Tuesday :: Jul 11, 2006

The Economy in 2H 2006

by eriposte

Let me start this post by saying that I'm no expert in economics - and I'm certainly not a professional economist like Brad DeLong or Mark Thoma or Max Sawicky or the great folks at Angry Bear or EPI (to name just a few). So, you can feel free to ignore this entire post if you don't want to read economics observations by a non-economist. However, I do dabble in economics once in a while because it is a subject that I find very interesting. Through occasional readings in economics, I discovered the Economic Cycle Research Institute (ECRI). ECRI was founded by the late Geoffrey H. Moore. The index of ECRI's that I particularly watch every week is the Weekly Leading Index (WLI), which was developed as a more timely and accurate prognosticator of business cycles than the Index of Leading Economic Indicators (LEI) that was previously developed by Moore for the U.S. Commerce Department. ECRI's approach seems to have a good track record (often contrarian to the "experts" you hear in the news) - or, at least, it was good enough to snare me as a paid subscriber.

Since I have increasingly become intrigued by ECRI's approach, let me briefly summarize my understanding of ECRI's latest indicators and outlook for the US economy in the second half of 2006 (links to the ECRI observations that I base my comments on are below the fold).

(a) ECRI's Leading Home Price Index – LHPI - is trending down noticeably for the first time in about 11 or 12 years. This appears to indicate a possible, significant slowdown in the housing market sometime in the second half of 2006 - which could, in turn, translate into a slowdown in consumer spending. [Related notes: EPI's Jared Bernstein notes this about the mediocre June 06 jobs report - "The slower growth in jobs is most likely due [to] the same headwinds responsible for slowing down the overall economy: higher interest rates, the cooling housing market, and high energy costs...An important hint from today's report, for example, shows that employment in residential construction fell 6,800 over the past two months, the sector's first back-to-back monthly losses since the spring of 2001..." Further, Calculated Risk at Angry Bear notes that Household Debt Service as a percent of personal disposable income hit a record high in Q1 06.]

(b) ECRI is seeing a significant downshift in their long leading index of global industrial production. This, in turn, could start impacting US economic growth sometime in 2H 2006 and possibly even coincide with a consumer spending slowdown that may arise with a slowing housing market. So, there is a distinct possibility that export-led growth may not be able to sufficiently make up for a possible consumer spending slowdown in late 2006 in the US.

(c) The WLI Growth Rate just hit a one year low (0.9%) and has been in a downward trend for the past several weeks. Partly due to this, ECRI's inference is that growth prospects for the second half of 2006 are not rosy. (This does not mean a recession is going to occur but it indicates that we are headed for a slow growth period at the minimum). [Incidentally, note that the LEI has also been dropping recently].

(d) ECRI's Future Inflation Gauge (FIG) has also been declining (overall) of late after hitting a 5-1/2 year high last October, suggesting that fears of significant inflation later this year are unfounded (assuming no rash acts by this administration - like, say, a war against Iran) - which would mean that if the Federal Reserve hikes interest rates further that could complicate what appears to be a challenging 2H 2006 macroeconomic scenario, not to mention the already weak wage picture. [I guess I'm saying that an additional 25 bp hike in interest rates does not seem advisable in this scenario].

Bottomline: buckle up a bit as we head into late Q3 and Q4.

Below the fold you'll find some extracts from recent ECRI comments - I recommend you read them but be careful in how you interpret the meaning of the word "downturn". ECRI is specifically talking about a downturn in the indicators or a downturn in growth. They are not necessarily talking about an economic downturn. They are talking largely about growth cycle downturns, which may or may not lead to economic downturns.

Links to ECRI commentaries

This article mentions two of the key points that ECRI is making now vis-a-vis the US economy (emphasis mine):

The Blue Chip Economic Forecast survey of 53 economists sees growth at slightly less than 3 percent for the next five quarters.
The rosy 3 percent scenario is based on economists' best guesses that housing will slow, but not collapse, and that consumers will be able to keep spending at a healthy rate, bolstered by decent wage gains. Capital spending by businesses is expected to fill some of the gap left by housing.
"The outlook for home prices is much worse than the consensus thinks," said Anirvan Banerji, director of research at the Economic Cycle Research Institute. Banerji said the ECRI's leading index of home prices is flashing warnings that real home prices (adjusted for the rise in consumer prices) could fall.

"We'll have a harder landing than people expect," Banerji said.

Banerji also rejected the idea that capital spending or exports will save the day. The ECRI's long leading index of global industrial production is falling, signaling a global industrial slowdown in the next year. ECRI's forecast is being confirmed by recent softness in new orders in the Institute for Supply Management index.

Back in April 2006, ECRI's Managing Director Lakshman Achutan gave an interview to James Picerno at the Capital Spectator where he made some pertinent observations which I reproduce below. I've clipped the questions for the most part and am only showing some of Achutan's responses/comments - go to the Capital Spectator and read the whole thing (emphasis mine):

A: ...Mind you, a year ago, the majority of professional forecasters were predicting a sharp downturn. So they were wrong for 2005. Part of the lesson from the 2005 experience: this economy can live through anything. So, the safest bet is that it'll do well.

And that view's ok in the first half of 2006. But our indicators aren't based on what happened in the past; rather, ours are based on what the leading indicators saying today. And on that score, we have a mixed bag.

Our leading indicators were forecasting strength in the early part of this year. But when we look into the second half of 2006, there are two downturns that have shown up pretty clearly in the leading indicators. We think these two downturns are going to impact the overall economy. One is in housing, and the other is in the global industrial sector, which very few people are paying attention to.
A: Our leading housing indicators turned down at the end of 2005. After four years of being bullish on housing, we finally said things are turning down. And we have seen both new and existing homes numbers coming in on the downside. That's going to pose some problems for consumer spending.
A: Part of the reason why the economy was so strong in 2005 was because the wealth effect from housing offset, and then some, the lack of wage growth and the higher prices paid for energy. It's like the consumer's been saying, "Oh, damn, my salary increase doesn't cover the rise in energy prices, but since my house is now worth twenty grand more, I can dip into my savings and continue living large." That's basically been the equation.
A: It's not that I'm saying that consumer spending drops. Rather, it's that the rate of spending growth eases.

A: I'm as hopeful as the next guy. But our leading home price index, which is now down around an 11-year low [eRiposte - if I am not mistaken Achutan does not literally mean 11-year low but a significant drop in the index for the first time in 11 years], hasn't turned up yet. This index looks out three quarters. So, I don't think we're going to get a reprieve here. And perhaps things deteriorate further. Minimally, the positive is gone, and that weighs on the ability of consumers to grow their spending. Unless, they get great, great salary increases.
Q: The other warning sign you mentioned is the industrial sector on a global scale.

A: Yes, and this downturn is completely off most radar screens. The industrial sector of the global economy has a cycle, and the reason it has a cycle is that a component built here goes into something built in Europe, which goes into something else built in Japan. We're all linked very closely. Any product can be sourced from all over the place. The factory floor is increasingly a global factory floor. And we see a cycle there. We have indicators on that--very long leading indicators. These are the ones that are looking out a year, and they've turned down quite clearly.

Q: How soon will the blowback from this downturn hit?

A: We don't have a great deal of precision on this, so I can't say the peak in the global industrial cycle will be, say, in June. But I think it's fair to say that we're going to have a peak in the global industrial cycle before the end of the year, probably in the second half.

What gets interesting here is the scenario is where a global industrial slowdown is lining up on some level with a pullback on consumer spending.
A: It's very esoteric. This is a slice from our long leading index, which has all kinds of components. The global industrial index is focused on many of the financially related components of our long leading index.

Q: What kind of financially related components?

A: Different kinds of liquidity, essentially. Profits, for example. Overall, it's all of the money-related stuff that drives the economy. This slice of the long leading index we take from each of our long leading indices for 18 major economies, including the G7 and India and China. We're taking that slice of the long leading indicators from all of those economies and that's a good leading indicator of the global industrial cycle. And that's turned down convincingly.

Q: Specifically, that downturn is saying….

A: It's saying that a cyclical downturn in the growth of global industrial activity is likely to appear in the second half of this year. If that's happening alongside a softening in consumer spending, the odds are that there could be a challenge to the layman's assumption about a strong economy.

Q: Yours is a contrarian view at the moment. The bond market, for instance, begs to differ, courtesy of the sharp rise in the 10-year yield to heights not seen since 2002.

A: Well, there's never been a time when the leading indicators have turned and everybody's says, "We totally agree." That just doesn't happen. It's the nature of turning points.

I'm not all bad news, by the way. But my good news is also contrarian.
A: ...Our future inflation gauge peaked in October 2005, and has fallen for four of the five months since then, including March. Granted, the labor market is bucking the trend by still holding the inflation index up a bit. In spite of that, our inflation gauge is close to tipping down. That would be good news if it begins to slip because it would start to give the Fed some options, if they needed them.
A: We argued that it was not a great argument [that an inverted yield curve was reliable predictor of a recession] when it first started happening and everyone was worried. It's a faulty indicator. We've never used it. It failed in the 1990s, it failed a bunch of times in the 1950s. It gives false alarms and it misses turns.

NOTE: My comments on the LHPI, FIG and WLI Growth Rate also derived from ECRI's 7/7/06 Recession-Recovery Watch weekly newsletter (it's behind their subscription wall - but a sample of an old 2004 newsletter is here (PDF)).

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