The data of late round the earth
Is showing, of late, there’s a dearth
Of positive vibes
Which aptly describes
Why people are losing their mirth
 
Last night and this morning we learned
The PMI data has turned
Much lower worldwide
Though many bulls tried
To urge us to not be concerned

 

Are we in a recession?  That question, which several analysts have already declared to be the case, is being asked more actively of late.  While the official recession call is not made until well after the fact by the National Bureau of Economic Research (NBER), for investing and hedging purposes, that is a little late in the game. Rather, the reason analysts exist at all is to help people understand the situation in real-time, not on a historical basis.  And remember, one of the biggest problems is that, almost by definition, most data are backward looking, describing what happened already, not what will occur going forward.

Now, it is true that when it comes to economic data, it tends to trend so extrapolating that trend makes some sense, but history has shown that the timing of those changes can vary widely.  Alternatively, we can look at the Survey data like PMI, ISM or the regional Fed surveys, to try to get a sense of what business managers are expecting.  This is certainly more forward-looking, but as it is describing expectations rather than actual spending and output, can diverge from what ultimately occurs.  We have seen this frequently over the past several years as several surveys indicated slowing activity while the hard data (payrolls, GDP, Retail Sales, IP, etc.) held up well.

This brings us back to the opening question, are we in a recession?  Well, so far this week the data that has been released is not pointing to strength of economic activity.  In the US, Monday’s Chicago Fed National Activity Index printed at 0.05, down significantly from the May print of 0.23.  Then yesterday, Existing Home Sales fell to 3.89M, far below expectations and pushing back toward levels last seen during the housing crisis in the GFC.  As well, the Richmond Fed Manufacturing Index fell to -17, well below last month and expectations.  

Turning the clock on the global day, we saw Japanese Manufacturing PMI fall to 49.2, well below expectations of 50.5, although the Services PMI held in well at 53.9.  Australian PMI data was soft (47.4) and the same was true in Europe (France 44.1, Germany 42.6, Eurozone 45.6). Again, there can easily be a difference between the survey data and the hard data, but the weight of evidence is starting to lean toward slowing growth.

Another key feature of a growing economy is rising profitability of the corporate sector.  As we have entered Q2 earnings season, it is worth looking at some of the big names that have released already.  Last night, Tesla reported weak earnings, and this morning we heard a similar story from LVMH in Paris and Deutsche Bank.  UPS was weak and Alphabet (Google), even though they beat forecasts, has been punished in the aftermarket because its YouTube data was poor.  In fact, I think that is a critical issue.  The equity market, or at least the large cap space, seems priced for perfection, so even good earnings may not support current pricing.  But more importantly, if large corporations are seeing earnings declines that could well be indicative of weaker economic activity.  And that comes back to that opening question.

To recap, we have recently seen broadly weaker Survey data, the US housing market is clearly struggling, and corporate earnings are not uniformly keeping up with expectations.  Does this mean we are in recession?  Absolutely not, but it has certainly raised the probability that the most widely anticipated recession in history is closer than we would like.

What are the implications of this situation?  Well, this morning we saw Bill Dudley, former NY Fed President, write in Bloomberg that the Fed shouldn’t wait until September to cut rates, but rather should cut them next week.  The market does not believe that will be the case as futures continue to price just a 4.7% probability of such a move, although the September cut is baked in right now.  In fact, dovish analysts and former policymakers are increasingly calling for the Fed to act before it’s too late.  Personally, I don’t see that happening, although if data continues to soften, there will be increasing discussion of a 50bp move in September, mark my words.

There is one other place to look for clues about economic activity as well, the commodity markets.  Consider that slowing economic activity generally leads to reduced demand for inputs like commodities, be they energy, metals or agricultural products.  A quick look at the Goldman Sachs Commodity Index, which is widely followed as a measure of broad commodity activity, shows that throughout Q2, at least, the trend has been down.

Source: tradingeconomics.com

My point is that the odds of a recession seem to be rising and that means we are likely to see weaker equities, weaker commodities, lower yields and a softer dollar, at least at first.  But remember, the dollar is a relative trade.  If the US enters recession, you can bet that so will many other countries, and the reaction functions around the world could well result in currency weakness of even greater magnitude elsewhere and the dollar holding its own.

Ok, I rambled a bit, so let’s quickly see how the overnight session went in markets.  After a very modest sell-off in the US, Asian markets were far more reactive to some negative US earnings reports with the Nikkei (-1.1%) and Hang Seng (-0.9%) leading pretty much all indices lower here.  Adding to the woes of the Nikkei was the further strength in the yen (+0.85%, +3.3% in the past month) as Japanese exporters feel the pain.  European bourses are also under pressure with the DAX (-0.7%) and CAC (-0.9%) leading the way lower after their worse than expected Flash PMI data discussed above.  Finally, US futures are all in the red this morning led by the NASDAQ (-1.0%) at this hour (7:30).

In the bond market, yields are little changed so far this morning despite the weaker data.  In fact, in the past month, 10-year Treasury yields have not moved at all.  There continues to be confusion as to whether inflation or economic activity is going to be the driving force in central bank activities and as long as that is the case, bond traders don’t know which way to jump.  One exception is JGB yields which are creeping higher again, up 2bps overnight.  There is now much discussion that the BOJ is going to raise rates at their meeting next week, as well as start to taper its ongoing QE program.  This is likely supporting the yen (as well as short covering there) but will seemingly undermine the equity markets in Japan if this is the case.  However, I expect this story to gain traction until the BOJ meeting.

In commodity markets, oil (+0.6%) is bouncing after a very rough week as the market awaits the EIA inventory data.  The API data, which is not given as much credence, showed a larger than expected draw yesterday, which seems to be helping crude this morning.  Gold (+0.1%) continues to hold its own but copper (-0.6%) remains under pressure on the weak China and recession stories.  Remember, it is often called Dr. Copper on the theory it has a PhD in economics for its ability to forecast economic activity.

Finally, the dollar is mixed this morning with the yen the notable outlier, but strength, too, in ZAR (+0.5%) on the back of a sharp rise in South African yields this morning.  But there are more laggards, albeit with modest movements in the G10 (EUR -0.1%, AUD -0.25%. SEK -0.2%).  In the EMG bloc, HUF (-0.8%) is the laggard, although we are seeing weakness throughout the CE4 on the back of the euro’s modest decline.  This story continues to be focused on the rate differential.  The more we hear about calls for the Fed to cut sooner or more aggressively, the more likely the dollar will remain under pressure.

On the data front, we see the Goods Trade Balance (exp -$98.0B) as well as the Flash PMI data (Manufacturing 51.7, Services 55.0) and finally New Home Sales (640K).  With no Fed speakers, the data will gain more prominence, especially if it shows up weaker than expected and continues the trend discussed above.  As well, the equity market will continue its importance to overall trading as further earnings reports are released.  Net, it is starting to feel like weaker economic activity is making itself felt.  That should result in a little dollar softness, at least until other countries demonstrate the same traits.  But for today, the one thing I see is further short covering in JPY and a continuation of that trend.

Good luck

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