The ECRI Weekly Leading Index (WLI), a measure of future U.S. economic growth stands at 120.6 unchanged from a week ago. We first began actively talking about the WLI in April as a predictive indicator for either sustained recovery or a double dip recession. However, the gauge most of us are looking for is the annualized year-on-year change. Reuters says:
The index was last below 120.6 in the week of July 24, 2009, when it measured 120.3, according to ECRI. The index’s annualized growth rate fell to minus 9.8 per cent from minus 9.1 per cent the previous week, originally reported as minus 8.3 per cent.
The index is saying that growth is slowing quite rapidly. But there is no imminent recession on the horizon. However, what happens by the end of the year or in 2011 is another story. David Rosenberg mentioned in June that a minus 10 reading is a recession lock for the entire 42 years of ECRI data available. The minus 9.8 reading is about as close to a double dip warning as you are going to get from the WLI. These numbers are telling us that the manufacturing and inventory led recovery is so stalled that a double dip recession is likely within six months.
And to wit, yesterday we saw some fairly abysmal numbers from the Philly Fed and Empire State manufacturing surveys. Here are the numbers from the Empire State survey which is for the state of New York. Zero is the demarcation point dividing contraction and expansion.
The Empire State Manufacturing Survey indicates that while conditions for New York manufacturers continued to improve in July, the pace of growth in business activity slowed substantially over the month. The general business conditions index remained positive but fell 15 points, to 5.1.The new orders and shipments indexes were also positive but lower than last month’s levels. Employment indexes dipped as well, with the average workweek index falling below zero for the first time this year.
The Philadelphia Federal Reserve Bank’s business activity index also dropped from 8.0 in June to 5.1 this month. Again, any reading above zero represents expansion.
I have recently given a double dip fairly high odds i.e. 50-60%. This is not the 100% you get from the WLI but the WLI is just one tool. Nevertheless, the punderati are seriously playing down how much the US economy is slowing. Even bears like Stephen Roach only say 40%. I believe Nouriel Roubini is at 20%. And if you listen to the financial news, you get the sense there is almost no chance of a double dip. Why are credit, manufacturing indices, and consumer prices dropping if that’s the case. On what are analysts predicating their rosy view that the double dip is an outlier?
Here’s how I called it in March:
I expect the following to occur:
- Public pressure to withdraw monetary and fiscal stimulus will work and stimulus will be reduced quicker than many anticipate – beginning sometime in early 2010. The Fed has already said it will stop buying mortgages in March and the Obama Administration is now focused on deficit reduction as evidenced by the paltry jobs bill just passed.
- The fiscally weak state and local governments will therefore receive little aid from the federal government. This will result in budget cuts, tax increases, and layoffs by the end of Q2 2010.
- At the same time, the inventory cycle’s impact on GDP growth will attenuate. By the second half of 2010, inventories will not add considerably to GDP.
- Meanwhile, the reduction of Fed support for the mortgage market will reveal weaknesses there. Mortgage rates may increase, decreasing housing demand.
- Employment will be weak in this environment, leading to another spate of defaults and foreclosures.
- The foreclosures and weak housing demand will pressure house prices and weaken lender balance sheets, especially because of second-lien exposure. This will in turn reduce credit growth.
I expect the weakness in GDP from this scenario to be evident sometime in the second half of 2010. The only thing in this sequence of events which is supportive of asset prices, credit and GDP growth is that the government will still be manipulating mortgages even after the Federal Reserve stops buying MBS paper. Fannie and Freddie are the only game in town in securitized mortgages, buying the vast majority of paper.
As they are now government entities with an unlimited backstop from the U.S. Treasury for losses, the nationalization of America’s mortgage problem I had foreseen can begin. I understand Fannie and Freddie have been shifting their excess funds from the term Fed Funds markets to Treasury Bills. This may be because of a regulatory mandate to achieve more liquidity and may help explain why the Fed Funds rate is creeping up to the upper bound of the Fed’s policy range. Whether this liquidity policy is in anticipation of the need to use Fannie and Freddie’s balance sheet is unknown. In any event, if Fannie and Freddie are used to forestall weakness in the mortgage market, they will eventually suffer huge losses.
Will this be enough to prevent a double dip? I think not, but you can bet the Obama Administration will try.
There is no stimulus coming either on the monetary or fiscal side. Moreover, it remains to be seen whether the Bush tax cuts for the wealthy will be preserved. Even Sir Alan Greenspan has come out against their preservation. My sense is that this recovery will have to be self-sustaining to continue because there will be no extraordinary measures coming from government to aid it. I doubt that it is self-sustaining. But the low mortgage rates are helpful. Let’s hope incipient signs of employment growth gather steam.
If employment does not gather steam, a double dip is likely. Where do see equity, bond and house prices in such a scenario? I see bond prices higher, equities and housing lower.