Since the start of the yr, financial information has continued to defy the recession calls of 2022. Therefore, it’s unsurprising that financial information shocked analysts’ extra dire predictions final yr. Of course, given the underestimation of the economic system beforehand, the danger of overestimation is now an actual risk.
The upgrading of estimates additionally contributed to the dialogue of the Federal Reserve’s want to lift the “neutral rate.”
The impartial rate of interest is:
“The real rate (net of inflation) that supports the economy at full employment and maximum output while keeping inflation constant.“
(Note: There is no accurate measure of the neutral rate, and it cannot be observed directly. In other words, it is a guess.)
The issue, as always, is that economists are looking at lagging economic data to make assumptions about the future. However, after over 40 years of rising debt levels, economic growth remains slowing. As shown, as debt issuance increased after each economic crisis since the turn of the century, economic growth rates declined. (I have projected the increase in debt based on the average quarterly debt growth since 2018.)
Naturally, if the economy grows at a slower natural rate, inflation and interest rates will ultimately match that growth rate. Furthermore, and most importantly, in the context of this discussion, avoiding a recession becomes increasingly challenging at lower growth rates.
While analysts become more optimistic about economic growth, the divergence of the economic data suggests increased risk to that outlook.
Production Comes First
As is always the case, predicting a recession is incredibly difficult. The influence of monetary and fiscal policy, corporate actions, and other events can increase or delay the recessionary onset. Nonetheless, restrictive policies, such as higher interest rates and tighter lending standards, will curtail the consumption that drives economic growth. The chart below is a composite index of bank lending standards and interest rates versus GDP. The financial conditions composite is inverted to compare declines in economic activity better. Unsurprisingly, tight financial conditions always precede weaker economic growth rates and recessions.
Critically, what drives the economic cycle must be understood. We often speak of the consumption side of the economic equation; however, consumers can not consume without producing something first. Production must come first to generate the income needed for that consumption. As analysts increase earnings estimates, the earnings derived from corporate revenues are a function of consumer spending. Such is a crucial part of the cycle.
The Invisible Hand
Of course, if you bypass the production phase of the cycle by sending checks directly to households, you will get a strong surge in economic growth. As shown in the chart below, the massive spike in economic growth in the second quarter of 2021 directly resulted from those fiscal policies.
However, once individuals spent that stimulus, the economic activity subsided as the production side of the equation was still lagging. Here is the crucial point. For a household to consume at an economically sustainable rate, such requires full-time employment. While the media touts the “strong employment reports,” such is usually the restoration of jobs misplaced throughout the financial shutdown. As proven, full-time employment as a share of the working-age inhabitants has solely recovered to pre-pandemic ranges.
In different phrases, now we have NOT created hundreds of thousands of recent jobs, as touted by the present administration, however slightly solely recovered the roles misplaced and the rise within the working-age inhabitants because the financial shutdown. However, larger inflation and rates of interest require extra earnings to take care of the identical progress charges.
The manufacturing aspect of the equation is now ringing a loud alarm.
The GDP & GDI Relationship
Let’s evaluate the financial cycle equation as soon as once more.
Production => Incomes => Consumption => Demand => Increased Employment => Increased Wages
It is a comparatively easy financial idea that appears to elude the overwhelming majority of mainstream analysts and, seemingly, the Federal Reserve itself. However, there are two measures of financial exercise. The most typical measure is GDP, which is solely the sum of Personal Consumption Expenditures (PCE), Business Investment, Government Spending, and Net Exports (Exports Less Imports)
The different much less noticed measure is Gross Domestic Income (GDI). The calculation of GDI is as follows:
GDI = Wages + Profits + Interest Income + Rental Income + Taxes – Production/Import Subsidies + Statistical Adjustments.
Therefore, provided that GDI measures the earnings aspect of the equation (derived from manufacturing), it’s logical that GDI ought to observe fairly carefully to GDP over time. Furthermore, it ought to be logical that deviations between manufacturing and consumption ought to point out a shift within the financial underpinnings.
As proven under, in 2021 and 2022, actual (inflation-adjusted) GDI supported financial progress. With $5 Trillion in stimulus supporting incomes, the consumption aspect of the equation rose. However, starting within the 4th quarter of 2022 and persisting by the 2nd quarter of 2023, GDI has turned adverse as all the stimulative financial measures have grow to be exhausted. Yet, financial progress has elevated sharply over that timeframe.
The following chart is a bit clearer. I rebased each GDP and GDI to 100 in 2016. Again, logically, GDI and GDP ought to observe carefully to one another given the financial relationship. However, the deviation is obvious beginning final yr.
The query is whether or not this Is an anomaly or has it occurred beforehand.
GDI Sends A Recession Warning
The brief reply is YES.
The chart under appears at actual GDP and GDI again to 1947 and measures the deviation between the 3-quarter progress charges of every. With solely the expectation being within the late 70’s, a recession adopted every time GDP deviated from GDI. In different phrases, the financial exercise finally catches all the way down to the first driver of consumption: manufacturing. Currently, the deviation of GDP from GDI is the most important on report.
In past articles, we reviewed many indicators that sometimes preceded recessionary onsets. Falling tax receipts, inverted yield curves, student loan payments, leading economic indicators, and even our financial composite affirm that recessionary dangers stay elevated. As proven, based mostly solely on the inverted yield curve alone, the chance of a recession is at one of many highest ranges because the Nineteen Eighties.
Given the wide selection of different confirming indicators beforehand mentioned, betting on the “avoidance” of a recession, significantly given such tight monetary situations, appears dangerous. Such was some extent made in “Financial Conditions Are Tighter Than You Think.” To wit:
“As shown below, financial conditions, measured by the difference between the 10-year Treasury yield and the “neutral rate,” clearly reside in restrictive territory. Such has beforehand at all times preceded an financial downturn since 1980.”
However, even if you wish to dismiss all the different indicators mentioned beforehand beneath the guise of “it’s different this time,” the recessionary warning signal despatched by the unfold between GDP and GDI ought to doubtless not be.
Sure, this “time could be different.” The downside is that, traditionally, such has not been the case. While we should weigh the chance that analysts are appropriate of their extra optimistic predictions, the chances nonetheless lie with the indications.
GDI is growing these possibilities.