November 2015
Schroders
Talking Point
Recession fears haunt the US
Keith Wade, Chief Economist
There is a sense that policymakers around the world have become more sensitive to the risks facing the world
economy. Three factors support this:
•
First, the decision by the US Federal Reserve (Fed) not to raise rates in September may have been
poorly received initially, but has helped calm emerging markets where currencies have stabilised.
•
Second, we seem to have reached a truce in the currency wars: the Chinese Yuan has not devalued
further and the Bank of Japan has resisted pressure for it to increase its quantitative and qualitative
easing programme (QQE) and push the Japanese Yen lower.
•
Finally, recent comments from Mario Draghi at the European Central Bank (ECB), where he opened
the door to further quantitative easing (QE), and actual rate cuts by the People’s Bank of China (PBoC)
have all improved risk appetite.
The ‘wobbly bike’
Whether this is the result of international co-ordination or a series of independent lucky decisions, central
banks have been key to restoring market confidence. Continued growth in China, Europe and the US has also
helped.
However, the recent growth scare has highlighted the vulnerability of the world economy to a downturn in
activity. Leading indicators such as the Conference Board indicator for the US have slowed of late led by a
softer S&P500, building permits, manufacturing new orders, and a shorter average work week. Growth
concerns have been exacerbated by fears that the central banks do not have the firepower to deal with a major
adverse shock. Interest rates remain close to zero and although further QE is an option, there are doubts about
its efficacy beyond boosting financial market prices and inflaming the debate about inequality.
In this respect investors are still focused on downside risks and whilst the likelihood of a China hard landing
may have receded, there has been increasing concern about a turn in the US cycle. This sets a ‘wobbly bike’
view of the world economy: slow moving, not very stable and vulnerable to pot holes.
Terrifying triggers for recession
Nonetheless, recessions need a cause and in the current environment, we need to identify what could tip the
bike over. Essentially, there are three ways a recession can occur.
The first is as a result of an increase in inflation, which prompts the central bank to tighten policy to slow
activity and bring inflation under control. There is always talk of engineering a soft landing in such
circumstances, but this is rarely achieved and we frequently end up in recession. Sometimes the recession is
deliberate such as when inflation is out of control.
Second, a recession can occur as a result of a build up of imbalances. Current account and, or budget deficits
build up and there is often talk of a new paradigm where global capital flows can accommodate greater funding
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gaps until investors begin to question the sustainability of the debt build up and the music stops.
Finally, there are recessions which originate in the corporate sector through a slowdown in profits, which
triggers a retrenchment as firms cut capital expenditure (capex) and jobs. If strong enough, there is then a
knock-on effect to consumption. More often than not though, slower profit growth is a symptom of an economy
heading toward recession, rather than the cause.
Today, economists are divided between those who fear inflation and those who are concerned about corporate
recession risks. Certainly, we have reached the stage of the cycle where inflation normally emerges and policy
is tightened. The current unemployment rate is close to the level seen just prior to the recessions of 2001 and
2007–09. It is below the rate prior to the 1990–91 recession. However, unlike the previous episodes, we have
yet to see wages accelerate in a meaningful way. The Employment Cost index came in at 2.1% year-on-year in
Q3, a rate which is unlikely to trouble the Fed.
Low headline consumer price (CPI) inflation may be playing a role in keeping nominal wages subdued at
present, but this will reverse in coming months as the depressing effect of lower oil prices drops out of the
annual comparison. We would not be surprised to see wages pushing higher in this environment as long as
unemployment continues to decline, or remains around current levels.
However, there is a countervailing force on inflation at present as a result of the appreciation of the US dollar
and the weakness in emerging markets. Import prices are falling and will decline further in coming months as a
result of the currency. The picture is similar to that seen during the Asia crisis of 1997–98 and whilst the
downturn in emerging markets today is not as severe as at that time, we could well move back into a period
where the emerging economies weigh on global inflation once more through lower goods prices. Such a
development would raise the hurdle for wage inflation to trigger higher rates from the Fed.
The other potential cause of recession is more deflationary: a significant corporate sector retrenchment. There
are continuing fears over company earnings growth in the US, although yet again the earnings season is
showing a high ratio of beats to misses against analysts’ expectations. At the macro level, profits have slowed
after several years of a rise in the profit share of GDP, and in real terms are barely growing. However, they
have not turned negative as they did ahead of the last two US recessions.
As with the outlook for inflation, this may change and wages are key. Should we see an acceleration in wages,
profits will be squeezed unless firms can maintain pricing power and pass on cost increases (i.e. inflation), or
productivity accelerates (i.e. job cuts and layoffs).
On balance we are inclined toward the latter. One indicator that companies are becoming more cautious can
be seen in the durable goods orders which are signalling cuts in capital expenditure ahead. This does not
suggest a corporate sector that is confident about demand and pricing power. Capex and employment often
move together so we need to be wary about the effect on the labour market.
Will this be enough to trigger a recession in the US? Weaker business capex alone is not sufficient and we
would need to see the malaise spreading to the consumer through the labour market. Nonetheless, the
combination of weaker employment gains and the fading dividend from lower oil prices is likely to moderate
consumption in coming months. Meanwhile, on the plus side, housing capex is firm and the drag from
inventory is likely to fade.
At the moment, none of the recession drivers have been triggered. The weakness in profits is not acute
enough and the pick-up in inflation would need to go beyond base effects to trigger a more aggressive Fed
response. We will remain vigilant but at this stage a US recession remains a scary scenario rather than a
central view.
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