I think this could be one of the most important things I’ve read this year.
Based on evidence that has always and only been observed during or immediately prior to U.S. recessions, the U.S. economy appears headed into a second leg of an unusually challenging downturn.
A few weeks ago, I noted that our recession warning composite was on the brink of a signal that has always and only occurred during or immediately prior to U.S. recessions, the last signal being the warning I reported in the November 12, 2007 weekly comment Expecting A Recession. While the set of criteria I noted then would still require a decline in the ISM Purchasing Managers Index to 54 or less to complete a recession warning, what prompts my immediate concern is that the growth rate of the ECRI Weekly Leading Index has now declined to -6.9%. The WLI growth rate has historically demonstrated a strong correlation with the ISM Purchasing Managers Index, with the correlation being highest at a lead time of 13 weeks.
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One of the greatest risks to investors here is the temptation to form investment expectations based on the behavior of the U.S. stock market and economy over the past three or four decades. The credit strains and deleveraging risks we currently observe are, from that context, wildly "out of sample." To form valid expectations of how the economic and financial situation is likely to resolve, it's necessary to consider data sets that share similar characteristics. Fortunately, the U.S. has not observed a systemic banking crisis of the recent magnitude since the Great Depression. Unfortunately, that also means that we have to broaden our data set in ways that investors currently don't seem to be contemplating.
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In recent months, I have finessed this issue by encouraging investors to carefully examine their risk exposures. I'm not sure that finesse is helpful any longer. The probabilities are becoming too high to use gentle wording. Though I usually confine my views to statements about probability and "average" behavior, this becomes fruitless when every outcome associated with the data is negative, with no counterexamples. Put bluntly, I believe that the economy is again turning lower, and that there is a reasonable likelihood that the U.S. stock market will ultimately violate its March 2009 lows before the current adjustment cycle is complete. At present, the best argument against this outcome is that it is unthinkable. Unfortunately, once policy makers have squandered public confidence, the market does not care whether the outcomes it produces are unthinkable. Unthinkability is not evidence.
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From an inflation standpoint, is important to recognize the distinction between what occurs during a credit crisis and what occurs afterward. Credit strains typically create a nearly frantic demand for government liabilities that are considered default-free (even if they are subject to inflation risk). This raises the marginal utility of government liabilities relative to the marginal utility of goods and services. That's an economist's way of saying that interest rates drop and deflation pressures take hold. Commodity price declines are also common, which is a word of caution to investors accumulating gold here, who may experience a roller-coaster shortly. Over the short-term, very large quantities of money and government debt can be created with seemingly no ill effects. It's typically several years after the crisis that those liabilities lose value, ultimately at a very rapid pace.
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In short, my concerns about the economy and financial markets are escalating quickly. Given the already vulnerable condition of the U.S. economy, a second phase of weakness would most likely contribute to already troubling levels of mortgage delinquency and foreclosure, and could be expected to push the unemployment rate toward 12%. It is not useful to rule out unfavorable outcomes simply because they seem unpleasant or unthinkable. It is also not useful to place superstitious hope in the Fed and the Treasury to fix the consequences of irresponsible lending without any ill effect. In the coming quarters, remember that every time you hear an incomprehensibly large bailout commitment from government, it will equate to an unconscionably large extraction of public resources, possibly through overt taxation, but more likely through the long-term destruction of purchasing power.
