Is a Recession Imminent?

by bonddad

Thu Sep 13, 2007 at 07:56:45 AM PDT

With the latest employment report showing a loss of 4000 jobs and the credit markets in a mess traders and economists have started to look at the increasing possibility of a recession in the next 6-12 months.

Economists in the latest WSJ.com survey pegged the risk of a recession at 36%, on average, up from 28% a month earlier. Fifty-five economists took part in the survey, and 52 answered the question about the likelihood of a recession. The survey was conducted after last Friday's report on August employment, which showed the first monthly jobs decline in four years.

Let’s look at a bit more detail at the underlying economic picture to see what’s going on.

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First, let’s start out with a big caveat: economic prognostication is at best an extremely difficult task. There are no clear-cut rules or methodologies; it’s as much an art as a science. I have found some extremely compelling arguments in both the bullish and the bearish analysis of the current economy. The best answer is that we really don’t have a firm idea on where the economy is going exactly, so the best thing any economist can do is to say "the possibility of X happening are y." I realize that’s not a satisfactory answer, but that’s pretty much the way it is.

Now that I have added an extremely broad disclaimer to anything I will say, let’s move forward.

Consumer Spending

This is a chart of personal consumption expenditures from the latest person personal income report from the BEA. The chart is the seasonally-adjusted annual amounts expressed in chained dollars. What we see is about 5 months with a little increase followed by a decent increase in the latest months report. We also had good back-to-school sales in the latest retail sales report.

August U.S. retail sales advanced 2.9 percent based on results from 47 retailers, the International Council of Shopping Centers said. Results exceeded the New York-based trade group's forecast for a gain of as much as 2.5 percent. From February through August, same-store sales have gained 2.4 percent, slower than the 2.9 percent in 2006.

The Big Picture had some great analysis which shows some of the problems with the numbers.

I would place consumer spending in the fair category – not good, not bad. Things were weak for most of the first half of this year, but things could be picking up. However, we don’t have enough information yet to see if spending is actually increasing or we had a one month uptick.

Housing

According to the National Association of Realtors the total inventory available for sale of existing homes was 4,592,000 in July. That is the largest absolute amount of homes ever on the market by a wide margin. At the same time, we are seeing home prices drop in a big way:

The annual returns of the U.S. National Home Price Index, the 10-City Composite, and the 20-City Composite shows all three still yielding negative returns as of June 2007. The quarterly S&P/Case-Shiller(R) U.S. National Home Price Index -- which covers all nine U.S. census divisions -- was down 0.9% from Q1 2007 and down 3.2% from Q2 2006.

"The pullback in the U.S. residential real estate market is showing no signs of slowing down," says Robert J. Shiller, Chief Economist at MacroMarkets LLC. "The year-over-year decline reported in the 2nd quarter of 2007 for the National Home Price Index is the lowest point in its reported history, which dates back to January 1987. On a regional level 17 of the 20 metro areas are showing declines in their annual growth rate from what was reported in May."

This is at a time when the credit markets are seizing up and lending standards are tightening.

Short version: housing stinks and will for the foreseeable future.

However, commercial (non-residential) construction has pick-up some of the slack. I wrote the following in relation to the latest construction spending report:

Non-residential construction has increased from 46% of all construction spending in July 2006 to 53% in July 2007.

The bottom line is non-residential construction continues to grow at a rate to absorb residential losses. This is good news for the construction employment sector which is an area that we should be watching for signs of weakness.

So long as this trend continues the impact of the housing slowdown on employment will be lessened. So – will this trend continue? I tend to doubt it, but only time will tell.

Employment

The latest employment report stunk.

The surprise disappearance of 4,000 nonfarm jobs in August -- economists had expected 100,000 would be created, based on data such as jobless claims and private-sector job estimates -- was driven by losses in construction and manufacturing, the Labor Department said.
The jobs report stoked fears of recession, sending shockwaves through financial markets as investors scrambled to sell stocks and buy longterm government securities as a safe haven. The Dow Jones Industrial Average tumbled 249.97 points, or 1.9%, to 13113.38.

Adding to concerns: Employment numbers for June and July were revised sharply downward. That means the job market was weakening even before financial turmoil erupted last month as long-festering concerns about rising delinquencies on riskier loans known as subprime mortgages suddenly spread to other markets. Moreover, some analysts said the jobs picture is likely to darken further; yesterday's report covered employment activity only through mid-August, so it doesn't include subsequent job losses in the mortgage-financing industry.

Short version – there could be some serious problems developing in the employment situation. This has been one of the bull’s primary arguments – unemployment was low which doesn’t happen when the economy is slowing down. The latest drop and the downward revisions of previous months put that argument in jeopardy. While future data is still needed to confirm the downward trend, the employment picture went from good to neutral pretty quickly.

The Financial Markets

By financial markets, I am talking specifically about the credit markets. (For those of you who need some background on how the credit markets work, please see this article.

Will they start to loosen up after the recent tightening? Yes they will. The question is when. It’s good to keep an eye on the T-Bill market to determine what the overall sentiment in the credit markets is.

Notice the yield have come off their extremely overbought levels earlier this month. But, yields are still pretty low compared to recent levels indicating there is some tightness. In addition, there are serious problems in the London inter-bank lending market right now.

The London interbank offered rate, or Libor, for euros fell 13 basis points to 4.01 percent today, according to the British Bankers' Association. The three-month rate held near a six-year high of 4.73 percent. The ECB's benchmark rate is at 4 percent.
The ECB yesterday injected an extra 75 billion euros ($104 billion) for three months to ease a credit drought. Global borrowing costs have surged because lenders are wary of providing cash to institutions that may have undisclosed losses from U.S. subprime mortgages. The squeeze has all but closed the market for commercial paper, forcing banks and institutions to raise ever more money in the interbank markets.
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The three-month rate for dollars slipped 1 basis point to 5.69 percent and the overnight rate fell 2 basis points to 5.16 percent, the BBA said today. The three-month rate climbed to 5.72 percent on Sept. 5, the highest since January 2001.

...

``The money markets are seriously malfunctioning at present, and there's no end to this crisis in sight,'' said Marcus Ostwald, a fixed-income strategist at Insinger de Beaufort SA in London.

In short, there are still some serious problems in the credit markets and it could be a awhile before they get sorted out. Treasury Secretary Hank Paulson agrees:

The crisis of confidence in credit markets is likely to last longer than previous financial shocks of the past two decades, Hank Paulson, Treasury secretary, warned on Tuesday.
He said the uncertainty in credit markets would last longer than the turmoil that followed the Asian crisis and the Russian default of the 1990s or the Latin American debt crisis of the 1980s.

So – are we headed for a recession? I definitely think the possibility is higher – somewhere in the 30%-40% range. That being said, the US economy is incredibly resilient and can take a big hit and keep going forward. The question is, are the hits we have taken too large to keep growing? While only time will tell, the possibility is yes.