Broken recession rules and the consequences for interest rates

Recession fears are frightening equity investors, possibly disrupting the objective recession indicators. Yet there are indeed weaknesses in the American economy. German and Dutch industry is recovering somewhat.

The stock markets have suffered a major setback in the past two weeks, although there was a significant recovery yesterday (and today). It is not always easy to attribute every price movement to a clear cause, but everyone tries to do so. The recent falls have been attributed to fears that the US economy is entering a recession. In a recession, corporate profits usually fall very sharply. That explains the fear among equity investors about recessions.

Stock markets look ahead. Investors do not wait to sell their shares until the economy has entered a recession, but anticipate it. 'Bear markets' – price losses of at least 20% – almost always occur in conjunction with a recession, but start before the recession starts. Anyone who wants to avoid the significant price losses suffered in a 'bear market' must therefore make a correct assessment of the economic trend. A significant price drop as we have seen in the past two weeks can be the start of such a 'bear market', but can also be a good 'entry moment'. A dilemma for the active investor.

Notoriously bad at predicting recessions
It usually doesn't help to listen to economists. Economists from official institutions are notoriously bad at predicting recessions. They never actually foresee that. Their bosses probably won't allow that. But economists at private financial institutions also often miss the point.

It is better to think in terms of probabilities and use objective standards as much as possible. But that too has now become problematic. The yield curve has proven to be a very good leading indicator for recessions. An inverted yield curve (money market rates are higher than capital market rates) has been occurring in the US for almost two years now, but the recession predicted by it is still a long way off. The patience of yield curve followers is running out. It has been claimed that the yield curve signal is no longer reliable because central banks have distorted capital market interest rates with their purchasing policy.

Attention-grabbing recession indicator
An indicator that has attracted attention lately is the 'Sahm rule'. This was developed in 2019 by Claudia Sahm, who worked at the Federal Reserve at the time. It found that the U.S. economy was either in or entering a recession when the three-month average unemployment rate was 0,5% higher than the lowest level of the unemployment rate in the previous XNUMX months.

American unemployment has risen in recent months and the Sahm rule has now come into effect. Claudia Sahm wrote a column on Bloomberg this week and also gave an interview in which she argues that her own rule probably does not provide a reliable signal of an impending or already started recession. She rightly points out that unemployment in the US has risen this time not so much due to a lack of demand in the economy, but due to the strong growth in labor supply due to sharply increased immigration. In addition, the labor market has been shaken up enormously during the pandemic. At the same time, she believes that the risk of a recession has been 'elevated'. It is true that the unemployment rate in the US is still low. But that's not the point. It's about the change. In a recession, unemployment rises first gradually, then quickly and then sharply, she explains. And that's just how it is.

Significantly disrupted labor market
Another objective indicator is the number of jobs under the heading 'Temporary Help'. The chart below makes it clear that this number of jobs typically declines prior to a recession. The number of 'temporary help' jobs has been declining for some time now, without a recession having started. Here too, it is likely that the labor market has been significantly disrupted in recent years.

I would like to show a few more pictures that do not directly lead to the conclusion that an American recession is about to begin, but which do indicate a weakening of the economy. The first picture shows that the number of 'chapter 11 filings', i.e. applications for suspension of payment, has been rising for some time and is higher than at any time since 2013.

The affordability of housing is very low. This has to do with the combination of high house prices and high interest rates. The implication is that little economic dynamism from the housing market can be expected for the time being.

Another weakness can be found in the defaults on various forms of debt. As the next picture shows, defaults on credit card debt and auto loans have been increasing for more than two years. They are at the highest level in more than ten years. But here too there may be a disruption, as defaults unexpectedly fell during the pandemic due to the large-scale financial support provided by the government.

Where do these weak spots in the American economy come from? There are probably several factors at play. The American economy has received a significant boost from the accommodative fiscal policy under President Joe Biden. However, the budget deficit is now declining and this means that the growth impulse is diminishing. The relatively high interest rates also play a role, as does the fact that families have been able to draw on savings pots built up during the pandemic for a long time. Those piggy banks are running empty.

I agree with Claudia Sahm. The US economy is not in a recession, but the risks are quite significant. I suspect that the Fed will eventually feel forced to cut rates at a fairly rapid pace.

Industry improves
Let's take a look at the European continent. Production in the manufacturing industry in the Netherlands increased by 0,8% in June compared to May. However, year-on-year there was still a decline of 4,9%. That was the second worst figure of the past two years. Perhaps we should cling to the month-on-month increase. In Germany, manufacturing production also increased in June: +1,4% month-on-month. Production in the five most energy-intensive sectors also rose 1,4% in June. This meant that the production level in these five sectors was almost 10% higher than in December last year. That gives the citizen courage.

Closing
Stock markets are focusing on whether the US economy is heading for a recession. Various objective indicators, such as the yield curve and the Sahm rule, suggest so. But the disruptions in the economy in recent years have undoubtedly reduced the predictive power of such variables. This does not alter the fact that the American economy has gradually started to show some weaknesses and that the risk of a recession has increased. If the economic downturn continues, the Fed will not hesitate to cut interest rates quite quickly.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.