If a recession is coming, it will be the most widely anticipated economic downturn of all time.
There have been five recent stories about a coming global recession. Robert Samuelson’s 1/10 column in The Washington Post is titled “Is the next recession on its way?” He acknowledges that the stock market may not be a great predictor of the economy, but the 6.0% drop in the S&P 500 last week was the worst first-week-of-the-year drop on record. That could be a harbinger of a recession.
The second-worst first-five-trading-day period of the New Year occurred in 2008, which ended down 38.5% as a recession unfolded. However, the results are mixed for the previous 10 worst first-five-day periods (including the same in 2008). The S&P 500 was down 4.0% on average for those 10 years, with the four up years averaging a gain of 11.2%, while the six down years averaged -14.1%.
Samuelson is especially concerned about the impact of China’s slowdown on the rest of the world. However, he doesn’t answer the question posed by the title of his column. He concludes inconclusively: “To the crucial question — does the market foretell a recession? — there is not yet a conclusive answer. How much China slows and how the rest of the world responds are open issues. U.S. stocks may have overreacted. Whatever happens, this is not your father’s business cycle.”
In his 1/10 FT column, Larry Summers is a bit more alarming. He too is worried that China’s troubles could spill over to the rest of the world:
“Traditionally, international developments have had only a limited effect on the US and European economies because they could be offset by monetary policy actions. Thus, the U.S. economy grew robustly through the Asian financial crisis as the Fed brought down interest rates. With rates essentially at zero in the industrial countries, however, this option is no longer available, and foreign economic problems are likely to have much more of a direct effect on economic performance.
“Because of China’s scale, its potential volatility and the limited room for conventional monetary maneuvers, the global risk to domestic economic performance in the US, Europe and many emerging markets is as great as at any time I can remember. Policymakers should hope for the best and plan for the worst.”
Economist David Levy is in the same camp according to his 12/19 Barron’s interview titled “David Levy Forecasts a Global Recession in 2016.” In the 1/2 issue of Barron’s, Jonathan Laing, in an article titled “The Trouble with China,” warned that the “old growth engines in China seem to have run out of steam. Don’t expect the Chinese consumer to pick up the slack and deliver the global growth that we’ve become accustomed to.”
Laing bases this conclusion on the insights of Anne Stevenson-Yang of the Chinese research outfit JCapital. She believes that official retail sales figures are inflated.
Households tend to save a lot, with most of the funds used to finance too much infrastructure and production capacity. Not enough has been spent on expanding the services economy. Income and wealth inequality has stymied the growth of a true middle class. The government’s anticorruption campaign certainly has depressed spending by high-income consumers.
The fifth story was a 1/11 Bloomberg article titled “Bank of America: Rail Traffic Is Saying Something Worrying About the U.S. Economy.” It was subtitled “Rail carloads are looking recessionary.”
For now, let’s go to China, which is so widely deemed as the epicenter of the global economic downturn.
Global Economy: China Syndrome.
Last week’s global stock market rout was widely attributed to the plunge in Chinese stock prices following the release of another weak M-PMI on Monday. The Shanghai-Shenzhen 300 index fell 9.9% last week and is down 13.8% since the end of last year. As we noted last week, Debbie and I aren’t convinced that the M-PMI was the problem. It actually edged up to 49.7 from 49.6 during November, and it has been just under 50.0 for the past four months in a row. Furthermore, the output component of the M-PMI was 52.2, close to its average reading over the past five years!
The actual problem seems to be that mounting capital outflows are depressing the foreign exchange value of the yuan. The weaker currency is a threat to the competitiveness of exporters in other emerging economies, who are already suffering from weaker sales to China. The currencies of many of those emerging economies have already depreciated significantly over the past three years. Another round of currency devaluation might trigger a wave of defaults by companies that borrowed in stronger currencies. This seems to be the China Syndrome scenario that has spooked stock, commodity, and currency markets so far this year.
We’ve written about this many times last year. Let’s update and expand the analysis:
(1) Industrial deflation & profits recession.
The weakness in China’s M-PMI in recent months has been long foreshadowed by the deflationary trend in its PPI, which was down 5.9% y/y during December, the 46th consecutive monthly decline. The PPI in manufacturing was down 5.4% last year, while the PPI for raw materials was down 10.3%.
At the end of last year on December 26, we learned that profits earned by Chinese industrial companies in November fell 1.4% y/y, marking a sixth consecutive month of decline. Industrial profits of large enterprises, with annual revenue of more than 20 million yuan ($3.1 million) from their main operations, fell 1.9% in the first 11 months of the year compared with the same period a year earlier.
(2) Mixed signals on services.
We received mixed signals on China’s services economy. On December 31, we learned that the official NM-PMI rose to 54.4 in December, the highest since August 2014. Then on June 5, Caixin/Markit reported that their unofficial NM-PMI fell to 50.2 during December, the weakest reading since July 2014. That suggests that the transition from manufacturing to services isn’t proceeding well. However, that’s totally at odds with the official stats.
(3) International reserves & capital outflows.
In our opinion, global financial markets were most spooked by the weakness in the yuan, which is down 1.2% ytd and 8.1% from its peak of 6.04 per US dollar on January 14, 2014. There has been a relatively good inverse correlation between the yuan and the Emerging Markets MSCI stock price index (in local currencies). The depreciation of the yuan could weigh heavily on exporters in other emerging markets and impair their ability to pay their foreign-currency debts, as noted above.
Then again, most EM currencies have been weak for a while now. The Emerging Markets MSCI currency index is down 15.5% from 2014’s peak. So far, there has been no emerging markets crisis triggering a global financial contagion. Furthermore, the weaker yuan boosts the purchasing power of Americans buying all those Chinese imports of goods that are no longer made in the USA.
Nevertheless, China clearly has a capital outflow problem, as evidenced by the $665 billion drop in its non-gold international reserves since they peaked at a record high of $4.01 trillion during June 2014. Over this same period, the yuan fell 5.7%, implying that it would have fallen more but for the sizable forex intervention by the government.
As we’ve noted before, subtracting the 12-month change in China’s international reserves from China’s 12-month merchandise trade surplus implies capital outflows of $1 trillion over the past year through November. The actual outflow might be half as much given that China’s reserves data are available in dollars but include major currencies like the euro and the yen that have depreciated appreciably.
Dr. Ed Yardeni
is the President of Yardeni Research, Inc., a provider of independent global investment strategy research. To read more of his blogs, CLICK HERE NOW.
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