ISM Follows Trend
In January of this year, I discussed the many warning signs that the economy was tracking much weaker than headlines suggested. However, the ISM sentiment survey's were surging higher in contrast to weaker production numbers elsewhere. I noted then:
"While the ISM composite survey is near the top end of its range, there are clear signs that the ratio will likely subside in the months ahead. I have mapped the normal cycles of the index in the past. It is important to remember that the ISM survey is a "sentiment" survey that tends to lag actual inputs like new orders and backlogs."
As expected, ISM numbers have declined rather sharply as economic realities have begun to weigh on "sentiment."
While the composite ISM index remains above levels normally associated with recessionary drags, the decline in the index is following a very clear cyclical pattern. This pattern suggests that we are late in the current expansion.
Furthermore, it is worth noting that the ISM surveys, which are widely watched each month as a barometer of economic activity, have a high correlation to core durable goods. The chart below shows the 12-month average of the monthly percentage change in core durable goods orders (non-defense, ex-aircraft) as compared to the ISM Manufacturing Composite Index.
There are two things to note. The first is that the decline in the ISM suggests that overall demand for core durable goods is under sharp pressure and suggests further weakness over the next few months as activity bounces towards lower levels. Secondly, and most importantly, is the TREND of the decline in core durable goods orders. Despite the excitement in recent months about the bounce in activity (part of a restocking cycle discussed here), the trend of that activity is has been steadily slowing. This explains why despite continued hopes of economic resurgence, there has been a continual disappointment. The decline in activity again suggests that we are late in the current economic expansion as witnessed prior to the last two recessions.
In January, I also noted the divergence between the ISM manufacturing survey and the decline in both imports and exports. To wit:
"The surging dollar and weak consumer demand are also being reflected in import and export activity."
The surge in the U.S. dollar has continued to weigh heavily on both exports and corporate profits (exports make up about 40% of corporate profits).
While the strong dollar has impacted economic growth from an export basis, it is interesting to note that the U.S. consumer has contracted as well. As shown in the updated chart below, the divergence shown above has now been rapidly filled.
Note that both the annual rate of change in imports and exports have now moved into negative territory. Importantly, notice the extremely sharp decline in imports which suggests that despite lower gasoline prices, the contraction in domestic spending is much sharper than currently realized.
However, as shown, when both imports and exports have contracted to negative levels previously it has been coincident with a recession.
Economists 2, Atlanta 0
The reason that I bring this up is because the majority of economists, and financial media analysis, continue to look at the current economic slowdown as simply a function of the colder winter weather.
Currently, the average economic growth forecast for the first quarter of 2015 is roughly 2%. Given the deterioration in a broad swath of indicators this is likely overly optimistic.
The Atlanta Federal Reserve publishes a "real-time" model, GDPNow, which is currently estimating Q1 growth at 0%.
"The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2015 was 0.0 percent on April 1, down from 0.2 percent on March 30. Following this morning's construction spending release from the U.S. Census Bureau, the nowcast for real residential investment growth increased from -1.1 percent to 1.8 percent. This was more than offset by declines in the nowcasts for real nonresidential structures investment growth (-19.3 percent to -22.5 percent) and real state and local government spending growth (0.3 percent to -0.8 percent)."
There is a high probability that even the Atlanta Fed is over-estimating growth in the first quarter as March's economic data points continue to substantially miss reduced estimates.
The contraction in household spending is significant and pervasive. As I discussed this past week:
"When we look at the households share of retained profits and savings as a percentage of GNP, an interesting picture emerges. The blue line in the following chart shows the household savings rate as a percentage of GNP from 1949 to 2014. The red line shows the housing savings rate as a percentage of GNP adjusted to reflect the household share of retained corporate profits:
From 2009-2013, household savings rates were on the rise. However, over the last year, those savings rates have been drawn down sharply to order to maintain expenditures and avert a recession in the presence of persistently high-profit margins.
However, the magnitude of the decline suggests that families have shifted a large chunk of their savings to maintain current economic stability. However, such actions come at a cost, and historically have been a leading indicator of much slower economic growth rates in the future.
The sharp decline in real household savings rates as a percentage of GNP also clears up the question as to why falling gasoline prices have not spurred a sharp increase in consumption. With the majority of households effectively living paycheck-to-paycheck any extra "savings" is simply absorbed into maintaining a strained cost of living."
I am not suggesting that a recession is imminent. I am warning that there are a host of signs as of late, including price momentum and internal deterioration in the financial markets, that suggests the risks are rising. For investors, this is critically important since the majority of major market reversions are coincident with economic recessions. While it is very likely that economic activity will bounce in the second quarter (data does not move in a straight line), it will likely be weaker than currently anticipated. The key analysis will be whether that bounce is strong enough to reverse the currently negative trends.