Submitted by Lance Roberts via RealInvestmentAdvice.com,
The domestic economic growth story took a beating in the first half of this year with an average growth rate of just 1%. For the seventh year running, the data has dashed the hopes of an economic resurgence by the Fed and the vast majority of mainstream economists. Unfortunately, this smidgen of a growth rate could not be blamed on “extremely cold winter weather” which, ironically, tends to occur during the winter or high oil prices. Both provided theoretical boosts to the economy during the first half. So what gives?
The good news is that the weakness in Q1 led to another “inventory restocking” bounce in Q2 just as we have witnessed in each year since the financial crisis. As I stated in 2014:
“With that inventory restocking cycle now complete, the current “Day After Tomorrow” syndrome will likely lead to another rundown/recovery cycle in the economy. The economic drag caused once again by “Mother Nature” combined with the impact from the onset of the Affordable Care Act is likely to keep economic growth suppressed below expectations once again this year.”
The EOCI, which is comprised of the CFNAI, Chicago PMI, LEI, NFIB, ISM, and Fed regional surveys, has bounced from lows in the first quarter over the last couple of months. However, there are three important things to note with respect to this index:
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Economic data for July and August already suggests the “restocking” cycle which began in late Spring is on its way to conclusion. While production measures are up, consumer demand remains suppressed. This is because business owners are not producing for an increased surge in demand generated by a rapidly strengthening recovery, but rather just replacing drawn down inventories.
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The trend of the EOCI data is both negative and running at levels normally associated with extremely weak or recessionary environments. As shown by the gold dots in the chart above, if it were not for repeated QE interventions to drag forward future consumption the economy would have likely been in a recession in 2012.
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Lastly, the 6-month rate of change of the Leading Economic Index (LEI) is currently flirting with levels historically more associated with recessionary economies.
This data all suggests that while we saw a “pop” in economic activity in the second quarter, it will likely not be more than that. The reason I say this is because interest rates are already suggesting the same.
One of the key indicators for economic growth, or lack thereof, is the direction of interest rates. When economic activity is truly rising, the demands for credit rise also. When rates are rising it corresponds with stronger demand for credit and stronger economic growth. When rates fall, it is more coincident with economic weakness.
The current decline in rates suggest “real” economic activity is likely weaker than headline data suggests. If such is indeed the case, and economic activity does weaken in Q3 and Q4 of this year, then the current decline in rates is likely giving investors a clue not just about the economy, but that markets also. The chart below shows the LEI as compared to the S&P 500.
The yield spread and the S&P 500 are major components of the LEI. Therefore, with the S&P 500 at all-time highs, the decline in the LEI suggests there is potential “trouble in paradise.” The chart below shows this to be the case.
Not surprisingly, rising interest rates have historically corresponded with stronger economic activity and a rising stock market. Falling rates have also generally corresponded with market weakness or major corrections.
The bad news is the ongoing decline in rates is likely a warning sign current economic weakness could morph into something more important in the not too distant future. This doesn’t mean that we are about to encounter the next great market unwind, but a correction of 10% or more is not unlikely. The case for such a correction is further supported by the ongoing liquidity extraction by the Federal Reserve as they continue to threaten an increase in interest rates. However, as noted last week, the “traded” Fed Funds rate, LIBOR, has already done the tightening for them and will likely be “impacting an economy near you” sooner rather than later.
Over the last seven years, there has been an ongoing “hope” for an economic resurgence. Each market and economic sputter have been quickly met with an inflow of Central Bank intervention. Yet, each resurgence ultimately failed as the underlying economic dynamics of the real rate of unemployment, excess slack, stagnant wage growth and rising costs of living remain unaddressed.
The ongoing misinterpretation and massaging of economic data to spin a positive view on the economy are fine and good. However, real economic recovery must start with the average American since consumption makes up nearly 70% of economic growth. While the current Administration and Federal Reserve promote policies that are supposed to create economic prosperity for all, the reality is that remains bottled up on Wall Street. The following graph shows the huge disparity between Wall Street and Main Street.
With the current economic recovery already pushing the long end of the economic cycle, the risk is rising that the next economic downturn is closer than not. The danger is that the Federal Reserve is now potentially trapped with an inability to use monetary policy tools to offset the next economic decline when it occurs.
This is the same problem that Japan has wrestled with for the last 20 years. While Japan has entered into an unprecedented stimulus program (on a relative basis twice as large as the U.S. on an economy 1/3 the size) there is no guarantee that such a program will result in the desired effect of pulling the Japanese economy out of its 30-year deflationary cycle. The problems that face Japan are similar to what we are currently witnessing in the U.S.:
- A decline in savings rates to extremely low levels which depletes productive investments
- An aging demographic that is top heavy and drawing on social benefits at an advancing rate.
- A heavily indebted economy with debt/GDP ratios above 100%.
- A decline in exports due to a weak global economic environment.
- Slowing domestic economic growth rates.
- An underemployed younger demographic.
- An inelastic supply-demand curve
- Weak industrial production
- Dependence on productivity increases to offset reduced employment
The lynchpin to Japan, and the U.S., remains interest rates. If interest rates rise sharply it is effectively “game over” as borrowing costs surge, deficits balloon, housing falls, revenues weaken and consumer demand wanes. It is the worst thing that can happen to an economy that is currently remaining on life support.
Japan, like the U.S., is caught in an on-going “liquidity trap” where maintaining ultra-low interest rates are the key to sustaining an economic pulse. The unintended consequence of such actions, as we are witnessing in the U.S. currently, is the ongoing battle with deflationary pressures. The lower interest rates go – the less economic return that can be generated. An ultra-low interest rate environment, contrary to mainstream thought, has a negative impact on making productive investments and risk begins to outweigh the potential return.
As I discussed recently, there is an ongoing belief that the current financial market trends will continue to head only higher. This is a dangerous concept that is only seen near the peak of cyclical bull market cycles.
“We saw much of the same mainstream analysis at the peak of the markets in 1999 and 2007. New valuation metrics, IPO’s of negligible companies, valuation dismissals as “this time was different,” and a building exuberance were all common themes. Unfortunately, the outcomes were always the same.”
While it certainly seems, with markets at all-time highs, that the current advance will continue indefinitely into the future, the hard reality is that it won’t. While “irrationality” can certainly last far longer than any logical analysis would suggest, such is the nature, and definition, of an exuberant bull market.
This time is “not different” and while it may seem for a while the bullish analysis is correct, as I stated last week, it is “only like this, until it is like that.”
via http://ift.tt/2aVeFXf Tyler Durden