U.S. on the brink of recession
Full steam ahead, then? Friday’s release of the first GDP estimate for 3Q16 headline showed US growth rising to an annualised 2.9%, up from 1.4% in 2Q and 0.8% in 1Q. On the face of it, this reading points to the US economy emerging from yet another soft patch, and so backing away from the recession frontier. Not so fast. A close look at the underlying components of the GDP report reveals the US as being perilously close to that threshold.
Firstly, the primary contributors to the apparent pick-up in growth (exports and inventories) are unlikely to last. Exports rose 10% QoQ (annualised), adding 1.2 percentage points to growth—after contributing almost nothing in the prior two quarters. Yet, this fillip was due to a likely one-off rise in food exports as US farmers responded to a weak soybean harvest in Argentina and Brazil. As that effect fades, US export growth will again look weak, weighed down by a strong US dollar and rising labour costs.
Equally fleeting will be the positive contribution from inventory building (+0.6 percentage points in 3Q, from -1.2pp in 2Q). Inventories are still high relative to sales, so while this volatile series will occasionally tick-up, negative contributions will be the norm until the inventory overhang is worked off (and little progress has been made thus far).
If that were the end of the story, we would simply pour cold water on the idea that growth is accelerating—nothing more. Alas, there is more to worry about. Private investment (residential and non-residential) has quit growing. Myself and Tan Kai Xian have previously argued that US homebuilding offers the best leading indicator for overall growth. This is probably because the housing sector is very interest-rate sensitive (and the economic cycle is largely a credit cycle). Housing is also sensitive to consumers’ income growth and confidence levels, and finally new home purchases lead to related purchases such as furniture and white goods. Hence, it was worrying to see the homebuilding part of GDP (i.e. residential–fixed investment), fall at an annualized –6.2% in 3Q, after a –7.7% decline in 2Q. These falls have lowered residential investment growth below 1% YoY (black line in the chart). When residential investment contracts, it usually indicates a recession is close. If at the same time business capital spending is contracting (blue line), then history suggests a recession is already underway. With business capital spending basically flat YoY, Friday’s GDP release shows an economy that is on the brink of recession.
In the next twelve months, the two most likely scenarios are:
1) The US slips into recession. In ‘The Rising Odds Of A US Recession’, it was pointed out that the labor market seems to be topping out and close to giving recession signals. As of Friday, the same can be said of US investment data.
2) Growth rebounds, but in the context of rising inflation this causes a bond market correction. The temporary reprieve of growth concerns could be good for equity markets, but a selloff in the bond market would not be (1987 anyone?).
Today, I offer similar odds for both scenarios. Either way, investors should prepare for a changed investment environment by reducing equity risk exposure and shortening the duration of fixed income portfolios.