January 10, 2012
The Great Debate About Recession Risk Rolls On
The economy appears to be on the mend, but the great debate about recession risk in 2012 is in no danger of fading. The labor market may be reviving, but that’s not enough—at least not yet—to convince some analysts that the danger has passed.
Let’s start with the Economic Cycle Research Institute, which bills itself as “the world's leading authority on business cycles.” The firm continues to stand by its late-September recession forecast, There’s a robust discussion about whether a dark outlook for the U.S. economy is still warranted in the wake of what economist James Hamilton calls a “favorable turn” in the recent update of leading indicators, albeit with some considerable caveats, he adds.
In any case, ECRI’s recession call is at odds with the consensus forecast these days. Leading the charge of the optimists is the Conference Board’s Leading Economic Index, which continues to signal expansion. “November’s increase in the LEI for the U.S. was widespread among the leading indicators and continues to suggest that the risk of an economic downturn in the near term has receded,” says Ataman Ozyildirim, an economist at the consultancy. Dwaine van Vuuren of PowerStocks Investment Research also offers an “opposing view” of the recession-is-fate forecast based on analysis of nine coincident and leading economic benchmarks.
Such optimism contrasts sharply with recent calls by others that a new recession this year is destiny. Last month, for instance, Van Hoisington of the fixed-income manager Hoisington Investment Management told Barron’s:
We are going to enter another recession next year, when we haven't really fully recovered from the previous one. We think we are in what Niall Ferguson, a Harvard historian, recently termed a slight depression. This isn't a normal business cycle. So long as there is downward pressure on prices, bond yields will either continue to go down or bottom out around the real rate, assuming that the inflation rate stops at zero. We aren't there yet, obviously, but are headed in that direction. That's why we've had a bull market and why it will continue until such time as inflationary expectations start to rise.
John Hussman of Hussman Funds weighs in by warning that the recent optimism arising from the economic news leans too heavily on anecdotal evaluations:
I can understand this view in the sense that the data points are correct - economic data has come in above expectations for several weeks, the Chinese, European and U.S. PMI's have all ticked higher in the latest reports, new unemployment claims have declined, and December payrolls grew by 200,000.
Unfortunately, in all of these cases, the inference being drawn from these data points is not supported by the data set of economic evidence that is presently available, which is instead historically associated with a much more difficult outcome. Specifically, the data set continues to imply a nearly immediate global economic downturn. Lakshman Achuthan of the Economic Cycle Research Institute (ECRI) has noted if the U.S. gets through the second quarter of this year without falling into recession, "then, we're wrong." Frankly, I'll be surprised if the U.S. gets through the first quarter without a downturn.
That's a strong forecast and given Hussman's background and record no one should dismiss it lightly. But if the recession forecasts are indeed accurate, we should start to see some clear signals of deterioration in the labor market, which is especially critical at this stage for the economy's health, or lack thereof.
It's true that employment indicators aren't leading indicators per se, with the exception of weekly initial jobless claims, which Hussman notes have "very slight short-leading usefulness." Indeed, initial claims have a history of rising in advance of, or during the early stages of each of the last seven recessions, as the chart below shows. But the trend in new claims is down for this series since last spring, and the momentum appears to be stronger over the past month or so. There's always a danger of reading too much into any one series, of course. But if there's a recession brewing surely it'll start showing up relatively soon in new claims. In other words, initial claims are on my short list as the statistical equivalent of the canary in the cyclical coalmine. In particular, there's likely to be a general change in direction in new claims if economic conditions take a turn for the worse in the weeks and months ahead.
In that case I also expect to see the stock market's annual return dip into negative territory if the forces of recession grow stronger. For the moment, the S&P 500 remains moderately higher vs. this time last year. Although the stock market has been known to see recessions that never materialize, new contractions are almost always accompanied by persistent and deep year-over-year declines in the S&P. The market flirted with some annual red ink briefly in recent months, but the flirtation evaporated quickly. Like many of us, stocks seem to be on the fence for deciding what comes next. As such, a sharp selloff at this stage would be rather ominous.
As for the conflicting signals between the Conference Board's leading indicator and the likes of ECRI and Hussman, some of the difference—perhaps all of it—may be related to the declining relevance of monetary factors as a reliable guide for the future path of the economy. Indeed, the Conference Board is scheduled to adjust the design of its leading indicator at the end of this month. For the details, see the research paper: "Using a Leading Credit Index to Predict Turning Points in the U.S. Business Cycle."
Meantime, don't forget about the risk of a foreign shock--Europe in particular. The crisis on the Continent is still playing out and, well, predicting is still hard, especially about the future.
Posted by jp at January 10, 2012 6:28 AM