Our expectations for a global economic downturn, including a U.S. recession, have hardened considerably in the past few weeks, with a continued expectation of a retreat in equity prices on the order of 40% to 55% over the completion of the current cycle as a base case.
The immediacy of both concerns would be significantly reduced if we were to observe a shift to uniformly favorable market internals. Last week, market conditions moved further away from that supportive possibility. As I’ve regularly emphasized since mid-2014, market internals are the hinge between an overvalued market that tends to continue higher from an overvalued market that collapses; the hinge between Fed easing that supports the market and Fed easing that does nothing to stem a market plunge; and the hinge between weak leading economic data that subsequently recovers and weak leading economic data that devolves into a recession.
We continue to observe deterioration in what I call the “order surplus” (new orders + order backlogs - inventories) that typically leads economic activity. Indeed, across a variety of national and regional economic surveys, as well as international data, order backlogs have dried up while inventories have expanded. Understand that recessions are not primarily driven by weakness in consumer spending. Year-over-year real personal consumption has only declined in the worst recessions, and year-over-year nominal consumption only declined in 2009, 1938 and 1932. Rather, what collapses in a recession is the inventory component of gross private investment, and as a result of scalebacks in production, real GDP falls relative to real final sales.
Emphatically, recessions are primarily points where the mix of goods and services demanded by the economy becomes misaligned with the mix of goods and services being produced. As consumer preferences shift, technology introduces new products that dominate old ones, or market signals are distorted by policy, the effects always take time to be observed and fully appreciated by all economic participants.
Mismatches between demand and production build in the interim, and at the extreme, new industries can entirely replace the need for old ones. Recessions represent the adjustment to those mismatches. Push reasonable adjustments off with policy distortions (like easy credit) for too long, and the underlying mismatches become larger and ultimately more damaging.
A few charts will bring the economic picture up to date. The first is our familiar composite of regional and national Fed and purchasing managers’ surveys. We also maintain a broad composite of dozens of other leading economic variables, which shows the same pattern of retreat. Keep in mind that employment figures (initial claims for unemployment, nonfarm payrolls, the unemployment rate and the duration of unemployment, in that order) are the most lagging economic series available and typically turn well after the economy does.
While a weak equity market, in and of itself, is not tightly correlated with subsequent economic weakness, equity market weakness combined with weak leading economic data is associated with an enormous jump in the probability of an economic recession. See in particular From Risk to Guarded Expectation of Recession, and When Market Trends Break, Even Borderline Data is Recessionary.
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