April 10, 2006
A CONTRARIAN SPEAKS
The economy's on a roll, or so we're told. The latest smoking gun is Friday's employment report. Even the bond market appears convinced that there's more growth percolating than previously realized. In turn, the bubbling labor market inspires fears of higher inflation among traders of debt. Reflecting the sentiment, the yield on the 10-year Treasury jumped sharply on Friday, closing at 4.96%. The last time the 10-year explored such yield heights, in the summer of 2002, Greenspan's Fed was losing sleep over deflation anxiety.
The opposite risk now threatens. That, at least, is the new new message from the fixed-income set. But while some say it's about time the bond market woke up, a few lone voices in the financial wilderness warn of something else, namely, the possibility that a slowdown may be lurking just over the horizon, and so inflation may not be lurking in the shadows after all.
In the interest of exploring how the other half thinks, we called one of the leading analysts who's braving the headwinds of contrarianism at this juncture: Lakshman Achuthan, managing director of the Economic Cycle Research Institute, an independent research shop in New York. ECRI's forte is one of applying a disciplined, quantitative analysis to the economic data in search of identifying turning points in cycles. On that score, this respected shop points to two warning signs at this moment, Achuthan tells The Capital Spectator. Housing and the global industrial sector may surprise with weakness, relative to the crowd's current expectations, he advises. What's more, Achuthan says that ECRI's widely monitored FIG, or future inflation gauge, is counseling that inflationary pressures will soon wane.
Given the bullish economic news of late, some may be inclined to dismiss such forecasts. But ECRI is not just another forecasting shop. Indeed, it has an impressive record in calling turning points in the economy, thanks largely to a methodology that's one of the more intelligently designed systems for discerning the future. For details on the methodology, which leverages decades of cycle-oriented macroeconomic research, ECRI's book Beating the Business Cycle will satisfy. For a quicker fix on ECRI's current take on what may lie ahead, here's an excerpt from our Friday conversation with Achuthan.
Q: We keep reading that the economy's doing fine. The bond market certainly seems to be throwing in the towel after seeing the strength in the March employment report. And that follows other numbers in previous weeks suggesting that the economy has a head of steam.
A: That's an ok view near term. I wouldn't argue with anything you just said for the next month or two or three. But once we get into second half of 2006, that logic falls apart.
Q: What are we missing?
A: For starters, Friday's employment report is a coincident indicator, not a leading indicator. It's really a reflection of what was going on in the first quarter. But, yes, it's true: the economy is relatively healthy.
Mind you, a year ago, the majority of professional forecasters were predicting a sharp downturn. So they were wrong for 2005. Part of the lesson from the 2005 experience: this economy can live through anything. So, the safest bet is that it'll do well.
And that view's ok in the first half of 2006. But our indicators aren't based on what happened in the past; rather, ours are based on what the leading indicators saying today. And on that score, we have a mixed bag.
Our leading indicators were forecasting strength in the early part of this year. But when we look into the second half of 2006, there are two downturns that have shown up pretty clearly in the leading indicators. We think these two downturns are going to impact the overall economy. One is in housing, and the other is in the global industrial sector, which very few people are paying attention to.
Q: Let's talk about each one, starting with housing.
A: Our leading housing indicators turned down at the end of 2005. After four years of being bullish on housing, we finally said things are turning down. And we have seen both new and existing homes numbers coming in on the downside. That's going to pose some problems for consumer spending.
Q: How so?
A: Part of the reason why the economy was so strong in 2005 was because the wealth effect from housing offset, and then some, the lack of wage growth and the higher prices paid for energy. It's like the consumer's been saying, "Oh, damn, my salary increase doesn't cover the rise in energy prices, but since my house is now worth twenty grand more, I can dip into my savings and continue living large." That's basically been the equation.
Q: So, the consumer's going to sharply curtail his spending when he finds out his home's value is shooting up any more.
A: It's not that I'm saying that consumer spending drops. Rather, it's that the rate of spending growth eases.
Q: Even so, slower growth in spending could affect the economy, thanks to the fact that consumer spending represents the lion's share of GDP.
A: Correct. But if you distill all the investment bank letters and policy maker statements into one theme, then the current bet is that any housing-related consumer-spending slowdown will be mild, especially because we have reasonable jobs growth.
Q: Ah, it's that pesky American optimism again.
A: I'm as hopeful as the next guy. But our leading home price index, which is now down around an 11-year low, hasn't turned up yet. This index looks out three quarters. So, I don't think we're going to get a reprieve here. And perhaps things deteriorate further. Minimally, the positive is gone, and that weighs on the ability of consumers to grow their spending. Unless, they get great, great salary increases.
Q: Maybe a few corporate titans reading this will respond accordingly. Meanwhile, we could pray for a collapse in oil prices, which might convince consumers to keep going to the malls.
A: That hasn't happened yet. Energy prices are still up there. There are other types of inflation going on too. So, it's not clear that whatever wage growth there is--Friday's report put it at a 0.2% growth for March--it's not enough to offset the lack of growth in home prices.
That in and of itself isn't something we're suggesting is anywhere near recessionary. Nonetheless, an interesting factoid is that five of every six dollars spent in the economy are spent by a homeowner. That's a lot of dollars spent that can be impacted by the housing market.
Q: The other warning sign you mentioned is the industrial sector on a global scale.
A: Yes, and this downturn is completely off most radar screens. The industrial sector of the global economy has a cycle, and the reason it has a cycle is that a component built here goes into something built in Europe, which goes into something else built in Japan. We're all linked very closely. Any product can be sourced from all over the place. The factory floor is increasingly a global factory floor. And we see a cycle there. We have indicators on that--very long leading indicators. These are the ones that are looking out a year, and they've turned down quite clearly.
Q: How soon will the blowback from this downturn hit?
A: We don't have a great deal of precision on this, so I can't say the peak in the global industrial cycle will be, say, in June. But I think it's fair to say that we're going to have a peak in the global industrial cycle before the end of the year, probably in the second half.
What gets interesting here is the scenario is where a global industrial slowdown is lining up on some level with a pullback on consumer spending.
Q: What about the corporate sector coming to the rescue? Many analysts point out that corporations are flush with cash--cash that'll some predict will soon be spent on such things as investing in technology and hiring more workers. If so, won't an acceleration in corporate spending pick up any slack from a slower pace in consumer spending?
A: I'm not sure that corporations would do that. First, it's not rational for a business manager to spend if there's a downturn. Also, if there's a global industrial slowdown going on, some of the bigger ticket items, the capital-intensive items will probable be less urgently needed.
Q: Items such as?
A: Machinery, machine tools, durable-production equipment.
Q: What are some of the things you're looking at when you speak of the global industrial sector?
A: It's very esoteric. This is a slice from our long leading index, which has all kinds of components. The global industrial index is focused on many of the financially related components of our long leading index.
Q: What kind of financially related components?
A: Different kinds of liquidity, essentially. Profits, for example. Overall, it's all of the money-related stuff that drives the economy. This slice of the long leading index we take from each of our long leading indices for 18 major economies, including the G7 and India and China. We're taking that slice of the long leading indicators from all of those economies and that's a good leading indicator of the global industrial cycle. And that's turned down convincingly.
Q: Specifically, that downturn is saying….
A: It's saying that a cyclical downturn in the growth of global industrial activity is likely to appear in the second half of this year. If that's happening alongside a softening in consumer spending, the odds are that there could be a challenge to the layman's assumption about a strong economy.
Q: Yours is a contrarian view at the moment. The bond market, for instance, begs to differ, courtesy of the sharp rise in the 10-year yield to heights not seen since 2002.
A: Well, there's never been a time when the leading indicators have turned and everybody's says, "We totally agree." That just doesn't happen. It's the nature of turning points.
I'm not all bad news, by the way. But my good news is also contrarian.
Q: At least you're consistent. Lay it on us.
A: Our future inflation gauge fell again. Our leading indicator that's specific to the inflation cycle dropped again. Essentially, it's on the verge of signaling a peak in the inflation cycle two or three quarters ahead.
Q: Why's it predicting a softer, gentler inflation?
A: There are a handful of drivers of the economic cycle: money supply, housing, import prices, sensitive industrial materials, the dollar, the labor market, and so on. A lot of different things influence the direction of inflation. None of them on their own will tell you that much. But when they collectively start to shift it's important to pay attention.
Our future inflation gauge peaked in October 2005, and has fallen for four of the five months since then, including March. Granted, the labor market is bucking the trend by still holding the inflation index up a bit. In spite of that, our inflation gauge is close to tipping down. That would be good news if it begins to slip because it would start to give the Fed some options, if they needed them.
Q: In other words, the option of halting the current round of interest rate hikes, and perhaps even lowering rates.
A: I'm sure the Fed will be very eloquent in the way it explains it. They'll say it in a way that slowly allows the market to get the sense that they're not so worried. Of course, that would have a big impact.
Q: Sounds like you're questioning the logic of the latest rise in long bond yields.
A: No, no, no. I just think it's late in coming.
Q: A rose by any other name. But let's move on…sort of. What do you make of the fading of the inverted yield curve and the return of an upward sloping yield curve, just barely, courtesy of the latest jump in long rates?
A: We argued that it was not a great argument [that an inverted yield curve was reliable predictor of a recession] when it first started happening and everyone was worried. It's a faulty indicator. We've never used it. It failed in the 1990s, it failed a bunch of times in the 1950s. It gives false alarms and it misses turns.
By the way, I'm talking of the three three-month T-bill v. the 10-year Treasury. Everybody studies the three-month and 10-year curve. That's the one that Nobel Laureates have looked at. If you want to data fit it and make it fit into your current view, then you make it the 2-year and 10-year, and then it becomes easier. The two-year and 10-year curve is more convenient, if you want to be more bearish. But there's no good reason to do that.
It's not that the yield curve doesn't have interesting signals. It is somewhat useful in forecasting slowdowns and speedups, but it's not good at forecasting recessions.
© 2006 by James Picerno. All rights reserved.
Posted by jp at April 10, 2006 7:45 AM
Amazing how accurate their indicators were.
Posted by: Steve at February 19, 2007 12:35 PM
Fantastic. To be a fly on the wall at that company! Would love to get a sense of the line item detail of some of their global leading indicators. Exactly who is grouped how, and how much is that group weighted? I'm afraid to click on the link to their site and find out how many pennies they earn for their thoughts.
Posted by: jf at April 14, 2006 3:14 AM