As the year closes, I'm worried about a piece I wrote in early October: 'Nine Ways to Spot a US Recession'. I was 'looking at a broad range of possible culprits to see which, if any, are showing the sort of form which might be turn out to be a harbinger of a US recession in 2020. I have identified nine different contenders, and tracked how they behaved in the run-up to the last two US recessions (in the Millennial recession of 2000/01 , and in the GFC recession 2008/09).
'Spoiler alert: none are flashing red, or even amber, yet.'
That just doesn't feel right, does it? Particularly given that the plunge in stockmarket values has been accompanied both by a genuinely pernicious flattening of the US yield curve involving both the capital risk premium and TIPS rates, and by a really sharp collapse in the US shocks & surprises index over the last two months:
I have revisited those signals, and though they aren't absolutely conclusive, most remain at worst cyclically neutral, and would more usually be thought pro-cyclically positive.
Even so, that conclusion still doesn't 'feel right'.
It is possible that I am looking for the wrong thing. Generally, recessions happen when, and because, disequilibria in economic and financial behaviour have emerged which remain unaddressed, or even unacknowledged, before being corrected by the recession. Most commonly, the disequilibria have been in prices (ie, inflationary boom followed by bust); bank leverage (credit booms and busts) and associated asset bubbles (usually real estate); labour markets (tight labour markets generating wage rises substantially higher than productivity gains can justify); inventory cycles; and, for smaller economies, excesses associated with capital flows exaggerated by mistaken fx policies.
I am going to suggest a further possible disequilibrium which might instigate a recession. I do so rather nervously because it doesn't feature in popular discussions of business cycles, and, so far as I know, has little direct academic tradition to support it. Indeed, it could be misunderstood as flirting with breaching Says Law (any economic theory which demands a breach of Says Law should be treated with great suspicion). Set against that, it is intuitively attractive and measures a phenomenon which is widely recognized. Moreover, history suggests that whilst it is neither necessary nor sufficient by itself to trigger a recession, it has more often than not been seen loitering in the close vicinity when the crime is committed. It is, in other words, a suitable subject for investigation.
The signal I am watching is the fluctuating relationship between profits and wages. At some level of description it must be true that there is a relationship between how much profit companies can make and the amount of money they pay their employees. If so, then when the balance between the two reaches a local extreme, it is likely to beckon a recession.
In inflationary times, this is easily understood: when labour markets become extremely tight (for whatever reason, crucially including the incentives embedded in the economy's political structure) and wages rise, a combination of rising inflation and declining profits can undermine return on capital, investment spending, with obvious cyclical consequences. The crucial signal, in this regime, is when wages peak relative to profits.
In disinflationary times, the situation is less easy to understand and spot for at least two reasons. First, since the crucial signal we need to watch is the when profits are peaking relative to wages, by definition it occurs at a time when profits are booming. Second, whereas the inflationary impact of sharply rising wages is obvious and invites a monetary tightening response from central banks; the disinflationary opposite shows itself as an otherwise inexplicable inanition of demand, which can at least initially be offset precisely by increased consumer leverage, which delays the onset of recession and disguises its underlying motivation. But notice this: if consumer leverage is used to delay or offset the imbalance, the result would be a build-up of consumer debt which over time will tend to tighten the relationship. Leverage initially disguises the pauperisation of the middle class, but eventually confirms it.
And there is a third factor: no one watches it.
So let's take a look: the chart above (so good I've run it twice) shows, as a % of GDP, wages & salaries minus profits from 1929 to Sept 2018. Two notes: wages and salaries is not the same as 'compensation', since 'compensation includes a range of mandatory 'payments' which are cannot, in fact, go towards discretionary spending. Back in 1929, the gap between the two was negligible; but rose relentlessly until it peaked at 10.8% of GDP in the early 1990s. Since then it has stabilized, and currently stands at 10% of GDP. Profits, meanwhile, is broadly defined to include corporate profits, proprietors' income and rental income. from 1929 to 3Q2018.
What is immediately apparent is that there are a couple of inflection points.
Between 1929 to the late 1940s the tendency was for the portion of wages/salaries to decline relative to profits - this was the essentially the deflation of the 1930s.
In the post-war period up to around 1980 (as one might suspect) wages/salaries tend to rise relative to profits - these were generally inflationary years.
Finally, after 1980s, the general tendency has been for wages/salaries to fall relative to profits - our time has been basically disinflationary tending towards actual deflation.
And here's how these inflection points were associated with the onset of recessions:
Peak of Wages to Profits
1945 - Recession Feb - Oct 1945
1953 - Recession July 52 to Oct 54
1960 - Recession April 60 to Feb 61
1970 - Recession Dec 69 to Nov 70
1974 - Recession Nov 74 to March 75
1980 - Recession Jan - July 1980, and July 81 to Nov 82
For the disinflationary years post-1980, the relationship changes, and the ability to use monetary and credit policy to delay or stave off recession makes it less obvious. Nevertheless, some sort of relationship survives.
Peak of Profits to Wages
1985 - Recession July 1990 to March 91
1997 - Recession March 2001 to Nov 2001
2007 - Recession Dec 2007 to March 2009
2014 - Industrial 'mini-recession' 2015 to mid-2016
What is clear is that since 2010:
the ratio of wages to profits has fallen to previously unknown lows, and
there has been no significant recovery accompanying the pickup in economic activity and
it appears that there has been a further modest decline in 2018.
If we are looking for a disequilibrium which gets its resolution through a recession, then perhaps this is it. Perhaps the slow-acting pauperisation of the middle class generates a profits recession by sheer financial inanition.
If this is the fundamental disequilibrium which breeds danger for the economic cycle, then we need to look closely at trends specifically in movements in financial stress of the household sector (ie, in terms of servicing current debts), and the availability of further credit.
In the 'Nine Ways to Spot a US Recession' piece I presented a ratio which combines two elements of observable financial stress: changes in interest payments relative to disposable income, and changes in the savings/disposable income. Back in the original piece I wrote: 'This index flashed red in both recessions: prior to the Millennial recession, this index showed a sustained leap in 1Q99 which was maintained until 4Q01; prior to the GFC recession the index jumped sharply in 1Q05, with no let-up until 1Q08. This looks like a useful early indicator of household-sector driven recession: at present it is not signalling recession in the short to medium term.'
Revisiting that ratio with data up to November 2018 shows us that by end-2018 this stress ratio had risen to its highest since early 2010.
As for household's access to credit, Fed data shows growth in bank's lending to consumer credit and residential real estate slowed to 2.7% yoy in November, and that underlying momentum was running 0.2SDs below 5yr seasonalized trends. This is not encouraging, but neither is it necessarily anything more than a sub-cyclical slowdown which can be expected to right itself in 2019 (to growth of around 3.5%).
More worrying is the tightening showing up in the little-watched credit union sector. Credit unions are an increasingly important vehicle for household financing: in the year to September, credit unions' loan books rose $89.2bn, whilst banks consumer and mortgage book rose $135bn. In other words, credit union loans were approximately two-thirds the size of bank loans to the household sector. The problem is that whilst credit union loan growth is still robust (up 9.5% yoy in 3Q, but slowing), deposit growth has slowed to 5% only, and the sector's loan/deposit ratio has risen to 85%, up from 81% in 3Q17, and an average of 74% since 2010. In other words, this source of household credit is (finally) running out of steam.
Conclusion: By now, it is possible sketch the outline of forces which could produce a US recession:
1. Wages growing at a pace insufficient to support continued profits growth;
2. A slow accumulation of household financial stress resulting from years of 1.
3. The exhaustion of financing ability from the credit union sector, ultimately the result of slowing deposit growth (see 1. and 2.)
It doesn’t make me ‘feel good’, but it does feel realistic.