Our expectations for a global economic downturn, including a U.S. recession, have hardened considerably in the past few weeks, with a continued expectation of a retreat in equity prices on the order of 40-55% over the completion of the current cycle as a base case. The immediacy of both concerns would be significantly reduced if we were to observe a shift to uniformly favorable market internals. Last week, market conditions moved further away from that supportive possibility. As I’ve regularly emphasized since mid-2014, market internals are the hinge between an overvalued market that tends to continue higher from an overvalued market that collapses; the hinge between Fed easing that supports the market and Fed easing that does nothing to stem a market plunge; and the hinge between weak leading economic data that subsequently recovers and weak leading economic data that devolves into a recession.
We continue to observe deterioration in what I call the “order surplus” (new orders + order backlogs - inventories) that typically leads economic activity. Indeed, across a variety of national and regional economic surveys, as well as international data, order backlogs have dried up while inventories have expanded. Understand that recessions are not primarily driven by weakness in consumer spending. Year-over-year real personal consumption has only declined in the worst recessions, and year-over-year nominal consumption only declined in 2009, 1938 and 1932. Rather, what collapses in a recession is the inventory component of gross private investment, and as a result of scale-backs in production, real GDP falls relative to real final sales.
Emphatically, recessions are primarily points where the mix of goods and services demanded by the economy becomes misaligned with the mix of goods and services being produced. As consumer preferences shift, technology introduces new products that dominate old ones, or market signals are distorted by policy, the effects always take time to be observed and fully appreciated by all economic participants. Mismatches between demand and production build in the interim, and at the extreme, new industries can entirely replace the need for old ones. Recessions represent the adjustment to those mismatches. Push reasonable adjustments off with policy distortions (like easy credit) for too long, and the underlying mismatches become larger and ultimately more damaging. (...)
While a weak equity market, in and of itself, is not tightly correlated with subsequent economic weakness, equity market weakness combined with weak leading economic data is associated with an enormous jump in the probability of an economic recession. See in particular From Risk to Guarded Expectation of Recession, and When Market Trends Break, Even Borderline Data is Recessionary.
The chart below presents the same data as the one above, except that it shows only values corresponding to periods where the S&P 500 was below its level of 6-months prior (as it is at present). Other values are set to zero. Again, while a uniform improvement in market internals would relieve the immediacy of our present economic and market concerns, we already observe deterioration in leading economic measures that - coupled with financial market behavior - has always been associated with U.S. recessions.
The immediate conclusion that one might draw is that the Federal Reserve made a “policy mistake” by raising interest rates in December. But that would far understate the actual damage contributed by the Fed. No, the real policy mistake was to provoke years of yield-seeking speculation through Ben Bernanke’s deranged policy of quantitative easing, which propagated like a virus to central banks across the globe. The extreme and extended nature of the recent speculative episode means that we do not simply have to worry about a run-of-the-mill recession or an ordinary bear market. We instead have to be concerned about the potential for another global financial crisis, born of years of capital misallocation and expansion of low-quality debt both here in the U.S. and in the emerging economies. For a review of these concerns, see The Next Big Short: The Third Crest of a Rolling Tsunami.
We continue to observe deterioration in what I call the “order surplus” (new orders + order backlogs - inventories) that typically leads economic activity. Indeed, across a variety of national and regional economic surveys, as well as international data, order backlogs have dried up while inventories have expanded. Understand that recessions are not primarily driven by weakness in consumer spending. Year-over-year real personal consumption has only declined in the worst recessions, and year-over-year nominal consumption only declined in 2009, 1938 and 1932. Rather, what collapses in a recession is the inventory component of gross private investment, and as a result of scale-backs in production, real GDP falls relative to real final sales.
Emphatically, recessions are primarily points where the mix of goods and services demanded by the economy becomes misaligned with the mix of goods and services being produced. As consumer preferences shift, technology introduces new products that dominate old ones, or market signals are distorted by policy, the effects always take time to be observed and fully appreciated by all economic participants. Mismatches between demand and production build in the interim, and at the extreme, new industries can entirely replace the need for old ones. Recessions represent the adjustment to those mismatches. Push reasonable adjustments off with policy distortions (like easy credit) for too long, and the underlying mismatches become larger and ultimately more damaging. (...)
While a weak equity market, in and of itself, is not tightly correlated with subsequent economic weakness, equity market weakness combined with weak leading economic data is associated with an enormous jump in the probability of an economic recession. See in particular From Risk to Guarded Expectation of Recession, and When Market Trends Break, Even Borderline Data is Recessionary.
The chart below presents the same data as the one above, except that it shows only values corresponding to periods where the S&P 500 was below its level of 6-months prior (as it is at present). Other values are set to zero. Again, while a uniform improvement in market internals would relieve the immediacy of our present economic and market concerns, we already observe deterioration in leading economic measures that - coupled with financial market behavior - has always been associated with U.S. recessions.
The immediate conclusion that one might draw is that the Federal Reserve made a “policy mistake” by raising interest rates in December. But that would far understate the actual damage contributed by the Fed. No, the real policy mistake was to provoke years of yield-seeking speculation through Ben Bernanke’s deranged policy of quantitative easing, which propagated like a virus to central banks across the globe. The extreme and extended nature of the recent speculative episode means that we do not simply have to worry about a run-of-the-mill recession or an ordinary bear market. We instead have to be concerned about the potential for another global financial crisis, born of years of capital misallocation and expansion of low-quality debt both here in the U.S. and in the emerging economies. For a review of these concerns, see The Next Big Short: The Third Crest of a Rolling Tsunami.
by John P. Hussman, Ph D. Hussman Funds | Read more:
Image: Hussman Funds
