One month ago, when the first Q2 GDP estimate was released, we reported that if one strips away the consumer part of the economy, the US was already in a recession.
Overnight, In his latest letter SocGen's Albert Edwards picks up on this topic, but first dispenses with the usual warning, saying that "the US economy is on crutches, and they are about to be kicked away" adding that "US economic growth is weak yet the labour market is tight. This juxtaposition is keeping the Fed in a quandary on whether to raise interest rates. As it stands it probably will, or will not, depending on which way the wind (data) is blowing that day!"
After the requisite "flip-flop Fed watching", Albert then proceeds to agree with what we said recently, namely that "the only thing keeping the US out of recession is the US consumer (see chart below). It is difficult to say consumption is driving the economy forward - rather it is like a woodwormridden crutch creaking under the strain of holding up a deadweight economy. This recovery ? the fourth longest in history - is surely nearing its end."
While so far the consumer remains resilient, and in fact in the second quarter, US personal spending unexpectedly soared to near cycle highs just as the rest of the economy dipped in a recession...
... this pace of consumption, of which Obamacare has been a significant recipient, will hardly sustain itself. According to Edwards, his "hypothesis that a US profits recession will lead to a collapse in business investment and take the economy into recession seems to be playing out. If consumption stalls then we really are in trouble, for the next devastating phase of the secular valuation bear market in equities will kick in ? much to the shock of both investors and the Fed."
But before we drill down into the consumer part, first a quick look into why the SocGen strategist so confident that the non-consumer part of the economy is about to tap out. For that, he present the following historical parallel:
The year 1986 has been the only case where a business investment recession did not cause an outright US GDP recession. Why? Because the economy had recently emerged from 1982 recession and it was growing very strongly indeed when the hit to capital spending came. In addition, households were leveraging up aggressively, which boosted consumer spending. Neither of these things is the case now. Indeed the current consumer/GDP conjuncture has echoes of Q1 2007 (circled in the chart below), when robust consumption only temporarily offset extreme weakness in the data elsewhere. But within six months, by November 2007, the NBER recorded that the economy had fallen into outright recession.
So going back to the consumer, what does Edwards believes will catalyze the next move in spending lower? Well, besides today's abysmal auto sales numbers (which Edwards did not have in front of him when he wrote his note), he brings up another point we raised several months, namely that "The Fed Has A Problem: Inflation May Hit 3.5% By December Due To Gas Price "Base Effect"." Indeed, now that we have anniversaried the low point in 2015's energy prices, it's all uphill from here for CPI prints. This is how Edwards puts it:
One key and imminent risk for the consumer is a rapid pick-up in headline CPI inflation as the weak oil price of H2 last year starts to drop out of the yoy calculations. Headline CPI inflation is set to rise rapidly from the 1% where it has hovered for the past six months and to converge with core CPI, standing at 2¼%. That will sap some 1¼% from real personal disposable income growth, which will decelerate rapidly, removing the key prop for recent moderate robust consumption growth. This is the economy?s crutch being kicked away.
In this likely outturn the increasingly tight labour market might mean the household sector can respond to the squeeze in real income growth by pushing up wages, which have been accelerating at a moderate but consistent pace over the last couple of years. An acceleration in wages might help offset the impact of slowing employment growth, as the pain in the corporate sector ripples over into all categories of their spending - hence nominal household disposable income growth (the dotted line in the chart above), may not slow so sharply. But with the Fed confronted with a traditional end-of-cycle, tight labour market with accelerating headline CPI and wages, the pressure to hike rates aggressively will be fierce. Perhaps the next recession will be of the normal, ?made in Washington? variety after all.
To be sure, rising wages (something corporations have only granted to the lowest paid workers as shown earlier this week) may delay the day of reckoning, but it opens up a whole new can of worms, because as Fitch warned just today in a report titled "Sharp US Wage Shock Could Cause Global Tightening; Major Slowdown", a domestic US wage cost shock could lead to substantial financial tightening, which would result in a significant slowdown in the world economy. In the report Fitch economists explore the consequences of a much faster-than-expected pick-up in US wage growth and the impact on economic growth, Fed policy and bond yields as well as international macroeconomic spillovers.
"Fitch's baseline forecast is for US wage growth to pick up gradually, which would support household incomes and help bring inflation back to target as the Fed gradually normalises policy, but a very sharp increase in US wage inflation would be problematic," said Brian Coulton, Chief Economist, Fitch. "A surge in US wage inflation would prompt the Fed to hike rates much more quickly than expected and threaten the lower-for-longer market consensus on interest rates that underpins current very low bond yields."
As Fitch concludes:
"The benefits of higher wages on US consumer spending would be quite quickly offset by up-front rate hikes from the Fed. Fitch's simulations suggest the Fed would react by raising interest rates by an additional 150bps (relative to baseline) over the course of six months. In combination with the impact of higher wage costs and bond yields, this would see growth 1.4pps lower than baseline in the US in 2017, at 0.6%. About half the impact on US growth stems from the Fed's reaction and higher wage costs and half from higher bond yields."
Or, in other words, a recession is coming if wages remain low, but should wages rise too fast, the recession will come even faster. Pick your poison.