Yesterday, were asked by a very sharp, longtime client of Hedgeye if we still had conviction in our #USRecession theme after the recent sharp rally in risk assets, which came amid a number of positive surprises across various economic data throughout the YTD. For those economic cycle junkies among you, we expand upon our answer to his question in great detail below:
Yes, we still do believe the U.S. economy may experience a shallow recession over the intermediate term and that it has the highest likelihood of commencing in/around 3Q16. Specifically, our top-three U.S. recession indicators (i.e. the Jobless Claims, Consumer Confidence and Corporate Profit cycles) are all continuing to progress according to our previously defined expectations:
Additionally, the domestic #CreditCycle continues to deteriorate in kind with the trends we identified at the onset of the year:
That being said, however, the meaningful retreat in HY OAS is new and noteworthy, so we must be cognizant of the extent to which the market is pricing in all of the above fundamental signals as head fakes. On that note, HY spreads would have to get back below their long-term historical mean of ~500bps on an index basis for us to consider that to be true. Right now, they’ve currently retreated back to just above 600bps, which implies a considerable amount of tightening from here for the credit markets to shake us off our recession view.
Commensurate with this decline in spreads, Standard & Poor’s notes that the U.S. distressed ratio – a gauge of the proportion of speculative-grade bonds with a spread over Treasuries of more than 10 percentage points – had fallen to 24.8% as of March 15 from 33.9% at the end of February. That’s the first bi-weekly decline since last May. Per S&P via the Financial Times, there were 279 borrowers with bonds trading in the distressed range, affecting total debt of $214B in March, compared with 353 issuers affecting $327B in debt the month prior.
Time will tell whether or not the aforementioned sequential improvement is a short-term, reflation-based market head fake. Credit spreads can widen just as quickly as they’ve tightened since mid-February…
But above all else, as we’ve stressed repeatedly throughout the year, a U.S. recession is actually the least pressing of what we consider to be the biggest risks to asset markets. Those risks are as follows (in order):
- Corporate profit recession (ongoing)
- Deteriorating credit cycle (ongoing)
- #BigBangTheory – i.e. market participants broadly losing faith in central bank Policies To Reflate (TBD domestically)
- A technical recession in the U.S. (progressing according to plan, but likely to be shallow like the 2000-02 C&I lending led downturn)
Obviously risks #1 and #2 are intricately linked, as is #3 – specifically because that would be proof of the Fed losing its perceived ability to counteract microeconomic gravity with shell games of ZIRP and debt-financed buybacks.
We discuss risk #4 in great detail at the conclusion of our 2/3 note titled, “Ex-Energy?”:
“And even if the U.S. economy avoids recording a technical recession, we could just have an 2000-02-style corporate deleveraging cycle that drags down equity market cap alongside it. After all, it's EPS that matters most to stocks, not GDP. Recall that the 2001 downturn was the shallowest recession in U.S. history; that didn't preclude the stock market (SPX) from getting cut in half [DESPITE the Fed cutting rates by a cumulative -525bps during the decline].”
Like Rome, economic contractions aren’t built in a day. Domestic high-frequency economic data needs to continue decelerating from here in order to become equally as reflexive on the downside as it is during an expansion.
And much like with bear markets that are historically rife with massive short squeezes to lower-highs, there will be “green shoots” (i.e. sequential upticks) across several key data sets that lead perma-bulls to believe the bottom is in with respect to growth. The TREND remains your friend on that front, however.
As the following chart highlights, every major category of high-frequency economic growth data continue to decelerate on a TRENDing basis in spite of whatever recently released, sequentially positive data points the bulls want to anchor on; meanwhile, every major category of high-frequency inflation data is accelerating on a trending basis. This confluence is a double-negative for TREND real GDP growth expectations for both investors (think: flows) and corporations (think: capex) alike.
Sure, select indicators such as last week’s Retail Sales report or today’s Service and Composite PMI readings have ticked up in the February/March timeframe, but does cheerleading that on A) account for the fact that they are all still making a series of lower-highs on a trending basis; or B) account for the sharp deterioration across the housing sector (CLICK HERE and HERE for more details) or nascent cracks across the commercial real estate sector?
Of course they don’t. Anyone who thinks they do likely lacks a repeatable process for contextualizing macro data, which we dissected at length in our recent Early Look titled, “Bull Market Marketing”.
It does, however, call attention to the analytically weak nature of the nascent bull thesis for U.S. stocks and credit. As the following table highlights, there’s a lot of green (i.e. accelerating) in the “Sequential Data” column to the right, while the “Trending” and “Quarterly Average” data columns are as red (i.e. decelerating) as ever:
Let’s ignore the ongoing, trending slowdown in Industrial Production growth in order to play devil’s advocate for a second. Can the nascent recovery in domestic manufacturing activity get back to healthy enough levels in time to offset ongoing degradation in the growth rate(s) of consumer spending?
To answer the question, base effects support some version of the soft bigotry of low expectations that is “muddle-along nirvana” for a quarter (i.e. Q1) while compares for both “C” and “I” are easier on a sequential basis – but not for much longer than that:
As an aside, base effects for Real PCE in the four quarters ended in 3Q16 remain as tough as anything the U.S. consumer has experienced since the four quarters ended in 3Q08. Recall that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08. As such, we continue to anticipate real consumption growth as having downside risk to +1% YoY in a moderate scenario. As one very astute client accurately pointed out in a recent meeting:
“While that may not produce an actual technical recession, it may certainly feel like one – especially relative to consensus expectations of a “resilient” U.S. consumer.”
As Keith remarked during a client meeting on Tuesday, it’s actually easier to make the bearish economic cycle call today than it was [at the top] in early July, as most economic data series weren’t broadly slowing then. Now we can simply sit back and watch market prices [hopefully] continue to come our way on a trending basis. Sounds simple enough.
And by the way, #Quad4 starts next Friday…