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Macro Report
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June 2013 highlights: The likelihood of recession remained at 7% Output by electric and gas utilities, industrial electricity consumption, miles traveled and gasoline supplied are the only variables showing recessionary tendencies
July 2013 trends: Average monthly employment remained at 190k (prior: 189k) per month - just enough to keep the unemployment rate from rising. The unemployment rate would be significantly higher if it wasn't for a declining labor force participation rate. Retail sales growth accelerated a bit (to 5.4% excl. food), but slowing trend continues (+1.3% excl. autos over last 3 months annualized)
CONCLUSION: The probability for recession is low. However, economic growth remains very weak. Real disposable incomes are not growing, and consumption is slowing. The recent rise in 10-year yields (1.6% to 2.7%) and emerging market troubles (Brazil, China) could have negative consequences going forward. Macro Report - US economic indicators - July 2013 Page 3
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Unfortunately, this does not have to be the case going forward. Due to impotence of monetary policy at the lower zero bound and rapidly increasing government debt the Fed might not be able to raise rates in the foreseeable future. A recession might hence happen without prior tightening by the Fed. We looked at many indicators from every angle; most had to be smoothed to cancel out short-term "noise" in order to prevent false signals (we use 3-months moving averages). Some indicators do not reveal useful signals unless you look at decline from recent peaks. Other data needs to be trend adjusted (number of miles driven, for example, benefits from rising number of cars and population). The table on the following page shows indicators we have tested. Our criteria: false positives (calling for a recession when there was none) false negatives (missed a recession) confidence it will work in the future and lead / lag time
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No two recessions are the same. Trigger levels can be too strict (missing some recessions) or too lose (giving too many false positives). We therefore created a range. The lower ("strict") boundary is the level necessary to avoid false positives; the upper ("lenient") boundary is the level necessary to catch all recessions. A high-quality indicator will have a narrow range, and recessions will be called with high confidence. An indicator at the upper boundary will be awarded a 50% probability, increasing towards 100% at the lower boundary. The overall "Lighthouse Recession Probability Indicator" (LRPI) is a weighted mean of individual indicators. High confidence and timeliness of signal have been awarded higher weights (maximum: 3) then those with low confidence or tardiness (minimum: 1). On the following page you see the LRPI since 1971, predicting every recession (assumed once 40%-50% probability is exceeded). The Federal Reserve Bank of St. Louis publishes a recession probability indicator by Chauvet / Piger (black line). It is based on four inputs (non-farm payrolls, industrial production, real personal income and real manufacturing and trade sales). However, the most recent data point for Chauvet/Piger is usually three months old, while LRPI is constantly updated (1 months old data). You can see that LRPI shows first warnings signs much earlier than Chauvet/Piger. In a recent response to a blog post, Chauvet clarified their indicator calls for a recession only "after exceeding 80% for a couple of months". Additionally, their indicator is "smoothed" as the raw data can reach 70% (2003/4) without being followed by a recession. Their indicator initially showed a recession probability of 20% for August 2012, only to be revised down to 1.7% six months later.
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An investor using the LRPI as a trading tool would have suffered only one loss of 7% (August 1980) while avoiding the dot-com crash (2001) and the 'great recession' (2008-2009). The system creates no unnecessary churn. While the control group ('buy-and-hold') would have created a higher return (with higher volatility) this might be due to the test period coinciding with one of the longest bull markets in history (1982-2000). Annex: LRPI Components Please find charts for all contributors to the LRPI on the following pages.
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The US central bank ("Fed") increased interest rates ahead of each of the last 9 recessions. The black line shows the absolute level of the Fed Funds rate; the blue line the increase from the prior post-recession low. An increase between 2 and 4.5 percentage points from the previous low preceded every recession since 1954. Recessions are shaded in gray. Yellow dots indicate the beginning of a recession; green dots the end. The absolute level (black line) is usually on the right-hand scale, while percentage changes (blue line) are on the left-hand scale. Negative absolute numbers should be ignored as they are merely needed for better formatting. This indicator has a double weighting in the Lighthouse Recession Probability Indicator.
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An increase in the price of crude oil of 75% to 100% preceded five out of the last six recessions. Close call in March 2011 and February 2012. Currently not a red flag. Crude oil would have to rise above $113/barrel in order to trigger an early warning. This indicator has a triple weighting in the LRPI
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Want to build a house? Need a permit! Any decline in permits of 25%+ from prior peak and you can bet on a recession. Missed the one in 2001 though. 2011 was a close call. Absolute level still below 1990/91 recession lows (despite US population growth from 250m then to 316m in 2013). Due to housing overhang unlikely to give a boost to the economy. Due to low level unlikely to do much damage to GDP either (should permits decline again). Currently no red flag. However, it needs to be seen how rising mortgage rates will impact the housing market going forward. This indicator has a triple weighting in the LRPI.
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The number of people on "payroll", or employed, is a good proxy for the health of the economy. You can see the long "valleys" of lost payrolls after recent recessions compared to earlier ones. A decline of more than 1% from previous peak payroll level indicates a recession. There have been no misses and no false positives; even the "tricky" back-to-back recessions in 1980 and 1982 have been called correctly by this indicator. However, not all jobs are equal; only 47% of all working-age Americans have full-time jobs. Since 2007, six million full-time jobs have been lost, but 2.5 million part-time jobs gained. Part-time jobs often come without "benefits" such as health insurance. From peak employment (Q1 2008) to Q1 2010 1.2 million "higher-" wage jobs (median hourly wage $21-54) have been lost; in the subsequent 2 years only 0.8 million have been recreated. While almost 4 million mid-wage jobs ($14-21) have been lost, only 0.9m have reappeared. Among lower wage jobs ($7-$14), 1.3 million have been lost, but 2 million gained. This indicator has a triple weighting in the LRPI.
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Current monthly payroll growth of 190,000 (12 months average) indicates zero probability of recession.
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July non-farm payrolls (+162,000) missed expectations (+175,000) June has been revised downwards by 7,000 However, it should be noted that the margin of error is around 100,000, and revisions can be up to 300,000
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Each month, more than 4 million people are newly employed and more than 4 million people quit their job or are fired. These are big numbers compared to the balance between those two (the monthly change in non-farm payrolls). The difference between those two lines are the net changes in employment (lower chart). You will notice less separations (fewer employees resign) during the 'great recession'; unemployment rose simply because new hires fell even faster. The US labor market is very dynamic, as more than 1/3 of total employees (4.2m x 12 = 50m) change jobs each year.
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This chart shows monthly changes in employment as initially reported (black dotted line), the revised number (thick black line) and the difference between the two (green/red chart, right hand scale). During the last recession (we didnt know we were in one yet), monthly employment numbers were revised downwards by up to 273,000. In Q3 2008, revisions were -159k, -190k and -273k (thats before Lehman happened).
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The overall employment picture may be misleading, as higher paying full-time jobs are usually being replaced with part-time jobs during a recession. Full-time employment growth (year-over-year) stands at 1.4% (previous: +1.2%). Part-time jobs usually come without healthcare benefits, forcing employees to cover their own medical expenses (leaving less money for consumption).
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During each recession, the number of part-time employees spikes up Companies, uncertain regarding the economic outlook, prefer not to enter longer-term commitments A part-time job may be better than no job, but usually does not sustain the costs of living of a family.
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The number of full-time employees used to be more than five times the number of part-time employees In each recession, full-time employees are replaced by part-timers The ratio has not recovered in a meaningful way since the 'great recession'
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The US unemployment rate is declining thanks to a decline in the 'labor force participation rate' (people with jobs relative to people who could potentially work). Many have exhausted their unemployment benefits, have left the workforce and are not counted as unemployed. Large numbers have applied for disability insurance, removing those folks permanently from the labor market (as opposed to unemployment, which usually is temporary). Economic growth depends on decent increases in employment and real incomes - none of which is occurring. Given low savings, increased consumption is possible only through credit expansion, leading to rising indebtedness. This trend is unsustainable, but encouraged thanks to very low interest rates.
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The University of Michigan, together with Thompson-Reuters, conducts more than 500 telephone interviews twice a month to gauge consumer sentiment, with a reference point from 1964 set to 100. A preliminary mid-month survey is followed up by a final one towards the end of the month. The indicator had one false positive (2005) and one miss (1981; the 1980-1981 recessions were back-to-back, so let's not be too harsh about that). A decline of 25%+ from previous peak indicates a recession. 2011 was a close call. The July reading (85.1) was the highest since July 2007 (90.4) This indicator has a triple weighting in the LRPI and does currently not deliver any warning signs.
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The Conference Board, an independent business membership and research association, conducts a survey of consumer confidence by mailing out surveys to more than 3,000 randomly selected households. The cut-off date for a preliminary number is the 18th of the months. The final number includes all surveys returned after that date. The indicator had two false positives (1992, 2003), but it did catch all recessions including the ones in 1981/2 and 2001 (difficult for a lot of other indicators). 2011 was a "close call". Consumer Confidence in July decreased to 80.3 (from 81.4 in the prior month), the secondhighest since January 2008. This indicator has a double weighting in the LRPI and currently does not raise any red flags.
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Most recessions have been accompanied by a reduction in the growth of debt. But, for the first time in 60 years, debt has actually shrunk in 2009. A meager 2% reduction caused a massive recession. The classic question of chicken and egg comes to mind: did the recession cause debt to shrink or did shrinking debt induce a recession? I have included the 1987 stock market crash (red triangle). A dramatic revelation dawns: economic growth is dependent on credit (debt) growth; without additional debt, growth is impossible. Unfortunately, data becomes available only once every quarter, with the latest data often many months old. To ensure timeliness for our LRPI we had to exclude this measure, however present it here for informational purposes. In Q1 2013, TCMDO was growing at a $3.1 trillion rate over the last 8 quarters (versus 2.8 trillion in Q4). TCMDO-to-GDP has increased to 357% (Q4'12: 356%, Q3: 353%, Q2: 354%, previous peak was 385% in Q1'09). Year-over-year growth accelerated slightly to 3.6% (from 3.4%) - still far below the past peak (10.6% in Q3 2007, when the S&P 500 hit its previous all-time-high of 1,575).
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After a three consecutive months of decline (April May, June 2012), US retail sales have resumed their previous growth trend. After a slow-down, the rate of growth has accelerated a bit over the past two months. For the LRPI, we have replaced this indicator with "real retail sales". Nominal retail sales include inflation, and hence say little about volume growth.
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Real retail sales (volumes) have finally surpassed their pre-recession level The rate of growth has moderated No recession signal currently This indicator has a triple weight in the LRPI
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Real per-capita retails sales are still 5% below their pre-recession peak The rate of growth improved to 2.5% in June (previous: +1.7%) No recession signal
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The growth rate in nominal retail sales excluding autos indicates 50% recession probability Auto sales, at $80 around 1/5th of total retail sales, continue to benefit from very low interest rates, abundant credit and deep-subprime used-car loans. Over the past three months, auto sales grew at 16% annualized Excluding autos, retail sales grew by 3.9% (1.3% 3-months annualized) In Q4 2012, 45% of all car financings were subprime (FICO score <660) Car sales could fall significantly if car manufacturers (respective their financing subsidiaries) and consumers lose access to cheap credit.
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Companies prefer to reduce employee's working hours rather than firing them straight away A drop in average weekly working hours in the manufacturing sector of 2% or more indicates a recession (except for 1996) According to "hours worked", the US economy is still sailing smoothly This indicator carries a double weighting in the LRPI
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The Institute for Supply Management (ISM) regularly asks company executives about orders, sales, inventories etc. A level of 50 indicates "unchanged" (economy stagnates). This indicator delivered one false positive (1989). The ISM new orders index has been hovering around 50 for a while. This indicator carries double weighting in the LRPI and currently does not give a warning sign.
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Defense and aircraft orders are lumpy and distort trends, so we exclude them here. We have "medium" confidence in this indicator due to limited historic data. The "red zone" has been set at -5% to 0%. May orders came in at $69.6bn - the highest level ever recorded. However, defense and aircraft orders are more than twice as much as the rest. Any cuts in defense spending or problems with Boeing's 787 model may affect total orders, with repercussions for many suppliers. So I wouldn't get too excited about the non-defense exaircraft data. This indicator carries a single weighting in the LRPI and currently does not give a recession warning.
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Multiple false positives (1985, 1989, 1995, 1998, 2005) muddy the water. Therefore, this indicator has been slapped with "low" confidence and a corresponding single weighting. Recent surveys hovered around the 50-point mark. The current reading suggests no growth in manufacturing supplier deliveries, but does not give a recession warning.
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If you run a business you need electricity Weather can have an impact as electricity use in the US peaks in summer due to air conditioning If electricity usage drops by 1% or more, it's a recession Limited historic data, but no misses and no false positives The drop of 1.5% in May puts the likelihood of recession at 100% "Electricity usage" carries a single weighting in the LRPI
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Electricity production should be linked to economic growth This indicator, unfortunately, had many false positives (1983, 1992, 1997, 2006), so confidence is "medium" Setting the trigger lower than -0.5% would eliminate false positives, but make you also miss some recessions Recent data has seen quite some revisions of up to 2.5% magnitude Electricity production suggests we are in a recession with 100% likelihood The indicator carries a single weighting in the LRPI
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The US population grows by 2.25m people (0.7%) per annum, so traffic increases constantly. If total miles driven grow less than 0.1% versus its own trend, you are likely to be in a recession (the unemployed drive less). The 2001 recession was missed. This indicator says we had a recession in 2011 (which is theoretically possible - we might not know it yet). The prolonged decline in miles traveled since 2007 is puzzling; the decline being deeper than the back-to-back recession 1980/81. Online shopping, car pooling and workfrom-home jobs might have contributed to this trend. A recent poll indicated young Americans are less keen on acquiring a driver's license than one or two decades ago. Unfortunately, data is made available only with a time lag of three months. This, combined with lower confidence, made us exclude this indicator from the LRPI. In March, historic data has been revised going back for years, denting confidence in this indicator further.
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Cars need gas, and gas needs to be delivered to gas stations Inventory effects are unlikely because of high turnover "Low" confidence because of false positive (1996) and limited historic data The harsh decline in 2012 is puzzling, but recovered since March 2012 Some US cities are upgrading their public bus fleet onto natural gas, potentially contributing to the decline in gasoline consumption This indicator is currently giving a 51% likelihood of recession
This indicator is related to "miles driven", confirming trends on one hand, but being redundant on the other. It has therefore been excluded from LRPI.
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The implicit price deflator is derived from the quarterly GDP report by comparing the currentdollar value of personal consumption expenditures (PCE) to its chained-value series The Federal Reserve prefers this variable over the official consumer price index (CPI) Increasing nominal yields combined with slowing inflation lead to higher real yields - a nightmare for the Fed Inflation expectations, too, are falling The Fed might have no choice but to reverse course and abolish its plans to 'taper off' bond purchases ("quantitative easing") towards the end of 2013
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Headline CPI-U ("consumer price index for urban consumers") is currently rising at a seasonally adjusted rate of 1.8% (previously: 1.4%). Core CPI-U (excluding effects from food and energy prices) is currently rising at a seasonally adjusted rate of 1.6% (previously 1.7%) .
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Real yield = nominal yield minus inflation. Resolving the equation for inflation you get: inflation = nominal yield minus real yield We use Treasury bonds for nominal yields, and TIPS (Treasury Inflation Protected Securities) for real yield. The break-even rate of inflation is the rate at which it does not matter if you bought Treasury bonds or TIPS. The resulting implied inflation rates for over the next 5 (red), 10 (blue) and 30 (black) years are printed in above chart. If you know the average rate over 10 years, and for the first 5 years of those 10 years, you can derive the expected rate of inflation for years 6 to 10 (green). The "expected" rate of inflation is not a forecast; it may or may not come true. Market expectations change. Changes in the expected rate of inflation are of interest due to a high correlation (over 75% until mid-February 2012) to changes in the S&P 500 Index (see next page).
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The current data point (red) is the pretty far away from the regression line since the beginning of 2012 Assuming historic correlations remain valid, either the stock market is over-extended or inflation expectations would have to catch up substantially. The expected value for the S&P 500 given current inflation expectations is around 1,450 (currently 1,690).
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