Talk of a US recession is wildly overblown
Chief analyst Bo Bejstrup Christensen dismisses the prophets of doom.
Disappointing US economic data, manufacturing already in recession, market faith in further interest rate hikes from the US central bank (Fed) largely gone and equity markets struggling to find their footing after their worst start to a new year in a decade. Meanwhile, accusations are being hurled at the Fed – it has tightened too soon, they say. In short, concerns are growing and the ‘R’ word is back on the agenda. Is the US sliding into a new recession? Our response is a clear no!
Why are we even having this discussion?
Let’s make one thing clear right away, we can fully understand why people are worried. Industrial production is declining and manufacturing sector confidence is at levels where the overall economy has many times previously been in recession. On top of this comes a significant tightening of general financial conditions, including higher funding costs for corporate bond issuers, lower equity prices and – most important – a considerably stronger dollar. Finally, the emerging markets are struggling, which not only means lower export growth, but also a greater risk of financial turmoil. The list is long and a degree of concern is warranted.
No reason to panic
Nevertheless, our view is that these concerns are verging on panic – which is creating, regardless of the challenges, undue anxiety. Essentially, we see the current situation as being the result of a series of temporary, negative shocks to the US economy.
Topping the list is the strengthening of the dollar – up more than 20% in trade-weighted terms since its low in 2014 – which is hitting both export volumes and earnings in dollar terms. However, the dollar cannot carry on strengthening forever, and most importantly the pace of strengthening must ease at some point. While we still see lower oil prices as good for the US economy overall, certain sectors are being hit hard – but again, while we are not overly optimistic on oil prices, they cannot keep falling.
Nor are we particularly optimistic about China or the emerging markets, but growth rates in China have already been halved, led lower by a construction downturn, and both Brazil and Russia are currently in full-blown recession. Things will not change tomorrow, and China will not return to previous growth highs the day after, but there are nevertheless limits to how far growth can fall – for example in Brazil, where growth over the past year has been a disastrous minus 7.5%.
The negative shocks that have hit the US are thus temporary and essentially external – so their impact is most keenly felt by those sectors of the US economy that are heavily dependent on the rest of the world, which means manufacturing in particular.
Market swayed by the wrong figures
The financial markets are always hungry for information. What is the current state of the economy? Where is it heading? That is why all types of data and statistics get scrutinised in an attempt to ascertain what the future might bring. Herein lies a challenge, however, as statistics are by definition a snapshot of history, whereas the future is about who and what will create growth – and the winners of tomorrow may not yet even exist.
More data is released for the US manufacturing sector during an average month than for the service sector. In part this is due to the decades-long status of the US as an industrial economy, but also because asking a car manufacturer how many cars it has produced is a more straightforward question than asking a doctor how much value has been created at his hospital or clinic over the past month.
Industrial data exaggerates gloom
The manufacturing sector contributes more to the data stream than it does to the actual economy. For example, value creation in the manufacturing sector as a proportion of the total economy has been falling for decades to less than 15% at present, while just 10% of the labour force is currently employed in manufacturing. Nevertheless, up to 40% of the monthly data stream stems from industry. This is important to note, because the external shocks are hitting the industrial sector, while the service sector has performed surprisingly well – so far – and indeed has created many new jobs.
Even more important, however, is that growth in the broader economy comes from sources that are exceptionally difficult to measure. Research in 2010, for instance, documented that new, small companies are the driving factor behind job creation during an average year. Without these companies, employment would stagnate. However, small new companies are difficult to measure, both because they are not particularly visible and also because they did not exist yesterday.
That is why we always focus on the bank system and the housing market in any discussion of recession. Entrepreneurs and innovators cannot start up new companies or expand without a well-functioning bank system. The housing market, meanwhile, functions as the primary source of funding for many start-ups, which is why appreciating house prices and access to borrowing against real estate are key prerequisites for growth and job creation.
No bank crisis – therefore no recession
Our greatest concern is therefore always whether the bank system is facing a crisis. At this point, we estimate the banks will lose on energy-related lending and on associated sectors. However, since the 2008/2009 crisis, a great deal of work has been done to build a better and more stable bank system that will not be as easily overwhelmed as before. Increased capital requirements, improved liquidity and greater transparency mean the bank system will be able to absorb the forthcoming losses without unduly tightening credit in other areas – something underlined this week by the latest assessment of bank lending practices, the senior loan officer survey.
The survey shows that just a handful of banks have tightened credit conditions for companies, but more importantly the banks are still easing credit conditions for consumers generally and for home loans in particular. The latter is important, as the biggest obstacle to a normalisation of residential construction activity is excessively tight credit terms. We estimate that residential construction will increase 20-40% over the coming three years and thus help support the economy at a time when the industrial sector is facing difficulties.
We also view talk that the Fed has erred as misplaced. Put another way, if the Fed had not started the normalisation process, the financial markets and the banks would perhaps still be falling over each other to make capital and funding available to, for example, the energy sector. Note, too, that Fed chair Janet Yellen herself stated in summer 2014 that lending to companies with low credit ratings had perhaps been overly brisk.
Picture will clear within six months
We should also think about how strong the US economy would have been if the dollar had not firmed as a direct consequence of the nascent normalisation of monetary policy. Unemployment in the US would be even lower and wage inflation considerably higher – potentially forcing the Fed to tighten more quickly, which would likely be a difficult process.
Instead, the Fed is trying to navigate safely through troubled waters and aiming for a set of financial conditions that creates the growth and thus the inflation that will allow the Fed to fulfil its mandate of full employment and inflation at 2%. The markets have come through a significant round of tightening by the Fed, who can therefore wait a little. Precisely because the Fed started in good time it can afford to move forward gradually and thus tailor its rate hikes to developments in the financial markets.
Right now the markets are panicking – which we see as an overreaction, even if partially understandable. The negative fallout from lower oil prices, in particular, will become clearer within the next six months. At that point the bank system will still be functioning and the housing market will be continuing to improve. So the recession is cancelled and the Fed can continue to raise interest rates – gradually and calmly. And we look forward to that!