Recessions are heralded by four horsemen of the stock market apocalypse.
1. Oil price spike.
2. Fed interest rate spike and yield curve inversion.
3. Fiscal spending cutbacks by the national government.
4. Forward earnings dropping.
Let us look at each in turn:
Oil Price Spike
The blue line is the oil price. The grey bars are recessions. Except for 1960, all recessions were preceded by a spike in the oil price. The oil price is rising at present after reaching multi-decade lows after the GFC.
Some factors are coming together to drive the oil price higher:
1. Increased world demand.
2. Supply problems from producers such as Iran, Venezuela, and the problematic Middle East in general.
3. Agreement by OPEC and other major oil producers such as Russia to curb oil production and drive up the price.
Fed Inverts the Yield Curve
Each recession since WW2 has been preceded by an interest rate inversion as the short rate exceeds the long rate. We are on that path, and despite the lessons of the past, we are doomed to repeat this folly. The chart below shows this sequence of repeated stupidity.
The pattern is so clear it can only be intentional. One can see when the inversion occurs that the recession is not immediate and there can be a lag of up to two years. But it does come, and the stock market comes down with it.
The Fed’s main aim is to control inflation; however, it seems that central banks have their understanding of inflation backward.
What I am asserting is that the Fed and the mainstream have it backwards with regard to how interest rates interact with the economy. They have it backwards with regard to both the current health of the economy and inflation, and, therefore, their discussion of appropriate monetary policy is entirely confused and inapplicable.
– Source: Warren Mosler
Mr. Mosler, a self-made multi-billionaire, and grounder of the modern money movement makes the following points about central bank interest rates.
The mainstream is wrong in its presumption that low rates are supportive of aggregate demand and inflation for the following reasons:
- Lower rates do not encourage borrowing to spend at the macro level. Rate cuts directly reduce government spending and the private sector’s net interest income from government debt.
- Lower rates do not increase inflation expectations or inflation. The reverse is true – inflation in the USA has started rising only after the Fed moved away from its zero rate policy. Japan and Euroland still have zero rate policies and below-expectation and guideline inflation levels.
- Lower rates do not lower the exchange rate and thus offer support through export income or reduce imports. Currency does not depreciate and make exporters more competitive via lower real wage costs, nor do inflation expectations rise for importers facing higher import prices. Higher rates have so far weakened the USD, and low rates in Japan and Euroland have made the currency relatively stronger.
Despite this evidence to the contrary, the Fed is intent on raising rates to what it feels is a normal level of around three percent. Each time the Fed raises, the FFR inflation does increase with the general rise in the price of credit given the high level of private debt in the economy (150% of GDP).
The Fed sees inflation rising and so raises the rate again, and this causes more inflation and gives it cause for another rate rise. It is throwing fat on the fire.
Its mainstream education, dogma and belief system do not allow it to see what is going on.
When the Fed raises the rate, it has the following main effects:
1. Each 0.25% rate increase moves about $70B income from the rest of the economy to the banking sector. This is an intersectoral flow that impoverishes all sectors apart from the banks.
2. The income from Treasury increases and adds dollars to the economy.
3. Banks pay more for their reserves; however, this is not great and is offset by their holdings of Treasuries which now earn more.
Cut to Fiscal Flows
The CBO recently released a report on the Federal budget and unwittingly showed when the next recession is likely to occur. This is shown below:
A big move down in GDP is enough of an income shock to business that a recession could well be triggered going into 2019. The CBO can rightly be criticized for its poor forecasting ability; however, over shorter terms of one to two years, it is quite accurate.
The reason for the GDP drop is the expiry of Federal tax concessions, which means more dollars are extracted from the economy in taxes per year, and this shrinks the economy. The CBO estimates that the tax expiration will lower GDP from a growth rate of over three percent to just over one percent by 2021. This is an income loss of around $555B per annum starting at the end of 2018. So by 2021, the Federal government would have extracted about $1.5T out of the economy.
A list of the expiring tax exemptions is listed below:
(Source: Joint Committee on Taxation)
To understand this better, one has to look at the balance of sectoral flows within the US economy using stock-flow consistent sectoral flow analysis.
Professor Wynne Godley first apprehended the strategic importance of the accounting identity, which says that measured at current prices, the government’s budget balance, less the current account balance, is equal, by definition, to the private sector balance.
GDP = Federal Spending + Non-Federal spending + Net Exports.
As a percentage of GDP, all three sectors sum to zero.
A table of the sectoral balance flows is presented below:
(Source: FRED plus author calculations)
*Estimate to be updated when the end of year numbers are known.
#Forecast based on existing flow rates and plans.
The table above models the sectoral flow change. If one deducts three percent of GDP from the government sector and assumes that the external sector remains the same, then the private sector balance moves into negative territory.
What this means is that each year after 2018, the Federal government will extract $555B out of the private sector. This means that the stock of wealth in the private sector (Main Street economy, you, me and everyone else) will have to reduce our stock of wealth or go into debt to pay the Federal government the additional taxes that it has levied.
The private sector shrinks in value which will cause the price of all financial assets in the private sector such as stock, bonds and real estate to fall in value. This is a mathematical certainty.
To see the association of how a negative, weak or declining private sector flow balance causes recessions look at the following chart showing sectoral balances for the USA since 1970. The red line shows the Federal government fiscal balance; notice how each recession is preceded by a movement of the red line upwards towards or over the zero line. Notice also that every recession is followed by a drop in the red line as the recession is cured by more Federal government spending to add dollars that grow the economy.
Professor William Mitchell, an expert on sectoral balances, has produced the following chart and forecast of the sector balances for the USA.
(Source: Professor William Mitchell)
Note that the mainstream in America believe that Federal government deficits are bad and are working to move the red line upwards and cause a recession. This belief is institutionalized and almost universal apart from those few people that understand functional accounting and sectoral balances and monetary sovereignty.
The following chart highlights the sector flows at key times in the past:
(Source: Trading Economics, FRED and Author calculations based on same)
The table shows that in 2000 the Clinton surplus budgets and the current account deficit of the time leading up to the Dot-Com crash caused a -6.44% of GDP private sector balance.
At the bottom of the Dot-Com crash, a Federal government deficit budget of 3.4% of GDP was enough to move the economy out of recession and grow the current account deficit. The continued strength of credit creation helped as well, remaining at 9.7% of GDP even at the bottom of the trough in 2003.
During the entire phase, credit creation was adding to aggregate demand by over 9-11% of GDP while the current account deficit was also maintained at over 4% of GDP. The private sector paid for the current account deficit and the Federal government surplus budgets by taking on debt. The private sector ran a deficit budget of over 9% of GDP to the banking sector.
The GFC crash saw the private sector balance again reach -3.8% of GDP before tipping over. This was caused largely by a large current account deficit of nearly 5% of GDP and a very small Federal government deficit of just over 1% of GDP. The Federal government deficit needed to be much larger at that time to ward off recession. It needed to be at least over 5% to pay for the current account deficit plus a little more for internal growth and private debt repayment. It was none of those things.
The trough of the GFC saw the current account deficit almost halved; the Federal government balance moved out to 9.8% of GDP allowing the private sector balance to move out to a positive 7.1% of GDP.
During the GFC phase, credit creation varied from over 13% of GDP in the peak and contracted to -3.6% at the trough. Private debt (the private sector deficit) peaked at 170% of GDP and fell back to 150% of GDP at the bottom of the recession as the chart below shows. It was the 9.8% of GDP Federal government spending and a reduction in the current account deficit that allowed for the private sector balance to improve and for some of the private debt to be repaid.
(Source: Professor Steve Keen)
Finally, at the end of the table is a comparison of the 1943 sectoral balances to show what it takes to win a world war and what can be done when a nation’s resources are marshaled together for a single cause. The same could be done for climate change, education, healthcare, and infrastructure.
Comparing booms and busts and the present one notes the following:
1. Credit creation is now much lower than it was. Credit creation drove the boom-busts of 2000 and 2007 and is now much weaker than at those times. It is hard to foresee a credit boom in the coming years to 2020; however, with the repeal of the Dodd-Frank Act and the gradual dismantling of other post-GFC era regulations and institutions, it could well happen.
2. Even in 2021, the private sector balance will be negative but not as strongly negative as in 2000 and 2007. A recession at this time due to tax exemption expiry could be more of a slowdown than a recession if it were to happen in isolation. We have though the impact of higher Fed rates and oil to add to the equation.
3. The sum of the flows gives one an idea of the percentage change to aggregate demand given that aggregate demand is GDP + Credit. What is cautionary is that the change to aggregate demand will be on the same level in 2019-21 as for 2009.
The market may ignore business success for a while, but eventually will confirm it. As Ben said: “In the short run, the market is a voting machine, but in the long run it is a weighing machine.“
(Source: Warren Buffett)
The point is that earnings, revenue and net income growth rates of the S&P are peaking now (shown highlighted yellow 2018 Q1), will be strong but flat over the next few quarters, and then fall off a cliff in 2019 Q1.
What this means is that the market also recognizes the impact the above-listed factors have and is adjusting its earnings outlook accordingly. The adjustment is downwards.
The move downwards is the reflected wisdom and conclusion of thousands of company CEOs across the country responding to lower Federal government spending, low credit creation and a sustained current account deficit.
Summary, Conclusion, and Recommendation
Were it not for all these factors not coming together at the same time, a recession could well be avoided. The fact is though that we have a combination of higher interest rates, oil prices, and lower Federal spending.
The higher Fed rates and oil prices are intersectoral fiscal flows in that money moves from one part of the private sector to the finance and oil sectors, the net money supply remains the same. The consumer though has lower purchasing power for other goods and services. Some money will leave the system in the form of income to foreign oil suppliers and be reflected in a worsening of the current account position.
The Federal tax exemption expiry is the more serious of the three factors. This is because this factor removes money from the net money supply. GDP = GDI and when income falls due to higher taxes, GDP must fall too.
Add all three factors together, and one has the ingredients for a recession.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.