Are we headed for recession (August 2019)?
I have been thinking quite a lot about the real economy and the financial economy. I draw a distinction between the vast majority of the citizens of the United States of America in the real economy -- they work and earn and save and spend -- and the financial economy. The real economy has household and business income. Citizens must have housing and items inside the home. They must have food and transportation and clothing and entertainment...the list is obvious because we are all part of this real economy. We earn. We borrow. We spend. We save. As you aggregate the real economy, real goods are produced and consumed either at home or abroad. Real supplies and materials ladder up into increasingly complex goods. Real work is done on infrastructure and real innovation and research occurs. This is different than the financial economy.
The financial economy wishes to make money based upon the real work of others in the real economy. The financial economy lends money to people and businesses. The financial economy wants to buy into companies that will grow in value based upon the success that they have in the real economy. I'd like to distinguish between lending to people -- credit cards and mortgages and personal loans -- and lending to businesses. The financial economy can harm the real economy when lending standards, especially for home purchases become too tight, but for the most part, that alignment of credit need and credit supply is pretty good. The lending of money to businesses is also robust, but in both cases the underlying reason is that interests rates are at unprecedented lows thanks to easy monetary policy driven by the great recession of 2008.
So how is the real economy doing in the USA? Let's get some perspective. The US economy is $19.5 trillion dollars in size. In 2000, it was $10.5 trillion. In other words, it has nearly doubled in 20 years. So how should we think about growth? Well, if the US economy grows 2.1% in 2019, as expected, that means that over $490 billion will be added. That is a lot of money. Said differently, if you are really big, you don't have to grow too fast to generate a lot of goodness for society. Now let's turn to employment. It is important to note that unemployment is low because a very large generation of workers has been and is retiring -- the Baby Boomers. That changes the numerator and the denominator of the calculation that arrives at 3.7%, an historical low. I can relate as a CEO that hiring is difficult at the "working wage" level. There is upward pressure on hourly wages to attract and retain workers. That is the first time I've experienced that in my 30+ years of business. In addition, highly skilled talent is competitive, but interestingly, great and experienced talent is available as large corporations "early retire" or "downsize" in challenged industries (think retail or financial services where technology has disrupted traditional verticals). How about those interest rates? Well, as I said, they are low, which means that housing is more affordable for many, as well as consumer debit to acquire more experiences, services and things. And how about prices, including food and energy? Low and not increasing. Competition and innovation and efficiency all benefit consumer spending. All told, the real economy is really solid, and if it weakens, it is still really large and diversified.
What about business? Well, here the news is mixed and most of it has to do with public policy and global growth. Industrial production is slowing and in some quarters retrenching because grow outside the USA is modest to negative. Europe is stuck. Latin America is muddled. Asia is no longer the tiger, especially China. This means all industries, whether technology or heavy equipment, cannot count on growing in these overseas markets. Now we add "trade wars" and things get more sticky. I should say that there is good sense to aggressively addressing intellectual property theft by China and other countries. I also think that we have been "pro-trade" for so long that people are really struggling with the use of tariffs when most of us have been raised to understand that they caused the Great Depression in the 1920-30s. But the reaction by the punditocracy is overdone. It's hysterical. It's hyperbolic. This is not the end of the world. Arguably, this re-ordering is driven by trade inequality and by domestic disruptions largely ignored by the "ruling class" of the post-WWII era. "Laissez faire economics" taught that the market would sort everything out. But when the steel mill closed in Western Pennsylvania or Northeast Ohio, the people did not move to Silicon Valley. Either the did not have the means (potential public policy error) or they simply did not want to leave their communities, even facing no employment and economic decline. This lack of mobility -- of no movement to where the jobs were -- created a large and diverse section of the population that now felt disenfranchised; abandoned by their government and society. Put differently, the "real economy" is doing better and the mood is not particularly sympathetic to "helping others through trade." Too many people felt that they needed "help" and now they may be getting it. Here is something no one is talking about -- how fast will the US consumer take notice and purposefully NOT buy something made in China or Mexico because they perceive them to be hostile to the US? Not long is the answer.
Let me quickly address the "inverted yield curve" -- which means the 2 year Treasury yield is higher than the 10 year Treasury yield. This is NOT a sign of pending recession in my humble opinion because of WHERE interest rates (yields) are today. For historical reference, the 10 year versus 1 year yields inverted in 1969 when 10 year yields were 6.64%. Happened again in 1974 when 10 year yields were 7.5%. How about 1989 when the yield curve inverted? 8.99%! Even in 2003, the yield was 5.03%. So why does this matter? Because today the 10 year yield is 2.04% -- the lowest level recorded. The inversion can with more frequency because of the COMPRESSION of the spread. There are only 200 basis points (2 percentage points) from 10 year rates to ZERO. That's unprecedented and NOT NORMAL. Hence, this is a sign of the times -- low rates, and not a sign of pending recession.
So where does this leave us? First, businesses adapt and do so faster than ever. There may well be a slow down in industrial production in the face of global events and public policy. This is intelligent as the alternative, played out repeatedly in the 20th century, is overproduction, layoffs and failing industries. Indeed the only industry that continues to repeat stupid practices is oil & gas exploration and development (even airlines have gotten it together). The "power of market share" has run its course as a meta-strategy. Second, the consumer is working, with rising wages, with low prices and interest rates. The real economy is solid. Third, the financial economy is in a panic. They have made money without intelligence for more than a decade. "Free money" from the Federal Reserve and "low interest rates" from the Fed has made investing in equities a no-brainer, money-maker. The puerile behavior of the Wall Street punditocracy is offensive. They whine for lower rates and monetary easing -- not because it is the right thing for the economy, but because it will make them more money more easily. Do not be frightened by their hysteria. It is self-serving in my humble opinion. Last, we therefore are seeing a separation of the real and the financial economy and it is not healthy. The Wall Street pundiocracy should see that the Fed should continue to reduce its balance sheet exposure and gradually raise interest rates. Why? Because there is an imbalance between debt and equity markets that can only be reconciled with 30 year Treasuries over 3%. Moveover, given the paralysis of fiscal policy, when we do need the Fed to assist with inflation or employment, they must have more weapons in their arsenal than they do today.
So don't panic. Work, spend, save and invest, and find some happiness every day.
The financial economy wishes to make money based upon the real work of others in the real economy. The financial economy lends money to people and businesses. The financial economy wants to buy into companies that will grow in value based upon the success that they have in the real economy. I'd like to distinguish between lending to people -- credit cards and mortgages and personal loans -- and lending to businesses. The financial economy can harm the real economy when lending standards, especially for home purchases become too tight, but for the most part, that alignment of credit need and credit supply is pretty good. The lending of money to businesses is also robust, but in both cases the underlying reason is that interests rates are at unprecedented lows thanks to easy monetary policy driven by the great recession of 2008.
So how is the real economy doing in the USA? Let's get some perspective. The US economy is $19.5 trillion dollars in size. In 2000, it was $10.5 trillion. In other words, it has nearly doubled in 20 years. So how should we think about growth? Well, if the US economy grows 2.1% in 2019, as expected, that means that over $490 billion will be added. That is a lot of money. Said differently, if you are really big, you don't have to grow too fast to generate a lot of goodness for society. Now let's turn to employment. It is important to note that unemployment is low because a very large generation of workers has been and is retiring -- the Baby Boomers. That changes the numerator and the denominator of the calculation that arrives at 3.7%, an historical low. I can relate as a CEO that hiring is difficult at the "working wage" level. There is upward pressure on hourly wages to attract and retain workers. That is the first time I've experienced that in my 30+ years of business. In addition, highly skilled talent is competitive, but interestingly, great and experienced talent is available as large corporations "early retire" or "downsize" in challenged industries (think retail or financial services where technology has disrupted traditional verticals). How about those interest rates? Well, as I said, they are low, which means that housing is more affordable for many, as well as consumer debit to acquire more experiences, services and things. And how about prices, including food and energy? Low and not increasing. Competition and innovation and efficiency all benefit consumer spending. All told, the real economy is really solid, and if it weakens, it is still really large and diversified.
What about business? Well, here the news is mixed and most of it has to do with public policy and global growth. Industrial production is slowing and in some quarters retrenching because grow outside the USA is modest to negative. Europe is stuck. Latin America is muddled. Asia is no longer the tiger, especially China. This means all industries, whether technology or heavy equipment, cannot count on growing in these overseas markets. Now we add "trade wars" and things get more sticky. I should say that there is good sense to aggressively addressing intellectual property theft by China and other countries. I also think that we have been "pro-trade" for so long that people are really struggling with the use of tariffs when most of us have been raised to understand that they caused the Great Depression in the 1920-30s. But the reaction by the punditocracy is overdone. It's hysterical. It's hyperbolic. This is not the end of the world. Arguably, this re-ordering is driven by trade inequality and by domestic disruptions largely ignored by the "ruling class" of the post-WWII era. "Laissez faire economics" taught that the market would sort everything out. But when the steel mill closed in Western Pennsylvania or Northeast Ohio, the people did not move to Silicon Valley. Either the did not have the means (potential public policy error) or they simply did not want to leave their communities, even facing no employment and economic decline. This lack of mobility -- of no movement to where the jobs were -- created a large and diverse section of the population that now felt disenfranchised; abandoned by their government and society. Put differently, the "real economy" is doing better and the mood is not particularly sympathetic to "helping others through trade." Too many people felt that they needed "help" and now they may be getting it. Here is something no one is talking about -- how fast will the US consumer take notice and purposefully NOT buy something made in China or Mexico because they perceive them to be hostile to the US? Not long is the answer.
Let me quickly address the "inverted yield curve" -- which means the 2 year Treasury yield is higher than the 10 year Treasury yield. This is NOT a sign of pending recession in my humble opinion because of WHERE interest rates (yields) are today. For historical reference, the 10 year versus 1 year yields inverted in 1969 when 10 year yields were 6.64%. Happened again in 1974 when 10 year yields were 7.5%. How about 1989 when the yield curve inverted? 8.99%! Even in 2003, the yield was 5.03%. So why does this matter? Because today the 10 year yield is 2.04% -- the lowest level recorded. The inversion can with more frequency because of the COMPRESSION of the spread. There are only 200 basis points (2 percentage points) from 10 year rates to ZERO. That's unprecedented and NOT NORMAL. Hence, this is a sign of the times -- low rates, and not a sign of pending recession.
So where does this leave us? First, businesses adapt and do so faster than ever. There may well be a slow down in industrial production in the face of global events and public policy. This is intelligent as the alternative, played out repeatedly in the 20th century, is overproduction, layoffs and failing industries. Indeed the only industry that continues to repeat stupid practices is oil & gas exploration and development (even airlines have gotten it together). The "power of market share" has run its course as a meta-strategy. Second, the consumer is working, with rising wages, with low prices and interest rates. The real economy is solid. Third, the financial economy is in a panic. They have made money without intelligence for more than a decade. "Free money" from the Federal Reserve and "low interest rates" from the Fed has made investing in equities a no-brainer, money-maker. The puerile behavior of the Wall Street punditocracy is offensive. They whine for lower rates and monetary easing -- not because it is the right thing for the economy, but because it will make them more money more easily. Do not be frightened by their hysteria. It is self-serving in my humble opinion. Last, we therefore are seeing a separation of the real and the financial economy and it is not healthy. The Wall Street pundiocracy should see that the Fed should continue to reduce its balance sheet exposure and gradually raise interest rates. Why? Because there is an imbalance between debt and equity markets that can only be reconciled with 30 year Treasuries over 3%. Moveover, given the paralysis of fiscal policy, when we do need the Fed to assist with inflation or employment, they must have more weapons in their arsenal than they do today.
So don't panic. Work, spend, save and invest, and find some happiness every day.
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