Hiking Into a Slowdown

It becomes ever more tempting to conclude that the timing of the Fed’s rate hike was really quite odd, even from the perspective of the planners – even though the U3 unemployment rate has fallen to a mere 5% and they are probably correct about the transitory nature of the currently very low headline “inflation” rate (as we have recently pointed out, actual monetary inflation currently stands at almost 8% y/y).


Recent economic reports have by and large not shown any noteworthy improvements – on the contrary. District manufacturing surveys are going from bad to worse, existing home sales just had another truly terrible month (this time bad weather can obviously not be blamed, but apparently there is a problem with filling in simplified forms) and even the Markit services PMI has suddenly undercut the entire range of economists’ expectations. Meanwhile, the growth rate in ECRI’s coincident index has just hit a 21-month low:


1-coincident indexECRI’s coincident index growth rate keeps falling. The weekly leading indicator has recovered from its lows (while remaining in negative territory), but we dislike the fact that this indicator is evidently strongly influenced by the stock market. In our opinion the stock market has long ceased to tell us anything about the economy.


In her press conference, Ms. Yellen inter alia went on about the “strong consumer” – as if one could consume oneself to prosperity. Both stronger employment and stronger consumption are a consequence of economic growth, not a cause of it. To believe otherwise, one needs to put the cart before the horse, based on the primitive Keynesian flow model of the economy (however, this model does not depict how the economy actually works).

A difficulty consists of the fact that capital consumption – i.e., a net loss of wealth – tends to masquerade as growing prosperity during a credit expansion. This is why the planners erroneously believe that growing the supply of money from thin air and artificially suppressing interest rates improves the economy. It is a bit like watching the erection of a Potemkin village and believing that there is actually something behind the facade.

Ms. Yellen always reminds us are that empirical data are the main guide informing Fed policy, but even those seem to contradict her point about consumers – to wit, growth in real personal consumption expenditures has just hit a 15 month low:


2-real PCEAnnual growth in real personal consumption expenditures by sectors


We have to briefly interpose here that we are not about to suggest what the Fed should or shouldn’t do. We are not armchair central planners proposing “better plans” for interventionists. Our only plan with respect to central banks is to argue for the urgent need to abolish them and adopt a completely unhampered free market in money and banking.

We are mentioning this because we don’t want new readers to confuse us with the many would-be social engineers that can be found elsewhere on the intertubes. The reason why we discuss central bank policy is the fact that it exists and that we all have to live with its consequences.

With that out of the way, we want to show a collection of updated charts from our friend Michael Pollaro, on what we think are key economic data points. We also want to point readers to a recent critical discussion by Mish regarding an “economic snapshot” paper produced by the NY Fed (we agree with his counterarguments).

As we have stressed on previous occasions, our focus is primarily on the business side of the economy, and within that, on the part that produces the greatest share of gross economic output, namely manufacturing. This is of course in keeping with the cause-effect vector mentioned above. The charts below show a somewhat broader array of data, i.e. they are not only about manufacturing.


Economic Data Snapshot

The aggregate data on business sales, inventories, employment, etc. are mainly updated until the end of October, resp. November. This is simply due to the respective official update frequencies. However, we can already infer from recent more up-to-date data releases (such as the Fed district surveys), that the trends shown in these charts are so far persisting.


3-Business SalesAnnual growth in business sales (red), inventories (green) and the inventory-to-sales ratio (blue) – click to enlarge.


Obviously, the last time declining business sales and a rising inventory-to-sales ratio were considered good things was “never”.


4-Business-sales-by-sectorBusiness sales by sector: y/Y change rate in overall sales (red), retail sales (green), wholesaler sales (purple), manufacturers sales (magenta) vs. the inventory-to-sales ratio (yellow area) – click to enlarge.


In typical business cycle fashion, industries in the higher stages of the production structure (further removed from the consumer) are showing the greatest volatility and are currently suffering the most due to the incipient downturn.


5-Busniness Inventories by sectorThis chart shows overall business sales in the yellow area and disaggregates the inventory-to-sales ratio (I/S) by sector. Retail I/S (purple), overall business I/S (blue), wholesalers I/S (green), manufacturers I/S (red) – click to enlarge.


6-Manufacturers, sales, orders, inventoriesSpotlight on manufacturing: y/y growth in new orders (green), sales (purple), inventories (red) and the inventory-to-sales ratio (blue) – click to enlarge.


7-Retail sales and inventoriesSpotlight on retail sales: y/y growth in sales (purple), inventories (red) and the inventory-to-sales ratio (blue) – click to enlarge.


8-Wholesale sales and inventoriesSpotlight on wholesalers sales: y/y growth in sales (purple), inventories (red) and the inventory-to-sales ratio (blue) – click to enlarge.


The next two charts show growth in total business sales and inventories relative to growth in employment:


9-Business sales vs employmentYear-on-year change rate in total business sales (red), non-farm payrolls/ establishment survey (light green) and employment/ household survey (blue) – click to enlarge.


10-Business inventories vs. employmentYear-on-year change rate in the overall business inventory-to-sales ratio (red), non-farm payrolls/ establishment survey (light green) and employment/ household survey (blue) – click to enlarge.


What is noteworthy about the foregoing two charts is that a large gap has developed between employment growth and business sales – the last time such a gap was seen was when it occurred to the upside, as the recovery in business sales (not surprisingly) led the the recovery in official unemployment data after the GFC.

It is fair to assume that business sales haven’t lost their leading indicator qualities. Keep in mind though that employment data have become quite skewed though by the surge in part-time jobs (which leads to what used to be counted as one job being counted as two) and the sharp decline in the labor force.

Another comparison chart worth looking at is the following, which contrasts business sales with junk bond spreads. The negative correlation between these two data series is more direct, although slight leads and lags do of course happen as well:


11-junk vs business salesBusiness sales growth (green) vs. junk bond spreads (blue) and the FF rate (red) – click to enlarge.


Lastly, as an addendum to the data on retail sales, here is a chart of the Redbook Index (weekly y/y growth rate in same-store sales). Over the past year this indicator has weakened considerably:


12-RedbookRedbook Index: a sales-weighted index of year-over-year same-store sales growth in a sample of large US general merchandise retailers representing about 9,000 stores.


None of this looks particularly encouraging, but it needs to be stressed that there is no guarantee yet that this weakness will lead to an official recession in the neat term. However, if a recession is indeed in store, we should expect more definitive signals to this effect to emerge quite early next year.


Additional Remarks – Production Structure and Yield Curve

The long period of ZIRP and historically strong money supply growth has kept our boom-bust index – the ratio of capital to consumer goods production – moving sideways at an extremely elevated level for an unusually long time. We can infer from this that there is probably more capital malinvestment in the economy than is superficially obvious.


13-Cap vs. Consumer goods productionThe ratio of capital goods (business equipment) to consumer goods production, a rough indicator of the distribution of factors of production between the different/opposing stages of the capital structure. Typically it rises sharply during credit booms and contracts during bust periods – click to enlarge.


Finally, we wanted to briefly mention the yield curve. As a result of the Fed’s oddly timed rate hike, the yield curve has flattened quite rapidly recently. This brings us to the question whether it is necessary for the curve to invert before a recession can be forecast with confidence. As we have previously discussed (see The Yield Curve and Recessions), per experience this is actually not the case in ZIRP (zero interest rate policy) or near-ZIRP regimes.

Below we reproduce a chart from said article that shows the past six recessions in Japan contrasted to the Japanese yield curve (represented by very short and very long durations, i.e., 3 months vs. 10 years). Only one of them – the one that began immiediately after the major bubble of the 1980s had burst – was actually preceded by an inversion. We suspect that a mere flattenig of the curve must already be seen as a major warning sign during or on the heels of a ZIRP regime.


14-Japanese-yieldsJapan: the yield curve and recessions – there have been five recessions in the past 2 decades that were not preceded by an inversion of the yield curve. What they all had in common was that they occurred during the ZIRP era – click to enlarge.



We are a bit worried that a consensus seems to be emerging lately that the Fed will soon “backtrack” from its rate hike. For the time being we believe so as well though, based on the data backdrop discussed above. It could however be that the Fed will get one or two more hikes in (even the BoJ once managed to implement two consecutive rate hikes – back when most of today’s stock market traders were still pimply teenagers).

This will largely depend on whether the above trends persist in the near term, as well as on asset prices, especially the stock market. All of this will in turn depend on whether the overarching downtrend in money supply growth rates continues (or perhaps even accelerates), or reverses again. So there are a great many moving parts, and we will have to wait and see how they develop. We would however say that it mainly comes down the question of whether the backtracking happens somewhat “sooner” or “later”.