According to Deutsche Bank, four signals are in place that have been associated with US recessions in the past:
- The US profit recession: US NIPA margins peaked in Q2 2014 and have been on a declining path for the past eight quarters. Since 1950, the average gap between a peak in margins and the start of a recession has been eight quarters (as falling margins typically lead corporates to cut back on hiring and investment);
- The 12-month change in the Fed’s Labour Market Condition Index (LMCI) has turned negative in August: on five out of the seven occasions this happened over the past 40 years, it signalled the onset of a recession (with an average lead of 3 months). Temp employment growth is below headline employment growth, a recessionary signal in the past;
- Capex growth has turned negative: US capex has fallen by 2% over the past year. Negative capex growth has been associated with US recessions in the past;
- Rising default rates: US speculative default rates have risen to 5.7%. Over the past 30 years, they pushed meaningfully above 5% on only four occasions, three of which turned into a full default cycle (with default rates ~10%) and a recession.
It's not just these four core necessary (and perhaps sufficient) factors that force DB's economists to be some of the most bearish on the street. The bank adds the following:
We remain cautious on the outlook for the US macro cycle. While the similarities with 1986 are intriguing, there are important differences that make the current episode more precarious:
- US profit growth is likely to remain weak: between Q4 1986 and Q4 1987, US NIPA profits rebounded by 23%. Such a recovery is unlikely now. The real problem for US profit growth is high real unit labour costs (a function of wage normalization against the backdrop of weak productivity growth and low inflation). In the absence of stronger productivity growth and inflation, real ULC growth will continue to put pressure on margins. This, in turn, risks leading to weaker hiring and investment growth. We note that our US equity strategist projects US EPS to stay flat through H1 2017.
- Leverage looks more problematic: US corporates were under-leveraged in 1986, with the corporate debt to GDP ratio 3 percentage points (pp) below the long-run trend. This made it easy for default rates to drop, as the shock from falling oil prices dissipated. Today, the US corporate debt to GDP ratio is at an all-time high and around 3pp above trend (more than at the start of past default cycles). This points to further upside for default rates (even as loose monetary policy keeps them below the level suggested by fundamentals). A flat yield curve and tightening bank lending standards also suggest default rates will remain high or even rise further. Our US credit strategist expects default rates to rise to 7.2%, despite stabilizing defaults by commodity-linked issuers.
- Monetary policy has less scope to be supportive: between mid-1985 and late-1986, the Fed cut rates by 550bps, boosting the economy and allowing the US dollar to depreciate. The US dollar dropped by 40% between its peak before the Plaza Accord in late 1985 and the end of 1987, leading export growth to accelerate to almost 20% yoy in early 1988. This time round, the dollar has fallen by only 7% and the Fed seems eager to hike, which could lead to renewed currency strength. If the Fed decided to ease policy again, its ability to do so would be significantly more limited than it was back then.
- Employment growth is unlikely to accelerate: the labour market recovery was less mature in 1986 than it is now (with the unemployment rate around 1pp above NAIRU, while it is now close to NAIRU). This allowed employment growth to accelerate to 3% in 1987, boosting consumption, while in the current episode, lead indicators are consistent with a drop in employment growth to below 1%.
As DB then shows, when the four conditions listed above all take place simultaneously, a recession always follows, with just one exception.
As the red x shown above demonstrates, there has only been one occasion over the past 30 years on which these factors have come together without this leading to a recession – namely, 1986.
This is what happened in 1986, a scenario which DB believes the market is pricing in right now:
[in 1986] all four signals were in place, yet the US avoided a recession. Back then, as now, the bleak reading on these indicators was preceded by a sharp rise in the US dollar (65% between 1978 and 1985, compared to 40% now) and a major fall in the oil price (71%, compared to 75% this time round). What makes the comparison even more striking is that: a) 1986 was the only episode over the past 60 years in which US corporate margins declined (from 8.6% in Q2 1984 to 6.7% in Q4 1986) without this leading to a recession; b) it was the only episode over the past 40 years during which capex growth turned negative (driven by falling energy investments) without this leading to a recession; c) it was the only episode over the past 30 years in which speculative default rates rose meaningfully above 5% without this leading to a recession.
So yes, in 1986 the US avoided a recession. And here why: as DB explains, the reason the economy did not go into recession but back then was that the Fed cut rates by 550bps and the US dollar dropped by 40% after the Plaza Accord, boosting export growth.
Needless to say, with rates at just above zero, there is no way the Fed can cut rates anywhere close to 550 bps, or even 50 bps; if anything it would either require trillions more in QE or for the Fed to join the ECB, BOJ and SNB in cutting rates negative. As for the dollar plunging 40%, that would mean sending other currencies of economies that are even weaker than the US, soaring by 40%, which may prevent a US recession, but would lead to a global depression.
As Deutsche Bank summarizes, "none of these support factors are unlikely to materialize this time round." However, perhaps so as not to precipitate a more violent market reaction, DB assigns only a 30% probability of a US recession over the coming 12 months. Maybe anything greater than those odds, and DB stock - which as we showed earlier today is again approaching all time lows - would be the first to get aggressively sold.