An interesting article I came across
The Canary in the Coal Mine
In 1996, the New York Federal Reserve did a study on what indicators were the most reliable predictors of a recession. The only one of six indicators that was significantly reliable was an inverted yield curve. They later did a private study with over 20 factors and still the only dependable indicator was the inverted yield curve. I read the studies in 1999. (I later learned of Ph.D dissertation done by the very smart Dr. Harvey Campbell, now a professor at Duke, which pre-dated the Fed study, but came to the same conclusions. The Fed study clearly relied upon his earlier work.)
In a normal world, short term rates are lower than long term rates. This makes sense, as investors want to be compensated for the risk of the longer holding period. There are exceptions to this rule, and at times short terms rates rise above long term rates, giving rise to what is known as an inverted yield curve. Typically, when the yield curve is inverted or negative for 90 days, you get a recession in about 12 months. Actually, it is more than typical. In the US, every time we have had a period of negative yield curves, we have had a recession within a year.
Thus, in August of 2000, as the yield curve in the US went negative, I predicted the US would enter a recession in the summer of 2001, and since the stock market loses an average of 43% in a recession, it followed that the stock market would tank. Quite the out of consensus call at the time. Although the NASDAQ was still in a swan dive, the New York Stock Exchange was climbing to within shouting distance of its previous high. The economy seemed to be moving along quite nicely. But the yield curve was staring us right in the face.
Now, I was not the only one that had read the Fed report. I am almost sure that every one of the Blue Chip economists had read it as well. But none predicted a recession. Things just looked too good, and none of the other data suggested a recession in the works. You can bet Greenspan had read the paper, but he waited until January to start cutting rates.
(As an aside, do you remember the writers and TV pundits that screamed at people to buy stocks because the market "always" went up 12 months after the Fed starts to cut rates? Well, it was not always, it was an average, and was a silly projection based upon a single factor. But if you were looking for a reason to be bullish and pump up stocks, it was as good as any at the time. It drove me nuts, as I could see the train wreck in personal portfolios that would develop, but there was nothing to do about it.)
I remember calling the author of the paper at the Fed and asking him whether he thought that we would be in recession within a year. "It will be interesting to see," he said.
Is England the Roadmap to the US Future?
While today the US yield curve is slowly flattening, it is nowhere near an inverted yield curve and not signaling a recession. But I have spotted an inverted yield curve in the world, across the pond, in England. And it worries me, as I wonder if it is a pre-cursor to problems in the US. Let's survey the current situation in England (thanks to the smart guys at Gavekal for some of this data).
UK unemployment is an amazing 2.7%. I am sure there are examples, but I cannot recall a major economic country with such a low unemployment rate. Inflation, although rising, is still under 2%. Wages rose by 4.4% in the three months through October, the highest rise in several years and more evidence of nascent inflation.
The housing market is doing quite well, thank you. In what everyone calls a bubble, housing in England still rose 12.5% year over year in November, although only 0.2% in the last month. Could it be slowing? UK household debt is 140%, which is above US levels.
The Bank of England recently noted, "Any sustained fall in [house] prices would reduce homeowners' cushion of housing equity. This might reduce their opportunity to re-mortgage to consolidate other debts or to lower their monthly payments. Financing difficulties would be exacerbated if any fall in house prices were accompanied by a wider economic slowdown." (Marshall Auerbach at Prudent Bear)
And government spending is on the rise. Quoting the team from Gavekal, "Just like the US, the UK participated in the supply-side revolution of the 1980s and 1990s. But unlike the US, the UK's supply-side revolution is in danger of being rolled back. UK government expenditures relative to GDP have been on the rise for seven long years, and the government has accounted for virtually all employment growth since 2001. Little by little, the spirit of enterprise created by the Thatcher revolution is being weakened by increased regulation and ever-rising public spending. This is a worrying development and if left unchecked, will undoubtedly have very negative effects on the growth prospects of the UK economy, and on the UK equity market."
The Bank of England is in a hard spot. They have been steadily raising rates to keep inflation in check and to rein in the white-hot housing bubble. Since the housing market is still doing well, and inflation is rising, one would think they should continue to raise rates. But with an inverted yield curve and a very strong pound, raising rates might not be wise, as that could push the country into recession.
If I lived in England, I would be getting my personal house in order. No long only stock funds, switching to bonds and absolute return type investments and funds. While the Fed study on yield curves was based on US precedent, the rule generally applies everywhere. Thus precaution is the order of the day.
But at the beginning of this essay, I hinted about the English situation perhaps shedding some light on the US. Let's see if we can make a case.
Hmmm. A strong housing market that might be peaking. A central bank that has been raising rates. A solid economy with inflation starting to pick up. A stock market that looks like it may have peaked? Oh, and did I mention a very large trade deficit? Sound familiar, my fellow countrymen (and women)?
The only thing we don't have is an inverted yield curve (yet?). Yet England did not have one as recently as six months ago, and was not all that out of bounds a year ago. I think England may be 6-9 months ahead of us in the softening process.
England may very well be a canary in the coal mine. While not totally analogous, there are enough similarities that it gives pause. And bears watching.
Yes, I know many will point to the positive economic data on both side of the ocean. But that misses the main point. The data stays positive, as will the mainstream economists, up until they turn negative. The upshot of the Fed study was that only the yield curve showed any reliability in its predictive ability. Everything else was "noise."
(By the way, the yield curve does not "cause" a recession, it simply indicates conditions that are likely to bring one about.)
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As I wrote a few weeks ago, in the late 90's and up until 2002, the vast majority of pundits told us why "this time it's different. Trade deficits no longer matter. Now they are all blaming the trade deficit for the declining dollar. But if that is the case, why is the British pound and Aussie dollar rising? Listen to what Marshall Auerbach (of Prudent Bear) wrote to Dennis Gartman:
"For those who say that the US dollar is going down because of the 'unsustainable US trade deficit,' it is worthwhile pointing out that at 6.5% of GDP, Australia's current account deficit is worse and at 5.5% of GDP, Britain's is approaching American levels. Yet sterling and the Aussie dollar have been two of the strongest currencies this year, rising 24% and 32%, respectively against the greenback. So, as your comments ('it matters when it matters') implicitly suggest, the 'unsustainable US current account' is really an ex post facto rationalization for those getting on a speculative bandwagon."
The world of currency valuations and trade deficits is a very complicated matter. Yes, trade deficits of the type that the US is currently experiencing, as well as that of England and Australia, are unsustainable. But normally when one uses the word unsustainable, one does not think in terms of multiple years, but that is precisely what can happen. It is entirely likely, even probable, that the US trade deficit will get worse this next year (barring a drop to $20 oil).
A dropping dollar is not going to magically fix the deficit as it did in the 80's. For one thing, the US manufacturing sector is a smaller percentage of the total economy than it was 20 or even 5 years ago. So even if we see exports grow a significant percentage, it is growth off a smaller base. It will take many years of outsized export growth to catch up with our growing imports. (Unless, of course, we see a recession and imports actually drop.)
That means for the trade deficit to come back into balance imports must go flat or drop. That is not a happy prospect. Again, going to Marshall's latest piece, as he says it eloquently. He is commenting upon articles by the IMF and other English institutions that worry about the housing bubbles in the US, England, and Australia.
"The humbling reality is that across three decades, only one economic event has been guaranteed to produce balanced trade in the English-speaking nations: a recession. When the economy is contracting, people naturally buy less of everything, including imports. Needless to say, no one appears ready to embrace this option, which means that the endgame will be much worse - even for those who have sought to conduct their monetary affairs in a responsible manner, such as the Bank of England. The current global financial fragility is unlikely to be saved by mere dollar devaluation; it is solved when the respecting offending nations restraining their respective profligate tendencies and implement policies designed to restore national savings to their historic norms. Of course, if all the offending nations do this together without any countervailing stimulus from Euroland or Asia, we will see a massive global contraction.
"The Bank of England and IMF may see this checkmate position coming. They may be concerned they will see a global income depression on their watch if housing bubbles burst. They may accordingly be warning global monetary authorities 1) not let the housing bubbles run any further, but perhaps more importantly, 2) not pop these bubbles in anything other than a careful, deliberate, and incremental fashion. That would be nice, but history shows us that there is a reason why we rarely see bubbles popping gently."
Today, things are alright. The canary is singing away. But the great imbalances in world trade will be brought into balance at some point, even if "unsustainable" is a few years off. It helps to get some early warning signs. Let's watch that canary closely.
John Mauldin
http://www.johnmauldin.com/
Copyright 2004 John Mauldin. All Rights Reserved.
