Is recession priced in?

Yes, stock and bond markets have discounted the worst, but the hard data has actually gotten better. First, there was the positive employment report last Friday, largely drowned out by Standard & Poor’s downgrade of America’s credit rating. And we now have three consecutive weeks of relatively low initial unemployment insurance claims, hinting that the labour market’s improvement continued into early August.

Finally, this morning we learned that retail sales performed relatively well in July. The 0.5% increase was in line with consensus estimates, but the composition of growth was better than expected: less came from autos and gasoline and more from home electronics, furniture and apparel. Morgan Stanley boosted its estimate of third quarter growth to 3%, annualised. Weekly chain-store sales reports have remained firm into early August, though they’re unreliable.

The retail sales news is particularly important because it’s consistent with the theory that the spring surge in petrol prices was a major cause of the economic slowdown earlier this year. Petrol has since dropped back, to $3.67 per gallon as of August 8th, from a peak of $4 and the most recent slide in crude prices should nudge it down further.

Beyond this positive data, an argument against recession is that the current composition of economic activity doesn’t look right. The Bank Credit Analyst points out that the economy is typically led into recession by “high-beta” sectors: housing construction, automobile sales and inventories. Yet all three are already at or near recessionary levels. Housing starts have yet to climb off the bottom, automobile sales have recovered only a third of their drop and the ratio of inventories to sales, after spiking during the recession, is now quite low. Just as a recovery needs a self-supporting cycle of rising production, income and spending, so a recession needs the opposite. That is less likely if the most vulnerable sectors are already moribund.

Of course, they could be pounded even lower by a large enough shock. The spike in oil prices might have done it, but it is now reversing. What about the equity market sell-off? Goldman Sachs estimates that the roughly 16% decline in stockmarket wealth since late July would knock 0.7 percentage points off growth by the end of 2012, while the decline in interest rates and oil prices would add 0.4 points. That yields a net effect of minus 0.3 points: a drag, to be sure, but not enough to generate recession.

Of course, business cycles are heavily driven by psychology. Today the University of Michigan said consumer confidence had fallen sharply. That was led by a decline in consumer expectations of the future, no doubt thanks to relentless bad news about America’s credit rating, Europe and the Dow. If something would just distract the news media from the economy, we might have a chance. Where’s Charlie Sheen when you need him?

What I find most useful about this quick take on the process of the ‘typical’ recession. It’s spot on and were it ten years ago, I would agree whole-heartedly.

But that’s where my admiration stops. We’re not in a post-war recession environment. The West has come to a long cycle credit saturation reckoning, a balance sheet recession, a depression, a new normal, whatever label you wish to put on it. And in such, it is not the old cyclical triggers of recession that matter, it is retrenchment in the new source of demand that has to date filled the hole left behind by the credit bust: government spending. Sadly, The Economist argument doesn’t even mention it.

A second Economist post does a better job when examining Europe:

Alas, all is not well in Europe. The big question continues to be: can European economies manage their aggressive austerity plans against a backdrop of lagging growth? And the growth outlook is darkening. Today, France, which found itself at the middle of the week’s debt-downgrade and banking panic, reported disappointing growth figures. From the first quarter to the second, the French economy failed to expand at all, held back in large part by a drop in household consumption. For now, French officials are declaring that they’ll keep to their deficit-reduction goals.

What’s worse, the euro-zone economy as a whole is rapidly losing momentum. Industrial production across the euro area fell by 0.7% from May to June. Production dropped in every large euro-zone economy, including a 1.7% decline in France and a 0.8% dip in Germany, which is widely considered the currency area’s bulwark against a return to recession. Activity dropped across southern Europe, falling in Italy for a second consecutive month. That’s especially bad news for an economy facing an accelerated austerity push.

Falling output will reduce the effectiveness of fiscal consolidation, both by negatively impacting revenues and by cutting the denominator in the debt-to-GDP calculation. Disappointing fiscal progress may lead to more market trouble, raising sovereign borrowing costs. Or it might lead governments to push for more aggressive austerity still. Or both. One thing is for sure: a return to euro-zone recession would set the stage for a prolonged crisis environment, through which the survival of the currency area will constantly be in question.

That’s exactly right, as Delusional Economics has pointed to repeatedly. And the same argument can equally be applied to the US where the recently agreed austerity Budget is set to cut GDP by of 1.5% when the economy is currently growing at somewhere around that level.

At current levels, the S&P500 is down 14% and is still pricing corporate profits growth. Commodity prices are down even less, with the CRB down just 12% from stratospheric heights. What has been priced is a short intra-cyclical slowdown. From Zero Hedge comes useful piece of research from Morgan Stanley:

Despite the recent decline in risk assets, we do not believe that recession is in the price. Exhibits 3 and 4 show the typical declines in developed market risk assets in recession. Compared to corrections in past recessions, S&P prices and corporate credit spreads would have more to go, though spreads are starting from a higher level than typically precedes recessions.

In short, I see no reason why ongoing austerity measures won’t set in motion a negative feedback loop of retrenching US and European consumers and further equity market volatility. Moreover, I can see this cycle culminating in a rise in inventories and a subsequent wind down cycle, ending the business cycle globally.

This is now my base case, but I can see several influences working against it. The first is that the US (but not European) oil price has corrected significantly. However, oil economist James Hamilton has an argument weighs against that hope:

Earlier this year, disruptions in Libya and the resurgence of demand from the emerging economies sent oil prices up sharply, a development that many economists believe contributed to the slow growth for 2011:H1. The chaotic markets of the last few weeks saw oil prices drop back down to where they had been in December. Will that be enough to revive the struggling U.S. economy? There is some evidence suggesting that it may be too late.

I recently completed a survey of a large number of academic studies that found a nonlinear economic response to oil price changes. One very well-established observation is that although oil price increases were often associated with economic recessions, oil price decreases did not bring about corresponding economic booms. For example, when oil prices plunged in the mid-1980s, theoil-producing states in the U.S. experienced what looked like their own regional recession. An oil price increase that just reverses a recent price decrease does not seem to have the same economic effects as a price move that establishes new highs.

The argument is substantiated with fairly technical data. But even if we accept some positive effect, a glance at the attached chart shows that the gasoline price in the US is still substantially elevated.

The other reason I can think of a reason to hope that a Western recession may not be a foregone conclusion is that Chinese policy makers appear to have shifted their tightening regime. That may also boost growth some in emerging markets and market sentiment a little.

However, BRIC economies have an aggregate GDP of $10-11 trillion versus combined EU and US GDP of $30-31 trillion and all tend to be very export dependent on the latter.

Markets can run for a while on technical relief but I don’t expect it to be sustained.