The Great Circle: Where We're At in the Business Cyle
There's an overwhelming floods of headlines, comments and data flowing around us which'll continue but which we can use some tools to filter in sense. Among all the various strands two stand out as the central themes. The first, which we talked about extensively last week and will continue to talk about, is that we're in the midst of a major systemic disruption in the credit markets. Systemic sounds so calm and collected but look it up. Now for the record we're not done BUT we think that the Fed has finally found/created/invented the toolkit to be able to establish and maintain orderly markets. WHEW ! The second is an almost complete failure on the part of the professional investment community to grasp the nature and structure of the business cycle, in general and this one in particular. We can only gape in wonder. After all this is their job.
There's been an enormous and growing amount of chatter in almost every forum about the
"Recession" and the outlook. There's been a larger, perhaps more hidden, discussion and sets of decisions that didn't think anything was coming or at best it would be very mild. As of right now little of this is correct but the dangerous one is the latter. We could take a lot of examples but the major investment manager (there have been more than several so we won't pick on a name per se) who recently said, "I wasn't convinced anything was coming but the last employment reports really scared me" captures much of the neglectful thinking. We've covered all of this ground in various forms and at various times before and even done the occasional comprehensive review and update. Our end-of-year/new year review and outlook for example. And our basic tools, techniques, analysis and prognostications haven't altered since the very first posting (Pass 1+ - The 'REAL' Data (Output, Consumption, etc.) over a year ago ! Even so it seemed like a very good time to recover and lay down the basics and see if that helps people get a clear picture of where we're at and what's likely to happen. We hope it helps.
UPDATE (3/24 18:18): Cases-in-Point. As a lesson in paying attention to the real data and the real patterns the headlines today were all about Existing Home Sales increasing MtM. Aside from the seasonal noise the YOY changes were much different. Our e-colleague CalculuatedRisk has done his usual straightfoward and reliable (& readily understandable job) of dissecting these realities in two posts plus another one on the Chicago Fed's take on Recession:February Existing Home Sales, More on February Existing Home Sales and Inventory and Chicago Fed: "Increasing Likelihood Recession has Begun".
A key quote:
"The first graph shows existing home sales, on a Seasonally Adjusted Annual Rate (SAAR) basis since 1993. Sales in February 2008 (5.03 million SAAR) were the weakest February since 1998 (4.77 million SAAR). Here is a graph of Not Seasonally Adjusted existing home sales for 2005 through 2008. This graph shows that sales have plunged in February 2008 compared to the previous three years. This also shows that February is typically one of the least important months of the year for existing home sales."
In other words there is literally no resemblance between the headlines and the underlying realities. You must understand the structure of the phenomenon. It is easy to understand. And apparantly the vast majority point-blank refuses to look at things as they really are. A phenomenon for which we have no explanation and simply keep shaking our head in crogglement.
Now just for the record we didn't use "Circle of Life" just for fun or post the graphic which'll take you to the song entirely for fun. The Economy is a circle, what comes 'round goes 'round and it demonstrates ebb and flows as much as the tides do and for similar reasons. Because it's a natural part of the way things work. Every cycle is different but they all share certain common characteristics and an overall character. At the end of the day when you plot the tide against time it looks like an oscillating sine curve just as the economy does. But just as different places on a coast and up the river will see high and low marks at different times the economy also has an inter-linked set of timetables which almost of the commentary that worries us is ignoring. So just for fun and as a favor listen to the song and really listen to what the words are saying about natural order, rythms and inter-relationships. The economy is as much natural ecology as it is anything.
And as a member species in that ecology you need to understand how it works to thrive and survive in it. Below we walk thru some earlier charts and some new ones that trace out the "Circle of (Economic) Life" because we think it's important for you to filter what's being said with these understandings. So what we try and do here is pull all the basic graphics and charts into one place to provide a short refresher on the business cycle. And understand and assess where we're at.Business Cycle
The graphic at right is my version of the how the basic business cycle works. You'll find it consistent with Ellis' "Ahead-of-the-Curve" or Mankiw's Macro for that matter. [BtW - an earlier posting offers up some guides to getting grounded in macro-econ:Social Notes: Be Your Own Economist and Related Readings]. And more detailed discussion in these prior posts:WtW Part Deux: Patterns, Cycles & Indicators,Weigh the World Works: Understanding the Business Cycle . But it's not an accident that we show the cycle as a circle because you see the feedback loops. Here Consumption is the engine which drives the Economy which Business then evaluates and makes decisions about Capex and Hiring. Consumer decisions are governed by their expectations about jobs, wages and borrowing capacity. Businessess have a similar evaluation governor that they use to decide to speed up, slow down or stay steady.
The OTHER key thing though to think about is that timing of going 'round the circle. Current Consumption determines current Production and evaluation of the growth determines Hiring which in turn determines future Consumption and so. It runs in reverse too, which is what's happening now. Now there is a normal pattern to this rythm which got disrupted by the Tech Boom/Bust where we were lucky to avoide a major downturn (yes the D-word is appropriate) but policy sustained consumer spending above where it'd be and avoided that. At the cost of a weak recovery that's been a poor generator of jobs and organic growth.
Current Business Cycle
So what is our timing, that is where are we at in our current cycle ? And what does that imply for the data we should be looking at ? The graphic at right is one you've seen before but it shows us at the tip of the cusp where a slowing economy tips over into a downturn. Which would mean that GDP would have been slowing for a while, as would employment and other lagging indicators but would be likely to show larger decreases. Well guess what - that's about exactly what's been going on. It also means, if we've got our timing right, that there's a long way to go. We've also mentioned the alternative paths before but you really need to think about that again, and again. So what do the actual data show ?
Real Business Cycle: Consumption => GDP => Employment
Oddly enough when you look back at the actual data, shown as YOY% changes as usual, the charts look startlingly like the conceptual pictures in the graphics. Gee, wonder how that works out ? Looking back to 1980, which is the last time we actually had a serious downturn with lots of disruption and volatility [trans: nobody's seen the real deal in a longtime and their reflexes are rusty]. Again we've talked about a lot of this before so let's just point out that a) Employment is both lagging and has been exceptionally weak this time. And b) Consumption tends to drive GDP but held up startlingly well during the '01 downturn. And then enterred a longer-term slowdown as the economy failed, we repeat failed, to re-establish organic growth after the stimulii faded.
Wages + Employment => Consumption
So if Consumption drives the Economy what drives it - other than the general discussion we had above ? Partly of course, as the mild downturn shows, it can be held up by borrowing against wealth, in this case Housing. But the core, tidal rythm (the circle of economic life) that establishes and sustains consumption is changes in employment and real wages. Which we can represent by looking at the YOY% changes in the combination, here W+E. Notice that we got a real positive gift from the gods in '06 when the sudden downturn in Oil prices pulled down inflation and pumped up real wages. Well guess what, that's history.
GDP => Investment => GDP
A feedback loop is when changes in one thing causes changes changes in another which, turnabout, feeds back and causes changes in the original. As GDP grows we reach a point where more capacity is required which in turn leads to Investment in equipment and hiriing. Which in turn leads to more Consumption and so on. Well a) the feedback runs in the other direction just as well and b) part of the linkage is expectations as well as current experience (the little blackbox sideloops in our initial cycle diagram).
Summary
Hopefully you can look at these graphics and charts and come to your own interpretation of where we're at in the business cycle. And what the various data and headlines mean. Here's our bottomline - it's early in a downturn. The credit market crisis has a long way to go BUT has a shot at being an orderly de-leveraging instead of an implosion. Fed policy should help us avoide tipping over into a major downturn but this is still going to be longer and deeper than the majority of the Street is aware of as yet. And we really will need serious fiscal stimulus to avoid something more severe.