US Economy: Q1 as a mid-cycle pause
I have mentioned 1994 as a benign comparison for the US economy of 2015 as opposed to the 1937 comparison Ray Dalio made recently. Having looked at reasonable worst case scenarios with 1997 Japan as a model, I want to look at upside scenarios with 1994 as a model. I am not forecasting an outcome here. Rather, I am trying to tease out reasonable upside scenarios for the US economy.
In 1994, the US Federal Reserve began a rate-hike cycle following the jobless recovery that resulted from the recession of 1990-91. The economy had begun to pick up steam after an unexpectedly slow recovery, which cost George H. W. Bush the White House. As Stephen Williamson put it:
“by early 1995, the Fed had just finished a substantial tightening cycle – the fed funds rate had increased from about 3% at the beginning of 1994 to about 6% at the beginning of 1995. So, the Fed… had just launched a major artillery barrage, and had stopped shooting until the smoke cleared…”
The U.S. came dangerously close to recession due to the Fed’s rate hike campaign. But the economy recovered and went from strength to strength afterward. For me, this is the benign outcome that the bulls are hoping for in 2015.
Now, New York Fed President William Dudley has said that even if the Fed raises rates, it will still have an accommodative stance. And I think that’s true, it is just that it will be relatively less accommodative; the Fed will be tightening relative to its previous monetary stance but it will still be accommodative, at least as far as capital markets go. Thus, if we look at the tapering of large scale asset purchases as a tightening equivalent to the mid-1990s rate hike cycle, 2014 and 2015 start to look a lot like 20 years ago.
So, the question becomes: is this a mid-cycle pause like 1995 or a meaningful leg down nearer the end of the business cycle? I think this is a very important question because of the credit cycle. And here I mean that a reduction in credit growth and eventual credit contraction will almost certainly mean recession, whereas continued credit growth will mean we have a mid-cycle pause on our hands that can withstand a rate hike or two.
In terms of real economy data, let’s look at retail sales, personal income, jobs, and output.
December, January and February retail sales data were weak. And that is what is going to lead to a weak Q1 GDP report later this month. But, these data could be an aberration unduly influenced by weather. And, in fact, research from the Chicago Fed regarding the Winter slowdown from Q1 2014 concludes that “weather has a significant, but short-lived, effect on economic activity.”
March retail sales have come out now and the number was up 0.9%, a decent figure but slightly below expectations. Overall, though, the March numbers are still somewhat weather-scarred and we will need to see the data from April and May that precede the Fed’s first potential rate hike before we can make conclusions about the underlying trend for retail sales.
If the Q1 slowdown was really weather-related, what we should expect for Q2 is that we get a rebound. And the rebound should be robust because there will be pent-up demand due to the weather-affected slowdown. That is certainly what we saw in Q2 and Q3 of last year. And if we do not see this in the data for April and May, then we should conclude that the weakness in Q1 was more than just an aberration.
From my perspective, the biggest point in favor of the temporary slowdown thesis is personal income. It is up consistently at a 0.3-0.4% pace for every month over the last five months. And in 2014, personal income was up at least 4% in every single quarter. Personal income for 2014 was up 4.0% y-o-y after a mere 2.0% rise in 2013. All of this speaks to household income that should help retail sales stay on track, all else equal.
And when I look at the jobs data, while the March numbers were certainly ugly, the numbers before that show steady progress. The JOLTS data also show a tightening labor market and the weekly jobless claims figures corroborate the upbeat data. There is nothing in the jobs figures before the weak March numbers that said the labor market was weak. That said, I would point out that January and February were both revised down when the March data were released. That makes the March release especially worrying because downward revisions are a sign of weakness. If we see another sub-200,000 jobs figure next month and/or downward revisions, a June rate hike is almost assuredly off the table.
On the manufacturing front, look at the ISM numbers. The PMI was down to 51.5 in March from 52.9 in February, which in and of itself is worrying. But the most important tell is that all of the forward looking indicators were weak, with the backlog of orders contracting outright. Look at the three squares highlighted in yellow below.
This chart speaks not to weakness in current output, but in inventories, customer inventories and new orders. Unless these figures turn around, it will infect the employment sub-index, which has already declined to 50.0, right on the border between growth and contraction. This will mean toward increased jobless claims and would be a harbinger that the mid-cycle weakness may be something more.
My overall view here then is that the mid-cycle pause story is balanced on a knife’s edge. Q1 was certainly weather-scarred. But the data for April and May will tell us whether Q1 was an aberration. I would pay special attention to capital investment, new orders and inventories as well as jobless claims.
That said, credit growth remains robust and that has me believing a mid-cycle pause a-la 1995 is still possible. I am looking at an alternative credit series from NACM that shows a lot more weakness (PDF here). For now, however, I will be using the credit series below as a baseline for understanding how the credit cycle is proceeding. And it looks robust at the moment.
1995, then, remains the upside scenario model as I believe even a Fed hike will not derail the US economy in the absence of unexpected fiscal tightening, as long as private credit growth continues upward.
If the Fed does hike in this reasonable best case scenario, the parallel to the mid-1990s will come in the form of a strong dollar, declining emerging market currencies and crisis and volatility in that universe, not necessarily in the US, at least until the credit cycle turns down.