Towards a US recession?
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.