.

In summary, if one were to “arrive from Mars” and consider a global economy in which world trade prices were deflating, savings rates were rising, investment rates were falling while government fiscal positions were stable or improving and monetary conditions were tightening as the tide of global capital flows ebbed away, one would expect to find evidence of a softening global economy and a rising risk of recession.

We would therefore argue that markets should not have been surprised that symptoms of a sharp global slowdown abound but nevertheless it does seem that markets have been. For that reason, we would tend to favour fixed income assets and the US and Japanese currencies over more cyclically sensitive “risk assets”.

Andrew Hunt International Economist London

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