Are Recent Small Improvements Meaningful?
In recent weeks evidence has emerged that the weakness in the manufacturing sector has begun to spread to the services sector as well (see e.g. Mish’s summary on the Markit Services PMI as well as the worrisome state of services activity on a global basis). This is not particularly surprising: as we have frequently pointed out, economic slowdowns and busts always tend to hit the capital goods industries first.
The sky above the manufacturing industries continues to be dark…
Photo credit: Bernat Casero
At the same time, a few data points in manufacturing have actually slightly improved – which is to say, that the pace of the declines has slowed and was in some cases not as bad as expected. This always seems to happen: as soon as economists adapt their previously overoptimistic expectations to a recent worsening trend, they will promptly be proven wrong again, as the pace of the trend slows.
Few things in this world are more certain than the fact that the consensus forecasts of mainstream economists are likely to be wrong. One can probably easily improve on their hit rate by merely flipping a coin. It is quite eerie actually – it is as if they were all Gartman clones.
However, the question that interests us is this: do these improvements mean anything? Our friend Michael Pollaro has provided us with updated charts on the situation, several of which we present below. As we have repeatedly said in previous updates, the probability of a recession has clearly increased – but the evidence that one has already begun or is about to begin shortly is not yet definitive. The following chart depicts the year-on-year change rate in the value of new factory orders, unfilled orders and inventories for non-defense capital goods excl. aircraft. Focus on the areas highlighted by the black circles and green rectangles.
There have been two occasions when gyrations similar to the recent ones have preceded recessions – shown in the first two black circles (2000/2001 and 2007/2008). The important thing here is that the short term ups and downs just prior to the beginning of the recessions were actually meaningless. In both cases there were one or two occasions when the data improved in the short term, but it turned out in retrospect that these signals were misleading. A much sharper downturn followed shortly thereafter.
The green rectangles show “false signals” – in these two cases, capital goods orders and associated data (such as industrial production, manufacturing sales, etc.) also declined close to recessionary thresholds, but no recession ensued. Let us consider these two cases: the first occasion was in 1997-1998. This was during the Asian, resp. Russian crisis. At the time, the US economy was in the middle of a major credit expansion and in the grip of the greatest stock market mania in history.
Japan’s bubble economy could not be slowed down by the crash of 1987, and the same happened with the US bubble economy in the late 1990s: a little crisis overseas could not stop it from resuming its expansion, especially with Alan Greenspan’s Fed immediately easing monetary policy further and the GSEs vastly expanding their mortgage purchases so as to pump additional liquidity into the banking system.
The second occasion was in 2011/2012. This was at the height of the euro area debt crisis. What happened? The Fed embarked on Operation Twist, and shortly thereafter on “QE3” (the ECB concurrently began to implement various expansionary measures, such as its LTRO program). Bubble activities resumed with a vengeance.
So there were very good reasons why the beginning corrections were aborted on these occasions: in both instances the Fed loosened monetary policy significantly. However, this time, the Fed is reportedly eager to tighten rather than loosen monetary policy (for the time being, anyway). And although this “tightening” has so far only had a small effect on credit and money supply expansion (although the latter has begun to slow down), it makes it less likely that the correction can be arrested and reversed by reigniting yet another round of bubble activities.
Regional Data vs. the ISM
It is also worth noting that the improvement in data was confined to the national ISM. The same cannot be said of any other relevant data series. Here is a comparison of the combined regional Fed manufacturing survey data with the data reported by ISM. First the headline numbers:
As can be seen, the regional surveys have actually been leading the ISM numbers in the last recession. It is definitely possible that the same thing is happening again. Here is a comparison of new orders:
Next up the employment figures – here the correlation is much closer, but the regional survey numbers are still weaker than the ISM data at present:
Finally, here is a chart comparing ISM new orders to total business sales (manufacturing sales). Business sales have only been updated to December, but even if the change rate in their decline should have slowed a bit in the meantime, there would still be a large gap between the two series – and in this case too, business sales have actually been leading ISM new orders in the last two recessions:
All these data continue to suggest that a recession remains highly likely. What will it take for final confirmation? Among other things, an even stronger decline in ISM new orders (likely below the 48 level as Steve Saville has suggested), a downturn in real non-residential private investment and a rise in initial unemployment claims above the most recent interim peak (according to John Hussman, a rise above 320,000 would do the trick).
To this it must be kept in mind though that the fundamental backdrop of the current cycle is slightly different from that of previous cycles, as the Fed has directly boosted the money supply during much of the recovery period, with commercial bank credit expansion playing second fiddle. Moreover, a lot of the credit that has been extended to businesses by banks was used for financial engineering purposes (share buybacks, LBOs, and even dividend payments!) rather than capital investment.
However, quite a bit of malinvestment has taken place anyway, as evidenced by the boom-bust sequence in the oil patch and the absurd valuations attained by tech “unicorns” (we believe many of these will crash and burn and take the earnings of a great many tech companies down with them).
Effects on the Production Structure
Lastly, below is our own boom-bust indicator, which compares the industrial production indexes for capital goods and consumer goods. As can be seen here, during boom periods, investment and factors of production are drawn toward the capital goods industries, and the production of capital goods rises strongly vs. that of consumer goods. Since booms driven by credit created from thin air cannot be properly funded by the economy’s pool of real savings, they prove unsustainable in the long term.
The economy will over time tie up too many final goods (or the economy’s “free capital” in the terminology of Richard von Strigl) relative to the amount it releases. Saving, investment and consumption schedules are no longer properly aligned, and the production structure becomes distorted: too many goods are produced for which demand is lower than expected (see oil), while not enough is invested in the production of goods that would have been demanded more urgently. Generally, the structure of production will be lengthened beyond the point that can be sustained with existing real savings. This is the result of the distortion of relative prices caused by the expansion of credit and money ex nihilo, which falsifies economic calculation and leads businessmen astray.
As consumption hasn’t been sufficiently lowered – as it normally would have been if sufficient savings had actually been accumulated – bottlenecks will eventually appear. If investment and consumption don’t “add up”, the over-consumption must still be funded somehow – and it is ultimately funded by the consumption of capital. Often this will greatly impair the middle stages of the production structure, in which capital maintenance will tend to be neglected while malinvestment in higher stages and over-consumption take place concurrently.
However, this cannot be kept up indefinitely, although the day of reckoning can certainly be greatly delayed by continuing the expansion of credit. Eventually though, consumer goods will become scarce relative to demand, and the price movements that have characterized the boom will begin to reverse, while upward pressure on previously suppressed market interest rates will begin to emerge (see junk bonds). The concrete sequence and the details of the phenomena attending the boom and bust periods differ from case to case, depending on contingent circumstances. However, what remains a feature of all types of historical business cycles is that in the end, the production structure has to be realigned to properly reflect reality.
Malinvested capital must be re-purposed and/or liquidated, which usually involves a shortening of production time by eliminating stages of production that cannot be sustained at the given level of savings, with factors of production re-directed toward the lower stages (consumer goods production), away from the higher stages (capital goods production). This rearrangement takes time and certainly feels uncomfortable – it’s not as if one could simply flip a switch after all – and is known as the bust period, or recession.
Photo credit: Julien Chabot
While we can still not proclaim with certainty that a recession is imminent, recent data releases have so far done nothing to lower the relatively high probability of a recession emerging in the US. Depending on upcoming developments this assessment could change again, but for the time being we remain on red alert.
Keep in mind that the growth rate of the broad true money supply, while much lower than at the peaks of 2011 – 2012, remains at a historically high level (more than 8% in terms of TMS-2). This tends to support bubble activities, but there is a limit to what loose monetary policy can achieve with respect to misdirecting scarce resources (a misdirection that masquerades as “economic growth”). The problem is precisely that capital is scarce – no new capital can be conjured into being by the actions of a central bank.
Charts by Michael Pollaro, St. Louis Federal Reserve Research
Dear Readers! We are happy to report that we have reached our turn-of-the-year funding goal and want to extend a special thank you to all of you who have chipped in. We are very grateful for your support! As a general remark, according to usually well informed circles, exercising the donation button in between funding drives is definitely legal and highly appreciated as well.
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- Fresh Mainstream Nonsense on Gold Demand
They Will Never Get It... We and many others have made a valiant effort over the years to explain what actually moves the gold market (as examples see e.g. our article “Misconceptions About Gold”, or Robert Blumen's excellent essay “Misunderstanding Gold Demand”). Sometimes it is a bit frustrating when we realize it has probably all been for naught. Gold wants to know what it has done now... Photo credit: Ajay Verma / Reuters This was brought home to...
- Switzerland About to Vote on “Free Lunch” for Everyone
Will the Swiss Guarantee CHF 75,000 for Every Family? In early June the Swiss will be called upon to make a historic decision. Switzerland is the first country worldwide to put the idea of an Unconditional Basic Income to a vote and the outcome of this referendum will set a strong precedent and establish a landmark in the evolution of this debate. The Swiss Basic Income Initiative in a demonstration in front of parliament. As we have previously reported (see “Swiss...
- Drowning the Fir
Presidential Duties Our editor recently stumbled upon an image in one of the more obscure corners of the intertubes which we felt we had to share with our readers. It provides us with a nice metaphor for the meaningfulness of government activity. First, here is a look at the picture – just quietly contemplate it for while and let it work its magic on you: Yes, these two gentlemen are actually watering a tree in the middle of a downpour... Photo via...
- Gold – The Commitments of Traders
Commercial and Non-Commercial Market Participants The commitments of traders in gold futures are beginning to look a bit concerning these days – we will explain further below why this is so. Some readers may well be wondering why an explanation is even needed. Isn't it obvious? Superficially, it sure looks that way. As the following chart of the net position of commercial hedgers illustrates, their position is currently at quite an extended...
- Heretical Thoughts and Doing the Unthinkable
Heresy! NORMANDY, France – The Dow rose 222 points on Tuesday – or just over 1%. But we agree with hedge-fund manager Stanley Druckenmiller: This is not a good time to be a U.S. stock market bull. Legendary former hedge fund manager Stanley Druckenmiller at the Ira Sohn conference – not an optimist at present, to put it mildly. Photo credit: David A. Grogan / CNBC Speaking at an investment conference in New York last week, George Soros’ former partner...
- Staying Home on Election Day
Pretenses and Conceits The markets are eerily quiet… like an angry man with something on his mind and a shotgun in his hand. We will leave them to brood… and return to the spectacle of the U.S. presidential primaries. On display are all the pretenses, conceits, and absurdities of modern government. And now, the race narrows to the two most widely distrusted and loathed candidates. US election circus: Deep State Rep vs. Rage Channeller The first, a loose...
- How the Deep State’s Cronies Steal From You
Expanding in Ireland DUNMORE EAST, Ireland – We came down the coast from Dublin to check on our new office building. For this visit, we wanted to stay somewhere different than we normally do. So we chose a small hotel on the coast, called the Strand Inn. Irish landscape with alien landing pads. Even the guys from Rigel II have heard about Ireland's corporate tax rate. Photo credit: Tourism Ireland It is an excellent place for seafood and soda bread on a...
- The World's 100 Most Influential Hacks, Yahoos and Monkey Shiners
Hacks and Has-Beens NORMANDY, France – What has happened to TIME magazine? Henry Luce, who started TIME – the first weekly news magazine in the U.S. – would be appalled to see what it has become. Time cover featuring the sunburned mummy heading the globalist IMF bureaucracy (which inter alia advocates that governments should confiscate a portion of the wealth of their citizens overnight, even while its own employees don't have to pay a single cent in taxes). Once you...
- The Japanese Popsicle Affair
Policy-Induced Contrition in Japan As we keep saying, there really is no point in trying to make people richer by making them poorer – which is what Shinzo Abe and Haruhiko Kuroda have been trying to do for the past several years. Not surprisingly, they have so to speak only succeeded in achieving the second part of the equation: they have certainly managed to impoverish their fellow Japanese citizens. Shinzo Abe and Haruhiko Kuroda, professional yen assassins Photo credit:...
- Kuroda-San in the Mouth of Madness
Deluded Central Planners Zerohedge recently reported on an interview given by Lithuanian ECB council member Vitas Vasiliauskas, which demonstrates how utterly deluded the central planners in the so-called “capitalist” economies of the West have become. His statements are nothing short of bizarre (“we are magic guys!”) – although he is of course correct when he states that a central bank can never “run out of ammunition”. BoJ governor Haruhiko Kuroda Photo credit:...
- Revolution at the Ranch
Alarming News BALTIMORE, Maryland – An alarming email came on Tuesday from our ranch in Argentina: “Bad things going on… We thought we had the originarios problem settled. Not at all. They just invaded the ranch.” Originarios on the march... Photo credit: cta.org.ar To bring new readers fully into the picture, Northwest Argentina, where we have our ranch, has a revolution going on. Some of the indigenous people – that is, people with Native...
- The Long-Buried Secret of Napoleon Bonaparte
Family Secrets DUBLIN – The smart money is getting out while the gettin’ is still good. That’s the message we get from reading the recent headlines. Here’s the Financial Times: Redemptions from stock funds have hit nearly $90 billion this year as portfolio managers and hedge funds struggle to navigate a market that no longer seems driven by radical central bank policy. S&P 500 Index: causing navigational problems - click to...