Last year when the Economic Cycle Research Institute’s (ECRI) widely followed Weekly Leading Index (WLI) growth rate fell deep into negative territory, fears of a double-dip recession in the U.S. went rampant. The stock market sold off and investors raised cash significantly. However, during the summer of 2010 the ECRI never made a recession call and then in October went as far as saying there would be no double dip recession. This time around we are facing the situation in reverse: the ECRI made a recession call in September and went as far as saying that there was nothing policy makers could do to avoid it. Various leading economic indicators are suggesting the economy improves into year-end, which is acting as a tailwind to the stock market as U.S. recession fears subside. However, is this just a brief respite from economic weakness before recession becomes reality in 2012? Time will tell but that looks like the case for now.
Late 2010: Long-Term Bullish, Intermediate-Term Bearish to Bullish
In late 2010 the ECRI ruled out a recession because, while their WLI, which is an intermediate looking leading indicator, suggested recession, their long-leading economic indicators were still rising and suggested an economy continuing on an expansionary path. What the plunge in their WLI suggested was that growth would slow markedly, however their long-leading indicators were still rising and so it was not surprising to see the WLI rise once again late in the year as the economy remained on its expansionary tracks. In essence, because their long-term economic indicators were still rising (expansion), the pronounced plunge in their intermediate-term indicators would eventually pick back up, with the WLI indeed rising into the end of the year.
The ECRI came out in October 2010 and announced publicly there would not be a double-dip recession and they were right, however they did raise a warning that the Fed, ever behind the curve, would likely over stimulate an economy whose growth would revive and thus increase inflation. The ECRI’s comments from October 2010 are provided below.
No double-dip recession
Because monetary policy acts with "long and variable lags," the Fed should, in principle, rely on forward-looking measures to time its actions. Yet, in practice, it does pretty much the opposite, relying on backward-looking statistics like core inflation and hard-to-assess measures of the so-called output gap, including estimates of "full employment."
In early 2010, when we warned publicly of an approaching slowdown, a sanguine Fed was plainly focused on its "exit strategy" to remove the trillions of dollars of cash it had injected into the economy after cutting short-term interest rates to near zero — only to belatedly reverse its stance some weeks ago…
In fact, the Fed is about to launch QE2 because it believes inflation to be too low, which really means they are willing to go to new extremes to head off the risk of deflation. Yet, over the last two centuries the U.S. economy has seen sustained deflation only when it has mostly been in recession — a scenario that our analysis rules out for now. While the current expansion is likely to be shorter than anyone is used to, its demise in not imminent.
Late 2011: Long-Term Bearish, Intermediate-Term Bearish to Bullish
In contrast to this time last year, the ECRI’s long-leading economic indicators are pointing down, not up, while like last year their intermediate-term WLI is beginning to firm and turn up as it did last fall. What this likely means is that the intermediate-term growth of the economy overshot to the downside temporarily as did the stock market and will likely rebound for a period of time before longer-term economic forces (employment, credit, lending standards) exert their influence on intermediate-term economic factors. In essence, because their long-term economic indicators are still falling (contraction), any pickup in their intermediate-term indicators will likely be overcome down the road by the bearish longer-term indicators.
To understand why the ECRI remains longer-term bearish on the economy, an excerpt from a Wall Street Journal article is provided below (emphasis added).
Explaining the Recession Call
The U.S. recovery wasn’t much to begin with, and now it’s dead…
Economists downplay the WLI because of its high correlation with movements in the stock markets that have been volatile lately. Joseph LaVorgna, chief U.S. economist at Deutsche Bank, calculates a correlation coefficient of 90% between the WLI and the S&P 500 stock price index.
“Essentially, so goes the S&P 500, so goes the ECRI,” he says.
The WLI, however, is not the only hammer in ECRI’s toolbox, says Achuthan.
To capture the macro-view, ECRI also puts together a long leading and short-leading index. The long-leading index, which has no exposure to equities, started falling back in December 2010 and is still falling.
In addition, ECRI puts together sector-specific indexes that cover areas including manufacturing, nonfinancial services, housing, credit and exports. These indexes are “overwhelmingly showing recession patterns,” says Achuthan.
In particular, the ECRI indexes are signaling the 3 “Ps” of a contraction: the decline has to be “pronounced, pervasive, and persistent.”
Achuthan makes clear that a recession is a “process” in which a negative loop feeds back on itself: Slowing demand lowers productions which results in dropping employment and incomes which in turn weaken sales further.
Ominously, Achuthan says policymakers will not be able to stop this recession.
“Once the feedback loop starts, it’s more powerful than any policy response,” he says, adding policymakers’ challenge is not to make the situation worse.
One of the biggest reasons for the rebound in economic indicators is the beneficial impact of deflating commodity prices. West Texas Intermediate Crude Oil, for example, has plunged more than 30% since its peak earlier in the year and the Commodity Research Bureau’s (CRB) commodity index is down more than 20% from a peak in April. Given roughly 70% of the economy is consumption-based, falling commodity prices puts more money back into consumer’s wallets and improves company profit margins who have been suffering from an inflation squeeze. So both consumers and companies benefit from falling commodity prices.
This relationship can be seen by looking at the prices paid indexes for regional Fed manufacturing surveys as well as national ISM manufacturing and service surveys. I highlighted this concept last week (All Clear?) in which I provided the following graphic. Take note that the relationship between prices paid (inflation) and manufacturing surveys are inversely correlated (inflation cuts into growth), thus the prices paid indexes are shown inverted (red, right scale) and lead the headline components by roughly 6 months.
Hat Tip: Francois Trahan, Wolfe Trahan Research
Source: Bloomberg
Below is shown the various prices paid indexes for Fed and national surveys and you can see that the peak inflationary threat seen in February to April crested and suggested six months forward that manufacturing surveys would likely trough. This has in fact been the case as the ISM Manufacturing Survey is bottoming right on cue. Shown below the table is the ISM Manufacturing PMI relative to the average of the ISM Manufacturing and ISM Non-Manufacturing prices paid indexes. The Prices Paid composite is shown inverted and advanced.
Source: Bloomberg
Looking at the bottom portion of the table above shows that prices paid indexes have not yet begun to rise in a sustainable manner which suggests we could have a six month manufacturing rebound ahead with the improvement in growth stalling around February-March 2012 given the prices paid indexes lead the headline manufacturing components by roughly six months.
A Window of Opportunity
If we do get a manufacturing rebound heading into 2012, it is conceivable that investors have a window of opportunity for gains heading into year-end before the bearish longer-term indicators from the ECRI begin to take hold again. If the prices paid indexes begin to rise sharply once again, that will suggest this window of opportunity is closing.
