Does Negative GDP Growth Portend Recession?

While it was generally expected that 4Q was a slow quarter for economic growth, it was probably a surprise to many that the growth rate was negative.  What are the odds that this negative growth portends a recession?

Assuming that the revised number remains negative this is the 42nd time in 279 quarters since 1947 that quarterly GDP growth has been negative.  Of those 42 times, 27 of them came during a recession (as defined by NBER).  Therefore GDP has contracted 15 times while the economy was not in recession.  Below is a list of those times.  The economy entered into a recession in the following quarter five out of those fifteen times.

Of course, NBER defines recession dates after the fact, so we could be in a recession right now and just not know it.  Given that the market is hardly lower today, that would probably be a surprising result.

Note: Figures are NON-Annualized

Nominal GDP Grew at 5.5% in 3Q12

The first revision of 3Q12 GDP was released this morning and showed that GDP grew at 2.7% annualized during the quarter, which was 0.7% better than the initial estimate.  That's also 1.4% more than it grew in 2Q12, when it only grew by 1.3% annualized.

People often forget that the headline GDP number is reported on a "real" basis, which means that it is adjusted for inflation.  In reality, real GDP is anything but real though, since the world is measured in nominal, not real numbers (especially important for debt), and economists do a debatable job of measuring inflation anyways.

On a nominal basis GDP was up 5.5% annualized last quarter, a pretty big number!  The deflator (inflation) ran at 2.7% which is also a fairly large number in its own right.  The 5.5% growth was actually the largest quarterly increase in nominal GDP this cycle, although it's not quite as large as it was at other points last decade.

Source: BEA

Katrina's Effect on Jobless Claims vs. Sandy

Before Sandy hit I mentioned that jobless claims would be one of the more sensitive economic indicators to any disruption caused by the storm.  Checking back in, today we found out that jobless claims spiked 78,000 following the storm to 439,000.  In 2005, claims rose by 96,000 after Katrina hit and it took six weeks for claims to fall back to their previous level.

Seasonality of Business Inventories

Business inventories were reported today up 0.7% for September which is slightly higher than expected.  Inventories are an important economic data point to watch because GDP growth is highly sensitive to expansion and contraction in inventories.  Currently, the inventory to sales ratio is at 1.28x which is slightly higher than it was to start the year.  This is something to keep an eye on because if inventories rise faster than sales, there can be an inventory liquidation and a corresponding contraction in GDP.

Cyclically speaking, inventory data is important to GDP but is somewhat difficult to interpret because it is also affected by secular and seasonal variance.  On a secular basis, businesses have found a way to continually become more efficient and reduce inventory over time.  This makes it difficult to interpret what the "right" level of inventory/sales should be.

Seasonally, inventories will also shift in response to the holiday shopping season.  The government data is supposed to be adjusted for this, but is imperfect.  On average since 1992, inventories are ~6% higher in November than they are to start the year.  This year, inventories have grown a little more than average since January.  (Note that it's important not to read too much into whether that means that companies are "over-inventoried" because the chart is really just showing the seasonality in any single year.)

Are we Heading For a Recession?

Every time the equity markets go through a correction the recession chatter seems to pick up.  In the last few days, the chart below has started to pop up around the internet in support of the idea that we might be heading for one again.  It's a recession probability index (which isn't widely followed to my knowledge) but has a good track record of predicting previous recessions and is past the threshold that has signaled false alarms before.

The indicator was developed by two professors, Marcelle Chauvet and Jeremy Piger.  The inputs are: "a dynamic-factor markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales."

I'm not particularly familiar with this indicator so it's tough to know what the biases could be, but I generally tend to be somewhat skeptical of models like this one.

A more time tested recession indicator is the slope of the yield curve--when the spread between 2 year and 10 year treasuries is inverted recession normally follows.  In a zero interest rate environment the yield curve may have lost some of its informational content, but it's been a great cyclical indicator for a long time and it's grounded in sound economic logic, so it shouldn't be totally ignored.  Today, even though the curve has flattened since '09 it is still not at or near the zero threshold.  As of right now I'm still on the lookout for the yield curve to go completely flat or invert when recession is imminent, even in this environment.

To clarify, I did write yesterday in my investor letter that I think recession will happen sometime in the next presidential term, but that doesn't necessarily mean it's imminent.  My base case is that it could start sometime late next year absent a totally botched fiscal cliff.  The forecast is mostly reliant on the average duration of economic expansions.  As I've written before, this expansion would be short even compared to the 1933 expansion if it ended today.

How Many Hours of Work Does it Take to Buy...

The reason that economists adjust nominal data to "real" numbers is that they are trying to create a better picture of general welfare after adjusting for inflation.  If an economy produces $100 worth of widgets one year and $150 worth of widgets the next, the dollar increase doesn't tell you much if the price of a widget also rose from $100 to $150.  In that case the economy has still produced one widget in the year, so welfare has not changed and theoretically real GDP should be flat.

At a fundamental level, "real" economic numbers are an attempt to measure output against time.  In the previous example, the data was adjusted to have a more clear picture of the number of widgets produced per year.  For humanity, time is really the only scarce resource there is.  Therefore, the number of hours worked that it takes a person to buy an item is the true measure of welfare.

Today's employment report showed that average hourly earnings fell slightly to $23.58.  Below are charts of the number of hours that it has taken to purchase a home, a barrel of oil, an ounce of gold and "an S&P 500," at the prevailing hourly wage of the era.  In general a downward slope would mean that societal welfare is increasing because it would take fewer hours to buy the same good.

Long Term Durable Goods Orders Chart

Durable goods orders posted a terrible print this morning for August.  The Series showed a 13% m/m decline.  Much of this came from the transports component, which is notoriously volatile.  Still, the magnitude of the drop is certainly noteworthy.

The 13% decline is the 3rd largest drop in the history of the series which goes back to 1992.  There hasn't ever been this large of a decline outside of a recession.

Before we declare the end of this expansion though, it is most likely that this is an anomaly rather than an indication of the state of the economy.  To some extent this datapoint was already reflected in the sub-50 ISM reading that was reported at the beginning of September.  For a more salient indicator, all eyes should be on how ISM measures this coming monday.

Housing vs. Equities

Case Shiller was reported this morning up 1.2% y/y for July.  The datapoint serves as confirmation that housing prices are recovering.

Below is a chart of Case Shiller vs. the S&P 500 since 2000.  It shows that even though housing prices may be starting to turn, they still have quite a ways to climb.  Also it highlights that even despite the housing bubble burst, housing prices have still risen since the turn of the century and have thus outperformed equities.

ISM as Recession Indicator

ISM was reported at sub 50 for the 3rd month in a row.  Does that mean that a recession is imminent?

Below is a chart of ISM stripped down to only include times that the indicator has been below 50 for at least 3 months in a row.  There have been roughly 17 periods in which ISM has had a 3 month sub-50 streak.  Of those 17 times, 6 have been outside of a recession: 1951, 1967, 1985, 1995, 1998 and 2003.

What Percentage of the US Population Works?

Below is a chart of the employment/population ratio for the US.  It measures the percent of the population in the US that is working.  Even though the unemployment rate is 8.2%, that only measures those looking for work who can't find jobs.  The number below takes into account the whole population.  At 58% of the population employed, the number is the lowest it's been since 1984.  The employment ratio for men is near an all time low set in 2010.

Still, compared to some other developed countries the percentage of the US population that is working is relatively high.  In Italy, less than half the population is employed.

Capacity Utilization Almost Back to Pre-Recession Levels

Capacity utilization was reported this morning at 79.3% which is a new high for this economic cycle and puts the indicator pretty close to its former cycle highs.  In 2007 capacity utilization peaked at 80.8%.

Increasing capacity utilization is generally a good sign for economic activity but can have important implications for the economy based on how businesses choose to react to the tightening capacity.  If businesses choose to invest in new infrastructure, this can provide a late cycle boom to the economy.  On the other hand if there is demand growth without capacity expansion, one would expect more inflationary pressure.

More Confirmation that the Housing Market May be Turning

In the Federal Reserve Senior Loan Officer Survey released yesterday, there was a good sign for the housing market in that more banks are reporting increasing demand for mortgage loans.  The bad news is that while the demand is picking up, banks are still not loosening credit standards much, and actually reported tighter standards last quarter.

Case Shiller Index Chart

Yesterday the latest Case Shiller data was reported for May, which showed that housing prices had risen 2% m/m but fell 1% y/y.  Still, the May data confirms the chatter that housing may finally be turning.  Housing is arguably the most important asset class in the US economy today.  If housing prices rise, not only does the banking system get a lot healthier, but the consumer's balance sheet becomes repaired too as debt/equity falls.  While housing prices may be rising slightly, there's still some way to go for anyone who bought a new home or refinanced in 05/06/07 to get above water.

July Economic Data Summary

Over the course of any month there is a heap of economic data that is released by various governmental and quasi-governmental organizations.  The data can come so quickly that it's often difficult to keep track of what has shown strength or weakness and which indicators are beating or missing Wall Street estimates.  To try and help summarize what was released in July, below is a list of 32 of the more important economic releases last month.  Of these 32 releases, 14 (~44%) missed expectations.

Baltic Dry Index Historical Data

Back in late 2007 and early 2008 when commodity markets were really humming, the Baltic Dry Index was a closely followed indicator of economic activity (especially in emerging markets).  It measures the daily cost of chartering a dry bulk ship to move commodities across the ocean.  In late 2008 it collapsed in the financial crisis and has never recovered as a glut of newly built dry bulk ships flooded the market.  It's interesting to see the the index is back to its lowest levels.

Philly Fed Economic Activity Indicator

Philly Fed data was released this morning and was disappointing again with the diffusion index at -12.9, meaning that 12.9% more respondents reported contraction than expansion.  There were also some special questions asked as part of the release that I thought were worth reposting here.

How Does Housing Compare to the Tech Cycle?

Even though Bank of America is trading lower, today's quarterly release capped off what was a surprisingly good quarter for major US Banks.  In general, loans and deposits both showed growth, capital levels are extremely high and credit quality is significantly improved from where it was during the crisis.  Similarly, the housing sector has had some healthy reports as well recently (see previous post).

Seeing as how housing and banking were at the epicenter of the previous crisis, what does the fact that the two sectors are recovering say about where we are in the current economic cycle?  To try to help discern how this cycle compares to previous cycles, below is a chart comparing the performance of housing (ITB) and Financials (XLF) in this cycle to Technology (XLK) in the last one.  The chart shows relative performance of ITB, XLF and XLK compared to the S&P 500.  ITB and XLF are shown from 2006 and 2012 and XLK is shown between 2000 and 2007.

After the sharp collapse of technology stocks relative to the S&P from 2000-2002, XLK languished on a relative basis for the next four years before finally starting to outperform in 2006.  Similarly, both XLF and ITB showed steep drops and have continued to be losers since.  Now, years later, they may finally be starting to show signs of a turn.  XLK continued to steadily outperform the S&P 500 through 2012.  However, by the time XLK turned in 2006, the general economy only had one year left before it began to contract.

Housing Starts Showing Signs of Life

Housing starts were reported this morning for June at the highest level since October 2008.  The housing sector may still be operating at a low level, but it looks for now like it has at least broken out of the range that it had languished in for several years.

Retail Sales June 2012

Retail sales were reported this morning for June and were weak again.  For the third straight month, retail sales declined, which is a reasonably rare occurrence.  Since 1992, there have been 4 periods that retail sales have declined in three straight months.  Two of those periods happened in 2008; one of those periods lasted for 6 months.  Below is a list of negative retail sales streaks:

Looking at the bigger picture, retail sales growth has slowed to just a 3.8% y/y increase in June.  The slowing trend doesn't necessarily indicate recession, but certainly demonstrates that the rapid growth phase of the economic cycle is over.  As recently as this time last year retail sales were up 9.2% y/y, but  now it looks like there isn't the same slack in the economy that there was then to generate large growth numbers.

Comments From Marriott 2Q12 Call

 Fastenal had negative things to say about the industrial/manufacturing outlook, but Marriott is a little more upbeat on its North America business:

I know that first and most important question you may have is, are you seeing a slowdown in North America, and the answer is no. There's plenty of evidence of continuing strength in our lodging business in North America.

An interesting response to a fiscal cliff question:

I think that if you're talking about the fiscal cliff of the expiration of the Bush tax cuts, the Obama employment tax cuts and maybe deficit impact, as well as the government cuts...I would say today that there is no impact of that threat on the numbers we've put on the books or the bookings that we're seeing. And we have certainly not made any effort to factor in a what-if. And obviously, we haven't given you '13 guidance anyway. But I think, by and large, this is going to be a question about what happens politically and how that translates into a U.S. economic performance in 2013 and beyond. It may be that it becomes relevant in the fourth quarter, but I doubt it. I think this is much more likely to be a question of how it gets factored into real economic growth, maybe a little bit attitude and sentiment as we're doing bookings in the fourth quarter but doubtful in terms of the impact to actual Q3 and Q4 numbers.

Also, not related to any outlook, but I like to file away useful information like this:

China is probably about 1 million rooms across the country as a whole. The U.S. is 5 million rooms. China will clearly see that 1 million rooms double and then double again over the course of the next period of time. It's going to imply substantial supply growth year-over-year for a number of years to come. But there's every reason to believe that demand is going to be growing with it.