I am sending this out to everyone on the distro today because I am going on vacation/holiday for the next week and I won’t be near a computer for all of that time. There will be no Credit Writedowns posts all this next week!! So I want to end this week’s daily posts with a sort of “where are we?” post.
If I wasn’t clear in yesterday’s daily post, I’m mostly bullish these days. Unemployment is low and jobless claims data say it can continue to fall. GDP growth has been above 3% for a while now and looks to stay that way as well. And companies and households are generally optimistic about the future. That’s a great picture for the next 6 to 12 months going forward.
Think of the business cycle as distinct from the credit cycle
The worry is the credit cycle. And I want to get to that. But let me talk about the business cycle as distinct from the credit cycle first.
Now, when I look at the business cycle, I go back to something I wrote 10 years ago, based on a book by Joseph Ellis called Ahead of the Curve”. There were a few big takeaways for me:
- Cause and effect relationships and the sequence in which they occur have been pretty consistent throughout history.
- Consumer spending drives the rate of economic change more than any other variable. Therefore, getting consumer spending turning points right is critical in predicting turning points in the economy as a whole. The sequence goes: consumers’ real hourly earnings to consumer spending to industrial production to capital spending to corporate profits.
- Year-over-year rates of change are the critical factor. Don’t look at the absolute levels, focus in on the change — the delta, if you will.
- Employment and business spending are lagging indicators.
- Recessions are lagging indicators too. That makes recession calls useless for business and investment planning.
So, when I’m looking at the business cycle, I’m looking for rates of change that will positively or negatively earnings and consumer spending first in a way that feeds through down the chain to industrial production, capital spending and so on. And so I’m looking for consumer spending rates of change first.
Take a look at the following chart:
Source: St. Louis Fed
The area highlighted in yellow is when a slowdown in consumer spending began in earnest. If you weren’t concerned about recession by mid-2006, you weren’t reading the data properly.
What about the Fed?
So that gets us to the credit cycle.
I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come…
An alternative perspective holds that the recent behavior of interest rates does not presage an economic slowdown but suggests instead that the level of real interest rates consistent with full employment in the long run–the natural interest rate, if you will–has declined.
Given the global nature of the decline in yields, an explanation less centered on the United States might be required. About a year ago, I offered the thesis that a “global saving glut”–an excess, at historically normal real interest rates, of desired global saving over desired global investment–was contributing to the decline in interest rates.
–Ben Bernanke: Reflections on the Yield Curve and Monetary Policy (Before the Economic Club of New York, New York, New York, March 20, 2006)
Bernanke was clueless about the slowdown in consumer spending growth in early 2006. Even by 2007, he didn’t think the housing slowdown would end in recession. But he was ignoring the golden rule of business cycle watching: it’s rates of change that matter.
And it was the Fed’s policy of raising rates that caused the credit cycle to turn down, adding a downside accelerant.
Look at this chart:
Source: St. Louis Fed
Now, you tell me if consumer spending or credit leads the cycle. You can’t tell from the chart, but Q2 2006 was the peak in credit growth last cycle. Where as consumption growth had already peaked about a year earlier in June 2005.
The way I look at is as the consumption growth peaking and credit growth following. The key, again, is the consumer.
And two things to note about the data series on credit. Notice how credit growth cratered in the Great Recession and never re-accelerated afterwards. It’s as if we have two phase shifts down, first in the break after 1990, and then a second time in 2007-2009. In both cases, the re-acceleration of credit growth lagged the previous cycles.
So, how do I see this cycle ending?
I look first to the consumer and signs that she is tapped out. And when I say tapped out I don’t mean falling consumption. I mean signs that real consumption growth has peaked. There are no signs this has happened.
Meanwhile, as this is occurring, the Fed will be raising interest rates. And so, at some point, after consumption growth starts to wane, the credit cycle will turn as well. And we will start to see debt distress and defaults. This will accelerate the downturn, reduce industrial production and capital spending enough that we will move into stall speed 1-2% growth.
At that point, one that we reached in late 2015 and early 2016, we will be on the verge of a recession. We won’t necessarily go over the edge. We didn’t in 2016. But, at this point, further policy tightening would push us over the edge.
Right now, all of that is a long way’s off. I don’t see a recession for another year at the earliest at this point. We’re in the Goldilocks phase right now. Let’s see how long it lasts.
Have a great next week.