The minutes from the Federal Reserve Board’s last meeting have come out and they are dovish. While on the one hand, we should praise the Fed for showing it is data-dependent just as it has professed to be, on the other hand, the abrupt change in is somewhat alarming. I would suggest the Fed is not necessarily panicked but it is certainly worried that it tightened into weakness in December and that future data will be much weaker than it previously anticipated. Some more thoughts follow below.
About a month ago, I was writing you about how the US economy is shaping up in 2016 and how the Fed will react. I wrote that “the US economy – while still far from recession – is still downshifting.” My concern, however, was that the Fed didn’t quite get this and was still talking a hawkish game. But that has since changed. Look at what Tim Duy shows in his latest analysis of the Fed’s minutes, released just yesterday. I think his opening paragraph does an excellent job of summing up the changed situation at the Fed:
The FOMC minutes indicates the Fed is just a dovish as believed. This was somewhat surprising given the tendency of minutes to have a more balanced perspective which would appear to be hawkish relative to current market expectations. But not this time. This time the message was fairly clear: They can’t ignore the asymmetry of policy risks any longer. Gradual went to glacial, with April now off the table, leaving June as the next possible data for a rate hike. Expect Fedspeak to sound somewhat hawkish given they will want to keep June on the table – but I am less than certain they will have the data in hand to justify another hike until the second half of the year.
Translation: the economy is so weak now that the Fed may not be able to even hit its target of two rate hikes, a target that was reduced from 4 hikes for 2016 predicted just in December. That’s astonishing really. Think about it for a second. Literally four months ago the Fed was telling us things were so good that we should expect 300 basis points of hikes over three years. That’s twelve hikes in three years. Now they are saying they may not be able to get a single hike off the table – so weak is the economy.
To me this speaks to policy error. basically the Fed tried to start hiking in December and it ran into a buzz saw, not just from economic weakness but financial fragility and global monetary policy divergence. And so now its hands are tied.
The right question now is: how weak is the US economy?
Let’s run through several data points to explore.
Q4 2015 real GDP growth was upgraded twice from 0.7% to 1.4%. That is positive. But it is still below the 2.0% trendline that I see as dividing a stall speed economy from a middling expansion. Moreover the rolling year-over-year real GDP numbers are also in jeopardy of falling below that trendline.
My biggest concern is that Q1 2016 is now weak. When I wrote last month, the Atlanta Fed’s GDPNow predictor was just above the 2% level. It has since dropped to well below 1%.
This deterioration in growth is both investment and consumption and that’s a very bad indicator in an environment in which corporate profits are plummeting.
No one thinks of jobs as a leading indicator because it is a decline in consumer spending and capital investment which lead to longer-lasting inventory purges that presage a decline in payrolls into garden-variety recessions. Declining payrolls are the end result of factors that combine to create recession. Yet, when I have looked at data, the year-over-year or six-month change in indicators like jobless claims and non-farm payrolls were good real-time indicators of how well the economy is doing. And the reason is that the increased or reduced flow of people with jobs or in unemployment roles is also a ‘shock’ to income. And that shock gets transmitted into the economy via spending. If payroll growth declines precipitously or jobless claims increase aggressively, it is a good real-time indicator of income weakness that translate into less consumer spending.
On this front, initial jobless claims continue to show strength. And that is encouraging. Even today we saw a 267,000 number versus a 270,000 estimate. Until this number starts to rise I am not going to be alarmed about the US economy. At the same time, we do see weakness via the non-farm payrolls growth decline.
That weakness began in the beginning of 2015, but could be ending due to the recent uptick in year-over-year non-farm payroll growth. This number bears watching in order to determine if we can get beyond a mid-cycle pause and move forward in this economic expansion.
The ISM numbers corroborate the possibility that we can power through with a mid-cycle pause. Manufacturing was at 51.8 and above 50 for the first time in months in the latest ISM manufacturing report. New orders and production both showed strong gains. And that says that the manufacturing slump many were talking about as a harbinger of bad things to come elsewhere is actually attenuating. I see this series along with non-farm payroll growth as one to watch going forward.
ISM’s non-manufacturing index came in at 54.5% in March, with the Business Activity Index at 59.8%, New Orders Index at 56.7%, and the Employment Index at 50.3%. All of this says the expansion in the US – while weak – continues apace.
I am on recession watch yes. But I am not ready to claim that recession is happening or coming based on the totality of the data.
Corporate profits are the one thing that worries me at the macro level because lower corporate profits will generate negative feedback into both business investment and jobs and income growth. But there is no a priori rule that lower corporate profits mean recession any more than there is a rule that manufacturing slumps presage whole economy slumps.
At the same time the data are weaker today than they were a month ago. And it is this fact which has flipped the Fed to dovish from hawkish.
If and when rolling year-over-year GDP growth declines below 2% and the economy moves much further into the stall speed category, it is the existing financial fragility that will determine feedback. We saw what happened with energy capex and high yield when oil and commodity prices collapsed. But right now two other debt focus points are exhibiting unusual levels of stress. One is the auto sector, where we have seen weakness both on the funding side and on the production side. The chart below from Calculated Risk shows declining sales volume hitting 4 months on the trot.
On the funding side, subprime auto in particular, shows weakness. And I want to spend a little time here because I think this sector is one of three with student loans and energy high yield we saw driving credit growth during the up-cycle. I will have more on student loans later.
On subprime, let me bullet point a few details:
- Aggressive new lenders with limited full-cycle experience. “The number of borrowers who were more than 60 days late on their car bills in February rose 11.6 percent from the same period a year ago, bringing the delinquency rate to a total 5.16 percent, according to the credit rating company…Delinquency rates for these newer issuers have often been higher relative to more established players. For example, the 60-day delinquency rate for subprime auto ABS deals sold by Exeter is almost 10 percent following 20 months of aging, compared with the 2.3 percent rate at more-established player AmeriCredit in the same period and vs. a high of 4.5 percent reached in 2000. New ABS programs launched by GO Financial and Skopos just last year, meanwhile, are already seeing delinquencies running into 6 percent at less than 12 months of so-called seasoning, according to JPMorgan.” (Bloomberg) “The early delinquency rates seen in the debt issue from Skopos Financial LLC, a Dallas-based lender that specializes in loans to people with weak or no credit histories, are in line with those for several similar bond deals from other lenders around the same time. About 12% of the loans backing bonds sold in November by Exeter Finance Corp., another Dallas-based subprime lender, were more than 30 days delinquent through February, according to the company. A spokeswoman said delinquency rates came down from the previous month.” (WSJ) “Small lenders are leading the increase in subprime auto bond issuance and are also the main driver of losses, according to a new report. Just over 70% of subprime car securitizations that occurred in 2015 were loans originated by small lenders—a reversal in trend since 2010 when the two largest subprime securitizers, Santander Consumer USA Holdings and AmeriCredit, held roughly that share, according to credit-ratings firm Moody’s Investors Service.” (WSJ)
- Unhealthy risk-taking in securitization market by credit unions. CUNA 2012: “It turns out that lending to borrowers with lower credit scores doesn’t have to be dangerous for your credit union. In fact, it can be a key facet of your loan-growth strategy. After the mortgage crisis, “subprime” might as well be a four-letter word. But the truth is you can add subprime borrowers to your auto loan portfolio without setting your credit union up for failure.”
- Extended maturities suggests quality deterioration: “Auto loan debt owned by U.S. households topped $1 trillion for the first time during 2015—and in the same year the average length of auto loans hit an all-time high of 67 months.” (CU Today)
The whole picture then is one of massively increased credit volume, now turning to slowing volume growth and souring credit, which in turn is inhibiting sales. I believe we will find this sector to be choc-a-block with bad debt, declining auto resale value and eventually trouble in the securitization market. I believe we will also see smaller lenders and credit unions having moved into this sector to increase growth and having taken too many risks in doing so. I also see this as a warning sign for consumer spending as auto sales bought on credit contributed greatly to past economic growth.
Finally, regarding financial fragility, there’s student loans. This from the Wall Street Journal bears reading:
About 1 in 6 borrowers, or 3.6 million, were in default on $56 billion in student debt, meaning they had gone at least a year without making a payment. Three million more owing roughly $66 billion were at least a month behind.
Meantime, another three million owing almost $110 billion were in “forbearance” or “deferment,” meaning they had received permission to temporarily halt payments due to a financial emergency, such as unemployment. The figures exclude borrowers still in school and those with government-guaranteed private loans.
Navient Corp., which services student loans and offers payment plans tied to income, says it attempts to reach each borrower on average 230 to 300 times—through letters, emails, calls and text messages—in the year leading up to his or her default. Ninety percent of those borrowers, which include federal borrowers as well as those who hold private loans, never respond and more than half never make a single payment before they default, the company says.
Here, I expect the distress to contribute greatly to economic deceleration only once a downturn has begun. Whereas the auto sector will create downside growth INTO recession.
My bottom line here then is that the US remains in a slow recovery. It is at stall speed, but increasingly showing signs that it could move below stall speed. While some indicators are pointing up, enough are pointing down that it is clear that more policy tightening at the Fed would be a huge error. And the Fed seems to have recognized this. But the effects of the December move are still in play. We will just have to see how much more deceleration in growth is in store. Whether the Fed is panicked or not, it is certainly now aware of the problem. It makes sense then to frontrun the Fed’s eventual acknowledgment that even its present downgraded forecasts are too optimistic.
Meanwhile, the hallmarks of increased financial fragility in two former boom lending sectors – autos and student loans – have joined the third boom sector, energy, in showing signs of distress. I expect the distress to worsen. And I see this downshift in credit conditions as a hallmark of end of cycle dynamics rather than the dynamics of a mid-cycle pause.
The biggest downside risk here is that the next downturn will be more pronounced than anticipated because of financial fragility. Moreover, I believe the policy support needed to prevent a deeper downturn will be limited. For a parallel, think 1997 Japan and that country’s subsequent drop into deflation.