Key points
- More signs the recession is over, but skepticism remains.
- Yield curve is telling a compelling recovery story.
- Understand the relationship between the consumer and employment.
The NBER pinpoints when the economy stops accelerating and begins to decelerate ... that's ultimately the start date (to the month). It pinpoints when the economy stops decelerating and begins to accelerate ... that's ultimately the end date.
But think about that. For illustrative purposes, let's assume the cycle looks like "/\" at the top and "V" at the bottom.
When you're at the top of the "/\", it still feels quite good ... we only know with the benefit of hindsight that we were on the precipice of an economic slide.
When you're at the bottom of the "V", it still feels quite awful ... we only know with the benefit of hindsight that we were on the cusp of an economic recovery.
Most regular readers know that I have felt since early May that the recession ended in this year's second quarter; more recently, many have joined me in that camp.
The most recent economic reports have been particularly encouraging, pulling in even more disbelievers.
- Unemployment claims are down sharply from the peak.
- Home prices are recovering.
- Vehicle production is rebounding smartly (partly thanks to the "cash-for-clunkers" program).
- The stock market had a terrific July, not to mention since the March low.
- High-risk bond yields have plunged (along with spreads).
- Corporate earnings have been well ahead of expectations.
- Productivity is spectacular.
- Many emerging economies are sharply accelerating.
We continue to believe that exports will be a very positive driver of US GDP in this cycle. Caveat: The Bureau of Economic Analysis' long-term revisions showed the recession having been weaker than originally thought; hence the better rebound from those lows.
Yield curve telling a recovery story
We know the stock market has been singing a recovery song since it bottomed in early March, but there are other indicators that tell an equally compelling story. One of those is the bond market via the yield curve.
The difference between long-term and short-term interest rates (the "slope of the yield curve"), seen below, has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters.
Steep yield curve signals recovery
As of July 31, 2009. Green-shaded areas represent periods of recession. Sources: FactSet and the Federal Reserve.
In other words, when the yield curve is steep (as it has been recently), it tends to signal the economy is troughing.
When the yield curve is inverted (as it was when long-term rates were below short-term rates back in 2006-2007), it tends to signal the economy is peaking.
The yield curve steepened as short rates remained low, but long rates moved higher reflecting the bond market's view of coming recovery (and the possibility of accompanying inflation pressures).
The yield curve has predicted essentially every US recession and recovery since 1950 with only one "false" signal, which preceded the credit crunch and slowdown in production in 1967.
One of the reasons for the strong record for this indicator, and its inclusion in the subcomponents of the Conference Board's Index of Leading Indicators, is the profitability a steep yield curve creates for banks and other lenders (they can borrow short at low rates and lend long at higher rates).
Although lending standards remain tight and lending subdued, the wider spread helps explain the burgeoning profitability of the financial sector.
What about the consumer and employment?
All that said, skepticism remains and the theme of pushback I get when expressing my more constructive outlook centers on the consumer and the jobs picture. There are a few misperceptions about the order of things in recovery that need to be made clear. Let's start with the consumer.
The US consumer had been the main driver of global economic growth and US GDP in the last cycle, representing more than 70% of the latter. Thanks to household sector deleveraging (about which I've written extensively), that percentage is likely to wane; leaving many to wonder how GDP can expand without the traditional heavy lifting by the US consumer.
In fact, the most common question I get from investors is about the relationship between consumer spending and employment and how we can get any lift from the former without a lift from the latter. Quite simply, consumer spending has historically led job growth; not the other way around, as you can see in the chart below.
Consumer spending leads employment growth
Chart shows average of annualized six month rate of change during the past six recessions. Sources: Department of Commerce, Department of Labor, and Ned Davis Research, Inc.
Staying on the employment topic, let's look at the three common gauges for the overall jobs picture:
- Unemployment claims (reported every Thursday morning).
- Payroll employment (the number of jobs lost or gained, reported monthly).
- The unemployment rate (also reported monthly).
Falling unemployment claims signal recovery
As of July 24. Green-shaded areas represent periods of recessions. Sources: Department of Labor and FactSet.
As you can see, the four-week average of claims has declined by 100,000 since the recent peak. The US economy has always been out of recessions at this point historically. On the other hand, the unemployment rate continues to rise and capture most of the headlines. I created the chart below to drive home the lagging status of the unemployment rate.
Unemployment rate lags big time
As of June 30, 2009. Red dots indicate the unemployment rate at the beginning of recessions and blue dots indicate the unemployment rate at the end of recessions. Sources: The Bureau of Labor Statistics and FactSet.
As the dots clearly show, the unemployment rate has always been near its low point as we entered recessions and near its high point as we exited recessions. In fact, the unemployment rate has never peaked before a recession has ended historically ... the average lag is six months between when recessions have ended and when the rate has peaked.
Don't count out the US consumer
But I digress. I don't want to send the impression that I feel this recovery will be largely US consumer-driven. The pressures thereon are enormous and of long duration, but that does not mean we won't see some growth contribution from the consumer.
BCA Research studied past housing and credit boom/bust periods in Europe and the United States as a roadmap for how the current crisis/recovery could play out. There are typically two phases of consumer deleveraging.
In the first phase, income shrinks but households manage to boost the savings rate by slashing spending even more ... that's the recession phase.
Then, as the savings rate moves up, consumers shift into the second phase of deleveraging, characterized by spending growth that turns positive, but is held at or a bit below income growth (thereby keeping the savings rate elevated). The flow of savings is used to reduce debt and the ratio of credit-to-GDP falls over a multiyear time frame.
The recovery tends to be subpar, yes, but it is, nonetheless a recovery. The jump in the savings rate to nearly 7% (from 0% last year) suggests the US economy is in transition to this second phase.
In sum, I think we're in recovery mode; albeit not without bumps along the way. And, although the pace of growth in the long term is likely to be subdued due to many of the aforementioned pressures, the "coiled spring" pop we're likely to see in certain areas—inventories, production, profits, and even employment—could be quite a bit stronger than many anticipate.
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