The balance of US activity news has improved so far in June, supporting the widely-held view that the economy is rebounding from weather- and strike-related weakness in early 2015. Monetary trends suggest that the pick-up will extend into late 2015 but investors should be wary of extrapolating optimism into 2016, for several reasons.
First, monetary strength may be fading. Six-month growth of real narrow money peaked in February, though appears to have remained solid in May* – see first chart. Real narrow money leads activity (industrial output) by nine months on average**, so this suggests that economic growth will moderate at end-2015.
Secondly, corporate finances are deteriorating. The “financing gap” of non-financial corporations, i.e. capital spending minus retained earnings, rose to 1.2% of GDP in the first quarter, the highest since the second quarter of 2008 – second chart. The gap is not yet at a worrying level but increases historically have preceded economic slowdowns or recessions, albeit sometimes with a long lead – third chart.
Note that the financing gap does not include borrowing to fund share buy-backs and M&A. A wider deficit measure including net equity buying tends to lead the yield spread between non-investment-grade corporate bonds and Treasuries and reached 4.3% of GDP in the first quarter, suggesting future spread widening – fourth chart.
Thirdly, cycle analysis warns of a possible economic downturn in 2016-17. This was discussed in detail in a post last August but, to summarise, the Kitchin stockbuilding cycle is scheduled to reach a low between 2015 and 2017, and the Juglar business investment cycle between 2016 and 2020. There is a risk that the downswings in the two cycles will coincide in 2016-17, producing a recession.
A recession should be signalled well in advance by a sharp slowdown or, more likely, a contraction in real narrow money – as previously discussed, such a contraction occurred before 10 out the 11 post-WW2 recessions, the exception being the 1954 downturn, which had a large fiscal element***. No such signal has yet been given.
*Based on May monetary data and a forecast of the consumer price index.
**Based on a study of G7 data over the last 50 years. The study – available on request – also confirms that real narrow money is superior as a leading indicator to real broad money, real bank lending and the rate of change of real bank lending (i.e. the “credit impulse”).
***Real government spending fell by 6.4% between 1953 and 1954.
