To­wards a US re­ces­sion?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

Last week’s Fed­eral Re­serve min­utes showed pol­i­cy­mak­ers to be ner­vous about the out­look for US growth, and so more likely to ex­tend the zero in­ter­est rate pol­icy. Many would, of course, ar­gue that this is to con­fuse cause and ef­fect, as US eco­nomic weak­ness in fact stems di­rectly from ZIRP. But what con­cerns us to­day is less whether a quar­ter point rise in pol­icy rates hap­pens next month or in Septem­ber, but if the US is in fact slid­ing into a far more se­ri­ous down­turn.

At the end of last year, while ques­tion­ing the growth prospects of the de­vel­oped economies, we did not ex­pect the US to be at the fore­front of such an event; now we’re won­der­ing if it is the main in­sti­ga­tor. This is, of course, a hereti­cal view that will get lit­tle trac­tion among the high priests of Key­ne­sian or­tho­doxy, although given the fore­cast­ing at­tempts of the Fed in re­cent years, you might think some hu­mil­ity was war­ranted. It also contrasts with the fairly cheery out­look pre­sented last Wed­nes­day our an­a­lysts on the out­look for US wage growth, and its im­part on eq­ui­ties.

Why do we fear such an oc­cur­rence? The ar­gu­ment in re­cent years has been that Fed pol­icy has helped in­flate the price of ex­ist­ing as­sets in pref­er­ence to build­ing new as­sets. Such a pol­icy could work so long as com­pa­nies re­tained pos­i­tive cash flows, al­low­ing them to keep buy­ing back their shares. Prob­lems were al­ways go­ing to emerge at the point that such ac­tiv­ity was funded not by cash flows, but by new bor­row­ing. At such a junc­ture, firms could move into a neg­a­tive cash flow sit­u­a­tion, even if their cap­i­tal spend­ing was weak. The seven re­ces­sions to hit the US since 1965 have been pre­ceded by the “fi­nanc­ing gap” mov­ing be­low - 1.5 % of GDP. The one false sig­nal came in late 1984/early 1985 af­ter a huge spike in the US dollar. The chart shows that each time the fi­nanc­ing gap of US com­pa­nies fell be­low -1.5% of GDP, within a year US cap­i­tal spend­ing plunged, with the decline be­ing a huge driver of the re­sult­ing re­ces­sion. At an in­tu­itive level, this makes sense as firms with high neg­a­tive cash flow sel­dom go on in­vest­ment binges.

Since the 2009 cri­sis US cap­i­tal spend­ing has been sub­par and firms have in­stead pre­ferred to buy back shares. Now, how­ever, they are mov­ing into a neg­a­tive cash flow sit­u­a­tion, so some­thing must give. Un­til the re­lease of the 1Q15 Flow of Funds re­port in June we are work­ing on 2014 data, but given the weak growth this year, lousy pro­duc­tiv­ity fig­ures and con­tin­ued huge vol­ume of US share buy­backs, don’t be sur­prised if US firms’ fi­nanc­ing gap slid be­low -1.5% of GDP. If that hap­pened, the chance of a US re­ces­sion would rise sig­nif­i­cantly.

To be clear, we’re not say­ing that the US is mov­ing into a re­ces­sion; rather that re­ces­sion­ary sig­nals are start­ing to ap­pear, which—given the pol­icy set­ting—is hardly sur­pris­ing given the mis­al­lo­ca­tion of cap­i­tal that took place in 2003-07 and af­ter 2009 as a re­sult of mon­e­tary pol­icy mis­takes. If this rather grim sce­nario does ma­te­ri­alise, then the Fed will suf­fer a mas­sive loss of cred­i­bil­ity, in­fla­tion will col­lapse and it would be very sur­pris­ing if long rates stayed at 3%. In­deed, US long rates will be the key in­di­ca­tor to watch in the com­ing weeks.

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