So far, the stock market appears to be anticipating a slowdown in economic activity, but not necessarily a recession. Some think that the decline in stocks might actually cause an economic pullback (consistent with George Soros’s concept of reflexivity). Certainly, a big drop in the stock market would hurt the economy, amplifying weakness; but it is highly unlikely that it would be the sole cause of a recession.
Oil and the Dollar. Over the past 21 months, the U.S. economic recovery has been slowed by the drop in the price of oil and the sharp rise in the U.S. dollar. The development of unconventional oil and natural gas reserves has been a key engine of U.S. economic growth for nearly a decade. Low prices have forced oil & gas producers to curtail drilling activity. The pronounced slowdown in the economies of key oil producing states, such as Texas, Alaska, North Dakota and Oklahoma is rippling through the broader economy. Its impact should be limited, however, as long as oil and natural gas prices and development activity bottom out within the next year or so.
The rise in the dollar has created headwinds for exporters and U.S. multinationals, the effects of which have been distributed more evenly throughout the U.S. Exports peaked in the second half of 2014 and have been falling steadily since. All of the decline has been concentrated in the exports of goods. Services exports have been flat. The year-over-year decline in the rolling three-month average of goods exports was 10.4% in December, according to a report released last week by the U.S. Bureau of Economic Analysis.
With the decline in exports, the profits and profit margins of goods exporters are being squeezed. Similarly, the foreign earnings of U.S. multinationals are worth less when translated back to U.S. dollars. Exporters and multinationals may seek to cut costs elsewhere to compensate for the decline in profitability, which could add to the softness in the overall economy.
Industrial Production. Weakness in the oil patch and exports has taken a toll on industrial production, according to the Federal Reserve. Up until this year, industrial production had been a bright spot in the recovery, with the monthly index showing average year-over-year gains of 3% or more since the beginning of 2010. In November and December, however, the Fed’s industrial production index logged its first monthly year-over-year declines since December 2009.
Within each of the three major industry groups: Manufacturing has been mostly flat. In December, it was up 0.8% over 2014. Mining was down 11.2% year-over-year in December, due mostly to declining coal production, but oil and natural gas extraction is also included here. Utilities production was down 7.9% over 2014, primarily as a result of warmer than average weather temperatures.
Industrial production figures for January are due out this week. Consensus estimates anticipate a slight rebound of 0.4% for the month because of a rebound in utility output, but that would still leave the index down 1.1% vs. the prior year, which would be the third consecutive month of year-over-year declines.
So far, despite the slowing in the industrial sector, the weakness caused by low oil prices and a strong dollar appears to have had only a modest impact on the rest of the economy.
Consumer Spending. Spending by U.S. consumers has generally remained solid, but the year-over-year rate of increase in monthly seasonally-adjusted real consumer spending has slipped to 2.6% from above 3.1% for most of 2014 and 2015. Spending on consumer durables, such as automobiles, has remained solid, with an increase of 5.0% in December 2015 vs. 2014. Although December’s gain is roughly consistent with the three-year average, it is well below the average monthly year-over-year gain for most of 2015. Consequently, it is difficult to say whether December’s lower percentage gain marks the beginning of a slowdown in consumer durables spending.
The three-year average rate of increase in real non-durables and services spending has been lower at 2.5% and 2.3%, respectively. Like consumer durables, December’s year-over-year gain in non-durables and services spending was consistent with the three-year average, but below the average monthly increases for most of 2015, especially for services. Some of the increase in services spending in 2015 was due to consumers bearing higher out-of-pocket health care costs under the Affordable Care Act. Since a year has passed (and that increased spending has been lapped), we should expect that the percentage increase in health care costs will return to a more sustainable (i.e. lower) level.
Despite the concerns about the impact of a slowing industrial sector on the broader economy, my quick look at the data suggests that there is no clear evidence yet that consumer spending is slowing.
Housing. Housing remains a solid contributor to economic growth, even though its contribution has been disappointing by historical standards. In 2015, total housing starts were up 10.8%, better than 2014’s 8.5%, but below the average 20% gains registered in 2012 and 2013. Likewise, single-family starts were up 10.4% in 2015, compared with just 4.9% in 2014 and below the average annual rise of nearly 20% posted in 2012 and 2013. The gains in both total and single-family starts were strongest in the second half of 2015.
Many economists have complained about the tepid pace of recovery in housing. Although seasonally-adjusted housing starts have doubled to 800,000 since the early 2009 lows, they remain 55% below the peak pace of 1.8 million starts achieved in early 2006. A host of factors, like more stringent mortgage underwriting standards and a newfound preference for renting among young adults, make it unlikely that we will get back to a production pace similar to the 2006 peak for the foreseeable future. Yet, there is still room to rise. Although investors soured on the housing market and the homebuilders in 2015, production momentum did improve in the second half of the year. Continued strong job growth has been a major part of the housing recovery story.
Job Growth. Employment growth was also considered weak coming out of the 2009 recession, but it has been solid and steady since 2013. The economy has added nearly 225,000 jobs per month on average since 2013, better than the 2003-2007 recovery and roughly equivalent to the average monthly gains seen from 1983-1990 and from 1992-2000.
This expansion has also been criticized for the slow growth in wages. Wage growth has averaged a little over 2% since the end of the recession, which is below the average 3%+ growth seen during previous expansions. Slack in the labor force has prevented stronger gains, but inflation has also been lower, obviating much of the pressure for wage increases.
Critics have also complained that too high a proportion of growth has come from low skilled, low wage jobs and not enough from higher skilled, higher paying jobs. This may be true; but the addition even of low wage jobs helps to raise household income, which supports growth in consumer spending and big ticket purchases, such as autos and homes.
There is still room for improvement. The average workweek has increased to 41.8 hours in recent months, a level consistent with past peaks. Sustained growth in the economy should lead to further gains in jobs and hourly wages.
Economic Forecasts. Oil and the dollar have taken some of the steam out of the U.S. economic recovery. The median forecast of real GDP growth for 2016 from The Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters was recently reduced from 2.6% to 2.1%. That’s a meaningful drop, but it still does not necessarily signal a recession.
Those economists also expect that job creation will be slightly stronger than in the previous Survey (with 204,300 jobs added per month vs. 197,000) and that inflation will be lower (with an 1.5% increase in the 2016 headline CPI vs. 2.0%).
Oil is Key. Low oil prices and continued strength in the dollar could raise the headwinds for the economy, potentially leading to spillover effects that may cause further reductions in the growth outlook. IHS, for example, has indicated that cuts of as much as 50% may still be needed to align capital spending with cash flow and 150 oil & gas companies could file for bankruptcy. This could lead to even steeper cuts in exploration and development spending; but it could also hit the high yield market hard, making it more difficult for smaller, leveraged companies to refinance existing debt or issue new debt. Likewise, further strength in the dollar could crimp the revenues and profits of U.S. exporters and multinationals even more, leading to cutbacks and possibly causing them to curtail hiring. Although the low price of oil and strong dollar have slowed the growth of the U.S. economy for nearly two years now, it is entirely possible that they could reverse course, turning a headwind into a tailwind for the U.S. economy and stock market.
Low oil prices are being driven by the determination of Saudi Arabia and other OPEC producers to hold market share and make higher cost producers, such as U.S. unconventional drillers, bear the brunt of the necessary production declines. This is being done, however, at a very high cost to their own economies.
OPEC may also be discovering that U.S. producers are more resilient than they anticipated. Hedging has helped U.S. producers sustain and even increase production levels, two years after the price of oil began its descent. (The U.S. Energy Information Administration in its Short-Term Energy Outlook does, however, anticipate that U.S. oil production will decline by 733,000 barrels per day in 2016 and by another 232,000 b/d in 2017.)
OPEC’s stance has already led to about 60 U.S. oil & gas producers filing for bankruptcy. As noted, analysts are concerned about further production cutbacks and debt defaults. Even so, the bankruptcy process, if it continues, will serve to consolidate the industry and allow the stronger producers to lower their operating and financing costs, putting them in a stronger position to compete.
Accordingly, OPEC may want to reconsider its position, especially since they are burning through their cash reserves. This downturn is also placing great hardships on Venezuela and Nigeria, two OPEC producers who are not prepared to weather a sustained downturn in prices.
Today, Russia and Saudi Arabia (and Venezuela and Qatar) agreed to freeze oil production at January levels, provided that other OPEC producers agree to do so as well. Iran, however, said that it expects to raise production to pre-sanction levels to claim its fair share of the market. It is also not clear whether Iraq will participate.
This deal marks the first step toward a negotiated agreement. A final agreement, if achievable, will most likely require all OPEC producers to take their “fair share” of production cuts to stabilize the market and bring the price of oil back up. Without such an agreement, oil prices could conceivably hover at these extremely low levels for some time, putting even greater pressure on their budgets and economies.
The U.S. Dollar is Also Key. The strength of the dollar (and the corresponding weakness in the euro and yen) has been driven by central bank policies designed to lower interest rates to jumpstart their economies and, in the case of Europe, bolster its banking system. Consequently, a reversal of the dollar’s strength (and corresponding improvement in U.S. exports and the foreign profits of U.S. multinationals) should most likely occur when the foreign exchange markets anticipate that economic growth in Europe and Japan has improved enough to allow the ECB and Bank of Japan to consider normalizing interest rates.
Although there have been some tentative positive signs in this regard, the outlook for both Japan and the Eurozone and Japan continues to be disappointing. Last week, Japan reported a 1.4% decline in fourth quarter GDP, slightly worse than expected, due mostly to a drop in personal consumption. Although concerns remain about the ability of the Japanese economy to achieve liftoff, some economists said that the decline was due to one-time factors, such as warm winter weather, and expect growth to improve in 2016.
On Friday, the EU reported that real GDP in the fourth quarter of 2015 increased by 0.3% in the euro area and the EU28 (i.e. the 28 countries that comprise the European Union). For all of 2015, GDP growth was 1.5% in the euro area and 1.8% in the EU28, which was an improvement over 2014’s increases of 0.9% and 1.3%, respectively, and the best since 2011, but still mediocre.
Yet, on February 4, the European Commission reduced its forecast for 2016 GDP growth for the Eurozone slightly from 1.8% (set last November) to 1.7%. Thus, it anticipates an improvement of only 0.2% from 2015.
The reduced forecast may have contributed to the run on shares of Deutsche Bank (DB) and other European banks last week, which was a primary catalyst for the global sell-off in stocks. Investors are apparently concerned by the sharp drop in prices of DB’s contingent convertible bonds and the rising cost of its credit default swaps. DB has responded by proposing to buy back about 10% or €5.4 billion of its outstanding senior notes. Since then, its stock price has rebounded and bond yields and CDS costs have come down.
Although GDP in most euro area countries is disappointing, there are some bright spots. The economies of Ireland and Spain, two of the countries on the periphery that sought help from the EU in the aftermath of the financial crisis, are now showing fairly robust growth. Ireland’s GDP growth rate is north of 7% on an annualized basis; Spain’s was 3.5% for all of 2015.
Greece has slipped back into recession, logging a 2015 GDP decline of 1.9%, but the European Commission upgraded its outlook for 2016 GDP growth there from -1.3% to -0.7%. Conceivably, if Greece can pass its formal review by the EU of its bailout program, it would secure the release of additional bailout funds and help to restart the economic momentum that was lost last summer. While the review by the EU has been delayed, it is expected to resume soon. Finance Minister Euclid Tsakolotos wants a deal to be completed by the end of February, but some have suggested that it could take months. An agreement would be good news for both Greece and the EU, as it would also reduce concerns about a potential break-up of the euro area.
China. Fears about a slowdown in economic growth in China or worse, a collapse of the economy due in part to overleveraging, has been one of the drivers of the sell-off in global equity markets. I, for one, am not concerned about the prospect of a devaluation of the yuan. While many seem to see this as a sign of economic weakness, I think it is quite reasonable for China to seek to back away from its peg to the U.S. dollar, which has undoubtedly hurt its export competitiveness. Yet, some say that the big decline in China’s January exports was due mostly to weak global demand.
More worrying, I believe, are the country’s apparent efforts to crack down on dissent, which conceivably could be a prelude to backing away from its embrace of market reforms. Such fears may be contributing to capital flight. For now, I am guessing that the country has the ability to sustain its economic growth path, even with January’s exports plunge, and expect that China will contribute to any meaningful rebound in global financial markets and economic growth.
Russia. Russia increasingly looks to be the key to resolving a number of the problems affecting global financial markets. Its intervention in the Syrian civil war has tipped the balance back in favor of the Assad government and created the conditions for a possible cease fire and the start of negotiations to end the war. It has taken the positive step to broker an end to the stalemate between OPEC and non-OPEC oil producers to bring supply back into balance with demand. It also continues to work toward a negotiated resolution to the problems in Ukraine, which might lead to a lifting of the sanctions that have hurt its economy and others, most notably the EU.
For sure, new events could change the picture suddenly and possibly for the worse; but success by Russia on any of these issues would have a positive impact on the outlook for the global economy and financial markets.
Half Full or Half Empty? While current trends point to a continued slowing in economic growth both in the U.S. and abroad, the course of the global economy will undoubtedly be shaped by events in the months ahead. It is not hard to imagine certain positive outcomes, such as an agreement by major oil producers to reduce supply, an agreement between Russia and Ukraine that results in a lifting of sanctions, a successful completion of the EU’s review of Greece’s progress on its bailout program, a cease fire in Syria and others, that would lift the spirits of the financial markets and improve the outlook for global economic growth.
Of course, events could go the other way or new ones may surface that would move the financial markets and the global economy in the opposite direction.
For now, stock prices have come down and many stocks seem to be trading as if the U.S. economy was on the cusp of a recession. (See, for example, my recent posting on homebuilding shares.) Although the technical picture of the market does not look great (more about that later), there are some mixed signals that suggest that stocks may find a floor soon (if they have not done so already). For those who can afford the risk, I believe that it may still be profitable to buy the dip, even though some strategists are arguing against it.
February 16, 2016
Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey 07036