Opinion Han de Jong
Broken recession rules: implications for interest rates
Recession fears are causing anxiety among stock investors, with the objective recession indicators possibly being disrupted. However, there are indeed weak spots in the American economy. Additionally, the German and Dutch industries are showing some signs of recovery.
Over the past two weeks, the stock markets have taken significant hits, although there was a considerable recovery yesterday (and today). It is not always easy to attribute every price movement to a clear cause, but everyone tries to do so. The recent price declines are attributed to the fear that the American economy may enter a recession. In a recession, company profits usually decline sharply. This explains the fear among stock investors of recessions.
Stock markets look ahead. Investors do not wait to sell their shares until the economy enters a recession, but they anticipate it. 'Bear markets' - price declines of at least 20% - almost always occur in conjunction with a recession, but they begin before the recession sets in. To avoid the significant price losses experienced in a 'bear market,' one must make a correct assessment of the economic cycle. A significant price decline like the one seen over the past two weeks could be the start of such a 'bear market,' but it could also be a good 'buying opportunity.' A dilemma for the active investor.
Notoriously bad at predicting recessions
It usually does not help to listen to economists. Especially economists from official institutions are notoriously bad at predicting recessions. They hardly ever foresee them. Probably they are not allowed to by their bosses. But economists at private financial institutions also often miss the mark.
It is better to think in terms of probabilities and to make use of objective measures as much as possible. However, even that is now problematic. The yield curve has proven to be a very good leading indicator for recessions. An inverted yield curve (short-term interest rates are higher than long-term rates) has been present in the US for almost two years now, but the predicted recession is still yet to come. The patience of the yield curve followers is running out. It is claimed that the signal from the yield curve is no longer reliable because central banks have disrupted long-term interest rates with their bond-buying policies.
Attention-grabbing recession indicator
An indicator that has recently attracted attention is the 'Sahm rule.' This rule was developed in 2019 by Claudia Sahm, who was working at the Federal Reserve at the time. She observed that the American economy was either in a recession or heading into one when the average unemployment rate over three months was 0.5% higher than the lowest level of the unemployment rate in the past twelve months.
American unemployment has been rising in recent months, and the Sahm rule has now come into effect. Claudia Sahm wrote a column on Bloomberg this week and also gave an interview in which she argues that her own rule probably does not provide a reliable signal for an impending or ongoing recession. She rightly points out that this time, the rise in unemployment in the US is not primarily due to a lack of demand in the economy but rather to the strong growth in the labor supply due to increased immigration. Additionally, the labor market has been greatly disrupted by the pandemic. At the same time, she believes that the risk of a recession is 'elevated.' It is true that the unemployment rate in the US is still low. But that is not the point. It is about the change. In a recession, unemployment rises gradually at first, then rapidly, and then significantly, she explains. And that is exactly right.
Significantly disrupted labor market
Another objective indicator is the number of jobs under the heading 'Temporary Help.' The graph below shows that this number of jobs typically decreases before a recession. Currently, the number of 'temporary help' jobs has been declining for some time without a recession having started. It is likely that the labor market has been significantly disrupted in recent years as well.
I would like to present a few more images that do not directly indicate an imminent American recession but do suggest a weakening of the economic cycle. The first image shows that the number of 'chapter 11 filings,' which are essentially requests for bankruptcy protection, has been increasing for a while and is higher than at any time since 2013.
The affordability of homes is very low. This is due to the combination of high house prices and high interest rates. The implication is that little economic dynamism can be expected from the housing market for the time being.
Another weakness can be found in the defaults on various forms of debt. As the following image shows, defaults on credit card debts and car loans have been increasing for over two years and are at the highest level in over ten years. However, there may also be a disruption here, as defaults unexpectedly decreased during the pandemic due to the extensive financial support provided by the government.
Where do these weak spots in the American economic cycle come from? Various factors are likely at play. The American economy received a significant boost from the expansive fiscal policy under President Joe Biden. However, the budget deficit is now shrinking, meaning that the growth impulse is diminishing. The relatively high interest rates also play a role, as well as the fact that households have been able to draw from savings accumulated during the pandemic for a long time. Those savings are running out.
I agree with Claudia Sahm. The American economy is not in a recession, but the risks are quite significant. I suspect that the Fed will ultimately feel compelled to lower interest rates fairly quickly.
Improvement in Industry
Turning to the European continent, production in the manufacturing industry in the Netherlands increased by 0.8% in June compared to May. However, on a year-on-year basis, there was still a decrease of 4.9%. This was the second-worst figure in the past two years. Perhaps we should hold on to the month-on-month increase. In Germany, industrial production also rose in June: +1.4% month-on-month. The production in the five most energy-intensive sectors also increased by 1.4% in June. This meant that the production level in these five sectors was nearly 10% higher than in December last year. That is encouraging.
Conclusion
Stock markets are focusing on whether the American economy is heading towards a recession. Various objective indicators, such as the yield curve and the Sahm rule, suggest so. However, the disruptions in the economy in recent years have undoubtedly reduced the predictive power of such variables. Nevertheless, the American economy has gradually begun to show some weak spots, and the risk of a recession has increased. If the economic weakening continues, the Fed will not hesitate to lower interest rates fairly quickly.
Han de Jong
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