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Respected fund manager / economist John Hussman argues that the US is entering a “double dip” on the basis of four criteria that, in combination, have identified the last seven recessions (at least). Hussman used the approach in late 2007 to anticipate the 2008-09 contraction.

The criteria are:

1. Wider credit spreads than six months ago.
2. A moderate or flat yield curve, defined as a yield gap of no more than 3.1 percentage points between 10-year Treasury bonds and three-month Treasury bills (currently 2.9).
3. A lower stock market than six months ago, as measured by the S&P 500 index.
4. A manufacturing purchasing managers’ index (PMI) at or below 54 coupled with non-farm employment growth of less than an annual 1.3%.

The PMI condition in the fourth criterion has yet to be fulfilled but Hussman argues that this is likely based on recent weakness in the weekly leading index (WLI) compiled by the Economic Cycle Research Institute (ECRI). Indeed, the WLI can be used instead of the PMI and yields nearly identical historical results, with the criterion already met.

Are there any reasons for thinking that “this time could be different”?

One doubt concerns the employment condition in the fourth criterion. In the last seven recessions, the annual growth rate fell beneath 1.3% from above. Employment is currently still lower than a year ago. Is a recovery in growth to above the critical level necessary before a new recession signal can be generated?

In earlier work, moreover, Hussman used a slightly different formulation, with a simpler fourth criterion – a manufacturing PMI of below 50 – and a lower critical value of 2.5 percentage points for the 10-year / three-month Treasury yield gap in the second criterion. Both formulations signalled the recent recession but only the modified version is currently giving a warning. Hussman, presumably, would argue that the new model is superior and provides more of a lead; the old version is likely to follow in due course.

The view here has been that narrow money trends are not yet weak enough to suggest a second recession. The chart shows a US real money measure that has weakened ahead of 10 of the 11 recessions since the second world war, the exception being the 1953-54 downturn, which was triggered by a large fall in government spending following the end of the Korean war. The measure has continued to rise recently, albeit at a slowing pace.

US fiscal policy is scheduled to tighten significantly in 2011 but it is doubtful that the economic impact will be as great as the post-Korean-war cuts – government spending on goods and services fell by a real 6.8% in calendar 1954, cutting 1.64 percentage points directly from GDP.

The UK’s inflation performance appears to compare unfavourably with the US – “official” consumer price indices rose by 3.7% and 2.2% respectively in the year to April. The gap, however, largely disappears if US inflation is recalculated using the European Union’s “harmonized index of consumer prices” (HICP) methodology. US HICP inflation was an annual 3.5% in April.

The US figure comes from a table of international HICP inflation rates published each month by the US Bureau of Labor Statistics. The UK and US April annual rates of 3.7% and 3.5% compare with 1.5% in the Eurozone and -1.4% in Japan. Similar UK and US inflation experience could reflect identical monetary policy strategies, involving large-scale “quantitative easing” and currency depreciation.

A key difference between the official US consumer price index (CPI) and the HICP is that the latter excludes owner-occupied housing costs, of which the most important component is “owners’ equivalent rent” (OER) – a notional payment by homeowners to themselves for accommodation. OER has a 25% weight in the CPI basket and is estimated – based on market rents – to have fallen over the last year, exerting a major drag on official inflation measures.

It is debatable whether OER, involving no cash transaction, should be a component of the CPI basket. An implication of its inclusion is that homeowners’ financial position has improved as a result of the recent decline in rents, even though this fall is a lagged consequence of a housing market slump that has slashed the value of their properties – by 32% from peak to trough according to the Case-Shiller house price index.

US “core” inflation (i.e. excluding food and energy) would also be significantly higher using the HICP methodology. A back-of-the-envelope calculation based on the CPI / HICP inflation gap adjusting for the larger weight of OER (32%) in the core basket suggests an April annual rate of about 2% versus an official 0.9%.

The lower official measure, heavily reliant on OER weakness, is helping the Federal Reserve to justify sustaining its super-loose monetary stance and encouraging claims that the US stands on the brink of deflation. The Fed would face a tougher task if required, like the Bank of England, to evaluate inflation performance using the HICP.

It would be understandable if some Monetary Policy Committee (MPC) members felt wary about the Osborne-King deal, under which the Chancellor believes he has bought off interest rate rises by acceding to the Governor’s demands for accelerated fiscal tightening while transferring supervisory powers to the Bank, including new “macro-prudential” tools to be wielded by a rival Financial Policy Committee. They might, in addition, be uncomfortable with Mr. King’s unilateral reinterpretation of the MPC’s target as “2% inflation at some point in the future excluding the impact of temporary factors and ignoring any price-level overshoot in the interim”.

Such frustrations, perhaps, contributed to external MPC member Andrew Sentance’s surprise decision to vote for an immediate quarter-point rate hike this month, despite financial fragility in the Eurozone and the imminent emergency Budget. His view – that accelerating real and nominal growth, persistently high inflation outcomes and doubts about the dampening impact of spare capacity warrant some withdrawal of current exceptional stimulus – is shared, however, by a significant minority of economists, including the four members of the Sunday Times Shadow MPC who also favour immediate tightening (see David Smith’s blog for the minutes).

The “MPC-ometer” model – which attempts to forecast the monthly vote based on the latest economic and financial indicators, with indicator weights derived from regression analysis of historical decisions – similarly predicted a three-member minority to hike this month. Yet the minutes suggest little support for Dr. Sentance’s argument, with an opposing minority even claiming that downside inflation risks have increased. The Governor, it seems, exerts an iron grip. A decision by the Chancellor to fill the external MPC vacancy with another neo-Keynesian sympathizer will seal the Osborne-King deal and confirm that the inflation-targeting regime has changed.

The story so far:

US and global equities have been following fluctuations in the US monetary base (i.e. currency plus bank reserves) over the last 18 months – see first chart. The most recent low in the base occurred in early May; the Dow Industrials index troughed five weeks later. The subsequent recovery in the base, however, stalled a month ago, suggesting that the rally in equities may be in the process of rolling over.

More positively, the Eurozone monetary base on an expanded definition including one-week term deposits – likely to be regarded by banks as a close substitute for reserves – has continued to rise strongly in recent weeks. The environment is reminiscent of June / July last year: the US monetary base moved sideways but the Dow rallied following a surge in the Eurozone base.

In contrast to then, however, the macroliquidity fundamentals are less favourable, with G7 real M1 growing more slowly than industrial output – see prior post. The stalling of the US monetary base in summer 2009, moreover, was clearly temporary given the Federal Reserve’s quantitative easing plans.

These various cross-currents may mean that equities continue to fluctuate in a trading range that frustrates both bulls and bears, an outcome also suggested by the “six-bear comparison” discussed in previous posts – second chart.

A more positive outlook would be signalled by Fed action to boost US monetary base. The most likely form would be a suspension of the “supplementary financing program” under which the Fed has borrowed $200 billion from the Treasury – repayment of this sum would inject an equivalent amount into bank reserves.

The Chancellor delivered a decisive Budget that should greatly reduce worries about fiscal sustainability. The composition of the measures announced was also welcome, with an emphasis on current spending reductions and indirect tax rises that should be less damaging to economic performance.

However, the new fiscal mandate – to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period – is unconvincing. Estimates of the cyclically-adjusted balance are highly uncertain and it is doubtful that the rule, even if monitored by the new Office for Budget Responsibility (OBR), would have constrained the fiscal policy of the last Government.

Other points:

• The additional £40 billion of savings by 2014-15 announced today builds on £73 billion implied by the previous Government’s plans, bringing the total to £113 billion – equivalent to 6.3% of projected GDP in that year. Spending cuts account for £83 billion, or 74%, of the overall adjustment.

• While the Chancellor focused his axe on current spending, capital investment continues to bear an excessive burden of the overall adjustment, mainly reflecting the previous Government’s plans. Investment is projected to fall by 42% in real terms between 2009-10 and 2014-15, accounting for two-thirds of a 7% fall in total managed expenditure excluding interest payments.

• The cyclically-adjusted current balance is forecast to be in surplus by 0.8% of GDP at the end of the five-year forecast period in 2015-16, implying that the Chancellor has built in about £15 billion of leeway that he will be able to “give away” before the next election. Put differently, he could have avoided raising the standard VAT rate to 20%, raising £13 billion by 2014-15, and still achieved the fiscal mandate.

• The OBR’s assumptions about the longer-term impact of fiscal tightening on growth assist the Chancellor but will displease Keynesian economists. The OBR forecasts that real GDP will be 0.3% lower in 2014-15 than in its pre-Budget forecast despite a 2.0% of GDP reduction in cyclically-adjusted borrowing, suggesting a fiscal multiplier of only 0.15. (The OBR warns that its earlier forecast may have been biased up, in which case the true multiplier would be even lower.)

• The OBR’s forecast of public sector net borrowing of £149 billion in 2010-11 looks overly cautious in light of recent encouraging monthly numbers, suggesting an outturn of below £130 billion – further grounds for questioning whether a VAT rise was necessary at this stage.

The transfer of responsibilities to the Office for Budget Responsibility (OBR) is unlikely to result in an improvement in fiscal forecasting, which is notoriously difficult.

The OBR this week projected a fall in public sector net borrowing excluding the temporary effects of financial interventions (PSNB ex) from £156.1 billion in 2009-10 to £155 billion in 2010-11. Recent trends suggest a significantly smaller deficit. May public finances numbers released today revised down the 2009-10 outturn to £154.7 billion. More importantly, monthly borrowing including intervention effects, after attempting to adjust for seasonal factors, has been running at about £10 billion recently, or £120 billion annualised – see chart. Assuming no further change, this is consistent with the PSNB ex measure falling to £126 billion in 2010-11, based on the Treasury’s March forecast that intervention effects would reduce headline borrowing by £6 billion this year. (PSNB ex figures are currently available only quarterly but will be published on a monthly basis from July.)

The OBR’s caution in extrapolating recent better trends is helpful for the Chancellor as he seeks to justify further significant tightening in next week’s Budget.

“Monetary stability” should be understood to involve a stable price level or very low rate of inflation over the long run coupled with avoidance of credit boom / bust cycles, which inflict major damage on economic performance. The two objectives are intertwined: historically, credit cycles have invariably been associated with significant and sustained price disturbances.

The Chancellor’s plan, therefore, to separate responsibilities for inflation and credit control between two policy-making bodies is questionable. It would have been preferable to assign new “macroprudential” policy tools to the Monetary Policy Commitee (MPC) while expanding its remit to include leaning against major swings in money and credit expansion.

The interest rates faced by borrowers and savers play a key role in the transmission of policy changes to financial market conditions and inflation. One way of thinking about the new arrangements is that the MPC will set the risk-free rate while the Financial Policy Committee (FPC) will influence spreads by varying capital and liquidity requirements. The MPC’s judgement, however, about the level of borrowing / saving rates needed to meet the inflation target may differ from the FPC’s assessment based on its stability goals.

The FPC, presumably, would have leant against credit expansion during the 2005-07 boom, resulting in higher borrowing spreads and slower economic growth. Based on the MPC’s forecasts at the time, however, this would have pushed prospective inflation below target, requiring the Committee to set a lower level of Bank rate, thereby undermining the FPC’s attempt at credit restraint. Would the FPC have responded by requiring a further increase in capital / liquidity buffers?

The preferred alternative of adding credit stability to the MPC’s responsibilities would have allowed such tensions to be resolved within a single policy-making body. The Chancellor, moreover, could have taken the opportunity to change the MPC’s target from 2% inflation “at all times” to a 2% per annum average rise in the price level over the long run. This would allow larger short-term inflation fluctuations to accommodate temporary conflicts with the credit control objective while requiring the MPC to correct under- or overshoots, thereby providing a firmer anchor for long-run expectations than current arrangements (under which the Committee is able to tolerate a persistent deviation while claiming to be adhering to its remit).

Some commentators argue that US stocks are more expensive than suggested by market price/earnings (P/E) measures because corporate margins are unusually high and should revert to average over coming years, depressing earnings.

The first chart shows gross and net corporate margins, calculated from national accounts data. The gross measure expresses the sum of profits, interest and depreciation as a percentage of corporate gross domestic product. Gross margins are at a record high and would have to fall by 19% to return to the historical average.

The current overshoot, however, is exaggerated by a long-run upward trend in depreciation, reflecting a combination of a rising capital/output ratio and a declining average life of capital goods. Margin sustainability is better judged using a net measure, excluding depreciation from both the numerator and denominator of the ratio (i.e. profits plus interest as a percentage of net product). Net margins, while high, are within the historical range and less stretched relative to the average.

The aggregate figures, moreover, obscure a bigger story: the divergence between the financial and non-financial sectors – second chart. Financial net margins are at a record high and would need to fall by 41% to restore the historical average. Non-financial margins, by contrast, are at a normal historical level, having moved temporarily below the average during the recession.

This suggests that non-financial P/E measures should not be significantly distorted by unusually-high margins currently but financial P/Es may be misleadingly low, in turn depressing market-wide valuations. The third chart shows forward P/E ratios, based on 12-month-ahead earnings estimates, for the S&P Industrials and Financial Sector indices.

The Industrials P/E is roughly in the middle of the historical range excluding the late 1990s bubble period. The Financials P/E is lower but the discount is smaller than usual. If earnings were recalculated based on average margins, moreover, the Financials P/E would be far above that of the Industrials and at the top of the historical range.

Possible margin compression, therefore, is a reason for caution on financial stocks but much less so for the rest of the market.

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COMMENT:
AUTHOR: APB
EMAIL:
IP: 86.146.121.66
URL:
DATE: 06/10/2010 08:19:32 AM

A breath of fresh air again, Simon – thank you.
On your US forward PE ratios chart, all the historical data must be ‘actual’, whereas only the most recent data point is ‘forward’ – is that correct?
Thanks
APB

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COMMENT:
AUTHOR: Simon Ward
DATE: 06/15/2010 11:00:00 AM

No, all the data points are based on forward earnings estimates.

—–
COMMENT:
AUTHOR: APB
EMAIL:
IP: 81.156.163.53
URL:
DATE: 06/16/2010 08:21:09 AM

Ok – which makes late-08 a standout buy!
Thanks Simon

APB

The May Royal Institute of Chartered Surveyors (RICS) survey signals a rebound in housing market turnover following weakness related to the ending of the previous stamp duty holiday (since extended) and the election. The net percentage of agents expecting an increase in sales rose to an eleven-month high, probably presaging a pick-up in mortgage approvals – see first chart.

Despite a recent increase in sales instructions, stock levels are the lowest since November. The new buyer enquiries and prices balances remain positive, the latter at levels historically consistent with solid gains – second chart.

At least until official interest rates rise significantly, real house prices may continue to follow the pattern of the early 1980s recovery, implying increases of 4% and 7% (Nationwide measure) respectively in the years to the fourth quarters of 2010 and 2011 – see third chart and previous post for more discussion. Assuming, conservatively, 3% retail price inflation, this would entail nominal growth of 7% and 10%, resulting in prices regaining their 2007 peak by late 2011.

Such a scenario could be upset by harsher tax treatment of housing but the coalition will be brave to grasp this nettle – the consensus is that any rise in capital gains tax on second homes and buy-to-let investments in next week’s Budget will be vitiated by generous taper relief.

The fall in consumer price inflation to an annual 3.4% in May from 3.7% in April was in line with a projected path presented graphically in a post a month ago and partly reflected favourable base effects, as well as a seasonally-unusual decline in unprocessed food prices.

The projection has been updated to take account of a recent easing of petrol prices and now shows the headline rate moving down to 2.9% by July, implying no further explanatory letter that month. It remains, however, well above the 2% target during the second half and rebounds in 2011, based on a firming of core price trends as the recovery develops and an assumed rise in the standard VAT rate to 20% in January – see first chart.

Tax changes aside, risks to this forecast are weighted to the upside since it assumes a significant near-term slowdown in core inflation that is at odds with rising price expectations in business and consumer surveys – second chart.

Geek’s note: the CPI at constant tax rates (CPI-CT) rose by only 1.6% in the year to May but this should not be used as an estimate of the hypothetical rate of inflation in the absence of this year’s VAT hike because the calculation assumes full pass-through of changes. Based, more realistically, on 50% pass-through, CPI inflation would currently stand at 2.5% if tax rates had been constant over the last 12 months (i.e. the mean of the headline rate of 3.4% and CPI-CT rate of 1.6%).