Why Paul McCulley Would Be Shorting The Economy With Both Hands Right Now

According to the plethora of long-only managers willing to trot out on the public stage and beg for more commissions, the US has been (and will remain) the cleanest-dirty-shirt in the global risk asset laundry basket; but as David Rosenberg of Gluskin Sheff points out not only has the S&P 500 hit a new record high in its total return index but it also possesses a rather 'ebullient' valuation premium (2012E P/E) of 13.8x relative to China 9.8x and Europe 11.4x. However, while this is more than enough to slow some investors from backing up the long-truck, Rosie goes on to highlight a very worrisome indicator - that favored by ex-PIMCO's Paul McCulley. The YoY trend in the three-month moving average of core capex orders (which was updated last Friday) has just cracked negative, crushing the hopes of US growth prospects and we assume equity superlatives. However, since the market no longer reflects anything; certainly not the economy, but merely who will ease more when and how, one really can't short much if anything, even if McCulley is 100% spot on.


The key piece of data on Friday was the release of durable goods orders and shipments for July.

The news here was not good at all.

The key leading indicator of business capital spending is the non-defense capital goods ex-aircraft (core capex) component, and it slid 3.4% in July on top of a 2.7% plunge in June for the worst back-to-back performance since December 2008-January 2009. These orders are down now in four of the past five months, and so far in Q3, the "build in" is a hugely negative -16.4% annualized tally and this follows on the heels of a -5.8% print in Q2. Now core capex shipments were flat in July, the softest reading in three months, but there is still enough statistical momentum being carried over from Q2 to keep the current trend running close to a +5.6% annual rate versus 5.4% in Q2.

But shipments are a coincident indicator while orders tend to be a leading indicator, and they are pointing in the direction of a very weak Q4 as far as business activity is concerned. Housing may be reviving, but it is only 2% of GDP whereas business capex represents a 7% share of the economy.

Paul McCulley, the former legendary economist and fund manager at PIMCO, who was once being touted to join the Fed as a policymaker, told me last year at the Altegris-Mauldin conference, the YoY trend in the three-month moving average of core capex orders had for a long time been his preferred indicator of how the broader economy was going to fare a few quarters into the future. Well, if you are bullish on U.S. growth prospects over the near-term, I suggest you look at the chart below:

Notice how the YoY trend just sliced below the zero-line in July (to -1.7% from +1.1% in June). Only once in the past did this NOT tip the overall economy into recession and that was back in September 1998 when the Asian crisis was at its peak, LTCM had to be wound up and Russia defaulted ... not exactly a pretty sign even if the recession was delayed for another two years.

In terms of sectors, it was order declines in machinery, electrical equipment and communications equipment that far outpaced gains in metals, autos, aircraft, and computers.

Source: Gluskin Sheff