Every quarter I write a report for UFM Market Trends of Universidad Francisco Marroquín (Guatemala), backed by the John Templeton Foundation, about the likelihood of a recession in the US. This week, we published our latest report on the US economy which included several surprising statistics (you know, the type of statistics you cannot read about anywhere else). Because, at first glance, everything seems to be going just fine: the economy is growing, the Fed is raising interest rates (allegedly because, according to the experts, everything is going remarkably well) and inflation remains subdued. But something is happening below the surface that cannot be directly observed from the headline numbers. Let me give you five charts which clearly show that beneath the surface things are not as pretty as they appear.
The US gross domestic product (GDP) had a tough beginning of the year. In the first quarter, an initial estimate showed that the US economy grew by 1.2%. More recently, this growth figure was revised upward to 1.4% in a second release. Yet, whatever way you look at it, this is a very weak growth number for an economy that, as some seem to think, is completely flourishing.
But the first quarter was not really an exception. In the first quarter of 2016, for instance, year-on-year growth equaled just 0.8%. From the fourth quarter of 2015 to the end of the second quarter of 2016, the US economy suffered from weak growth as well. Average growth in these three quarters was a bit higher than one percent.
Why was economic growth in the US so low in the first quarter?
While many factors contributed to weak growth in the first quarter (as you can read for yourself if you download our latest report here), one factor stands out: businesses have reduced their investments in new inventories.
If US companies would have invested as much in building inventories as they did in the fourth quarter of 2016, first quarter economic growth would have been 2.5%, not 1.4%.
What can we conclude from this? Either “corporate America” is committing a massive error that will be corrected in the next quarter, or concluded that the inventories they purchased at the end of 2016 currently fail to fetch demand.
It becomes even better: every single time US private inventories declined, we were in a recession. Also see the following chart:
Source: UFM Market Trends, Bureau of Economic Analysis (BEA), St Louis Fed
In sum, we are forewarned. Can we completely rule out a miraculous recovery in private inventories as for instance happened in 2015/16? Precisely then private inventories declined only to recover shortly thereafter. The answer to my question is, of course, a “no”: however, we should keep a close tab on what happens with private inventories in initial growth estimate for the second quarter.
Car sales in the US: they were never this high. Or, at least, until recently. Since the expansion in the car industry is beginning to suffer the consequences of declining sales. It should be no surprise that a bubble was created in the car industry: a bubble that, surprisingly, has many things in common with the subprime-mortgage crisis of 2008, in which lending standards were lowered and banks began to lend more, at longer maturities and to the wrong people.
That could become a thing of the past very soon. The bubble in the automotive industry might have burst: car sales, compared to a year earlier, decreased by almost 5%.
Not only that: car inventories are on the rise; unsold cars are accumulating. The last time that car inventories, relative to annual sales, were as high as today, was in 2008. In short: bad news. Car inventories are rising; car sales declining. The car industry is already beyond its peak.
Source: UFM Market Trends, Bureau of Economic Analysis (BEA)
The Fed published eight times a year the counterpart of our UFM Market Trends report, better known as the “Beige Book” (but which actually carries the title “Summary of Commentary on Current Economic Conditions”). In the latest release, the Fed came to the following conclusion, which happens to coincide with our own conclusion: “(…) [M]any Districts noted some softening in consumer spending, particularly in auto sales which declined in half of the Districts.”
Tough times have returned to the US car industry. And that means bad news for the broader US economy.
What does a simplified bank balance sheet look like in our present era? The answer to that question is not difficult to guess. On the right side, the liability side, we will mostly find demand deposits with a maturity of practically zero. On the left side, the asset side, we will mostly find long-term commercial and consumer credit (to a large degree residential mortgages with long maturities). In sum, historically speaking, maturity mismatches were never as big as they are today.
What did banks do in the past?
The answer is simple: banks held the very same demand deposit on the liability side. However, they invested the funds entrusted to them by their depositors to a large extent in very liquid commercial credit with short maturities. Granted, they also invested in government debt. But, in contrast to today, the majority of it was invested in government debt with maturities of less than a year.
In a boom phase of (artificial) economic expansion, banks increasingly mismatch maturities of assets and liabilities. They invest at ever longer maturities. But at a certain point, a systemic shortage of liquidity emerges. The first banks begin (Margin Call-style, a very entertaining movie featuring Kevin Spacey) to reduce their maturity mismatches drastically. They begin to cut long-term loans and investments and recover (partly) their illiquid asset-liability structure.
And that normally means a recession is around the corner.
Ironic, isn´t it? Banks that tell us that bad weather is heading our way by the maturity mismatches between assets and liabilities that they are willing to bear at any certain point. This is what happened with maturity mismatches over the past few years:
Source: UFM Market Trends
In 2008, our liquidity gap provided a clear warning: trouble ahead. The decrease in 2013 seems to be a “false positive,” but we should not forget that US GDP decreased 1.2% in the first quarter of 2014, something which has not happened ever since the 2008 crisis. As the NBR arbitrarily defines a recession as “two subsequent quarters of negative GDP growth,” we tend to miss these down quarters. The decrease in US GDP in Q1 2014 was followed by a miraculous recovery in 2015, until now.
Because now, in 2016, the floodgates seem to have opened: the five major US banks are scrambling for liquidity. And that, dear reader, is not a good sign. At least not for the US economy.
At a terrifying pace, I should have said. Far from exaggerating, this is actually what is going on: the US banking sector is lending less and less to businesses: generally a sign that a recession is near.
We are only a hair removed from a reduction in total outstanding commercial and industrial bank credit.
What was the last time that corporate credit growth was this low? We have to go back in time and to be precise back to 2008 to find the answer to this question. Commercial credit is cyclical and therefore a good indicator of where the economy is heading.
And that economic recovery the Fed is talking about? It does not exist. Banks are lending businesses at a slower pace, not a growing pace. Either businesses do not want to borrow, or they simply cannot borrow (because they are already too overleveraged). Whatever the case may be, slowing credit growth is a sign of weakness.
Source: UFM Market Trends, Board of Governors of the Federal Reserve
I have talked about this warning sign earlier in greater detail, but the yield curve spread does deserve a mention. And while perhaps a flattening yield curve does not imply that a recession is imminent (in the next six months), but certainly that a recession will be imminent if and when interest rates continue their current path. An inverted yield curve is, after all, the clearest sign that a recession has erupted.
Source: UFM Market Trends, St Louis Fed