Anecdotal Economics: Three take-aways from the recent data

At the CUNA/Rochdale Paragon ERM Certification and Update Schools presented in April, I taught a session titled “Anecdotal Economics.”  This concept holds that biases in economic thought, industry economists, and relationships in economic variables result in traditional econometric models that are fallible such that they fail to offer any significant predictive value.

Rather, by observing the world around us, and focusing on situations in which conditions vary from the normative state as measured against the backdrop of the immutable laws that govern economic activity, we can assess the likelihood and severity of turning points in economic cycles. To that end, presented below are three take-aways from recent economic data that offer insight into the current state of economic affairs, and indicate that things may not be as they seem, or as the pundits would have us believe.

Housing

George W. Bush famously said, “As housing goes, so goes the economy.”  And the recent housing crisis and resulting bubble and severe recession proved that notion out in ways previously unseen. Today, the housing market appears to be robust. But could another bubble be on the horizon?

Examining the S&P/Case-Shiller Home Price Index data for the 20 major markets that make up its composite index provides some clues. The composite index is up 5.3% year-over-year (YOY) as of February 2016, down from January’s post-recession high of 5.7%, but still well above the inflation rate.

The laws of economics should tell us that when aggregate prices of owner-occupied residential real estate, which does not generate cash flows, and thus cannot be valued using discounted cash flows, are based on simple supply and demand. The laws tell us that prices are based on supply and demand. Thus, other than in markets where demand is high and the available supply of buildable land is scarce (such as the New York metro), house price growth should roughly approximate the inflation rate. To the extent that the actual growth rate exceeds inflation, by a sufficient margin and for a sustained period of time, a correction is inevitable. This defies conventional wisdom to a degree, but was proven correct from 2007 through 2009.

Against that fundamental backdrop, let’s dig deeper into the individual market data that comprise the composite index. Seven of those markets exhibit prices at new record highs, and the recent trajectory of price movements in those markets indicates potential bubbles in each of them. Another eight markets, while not having returned to the highs of the recent housing bubble, exhibit price trends that might suggest bubble-like conditions (although, in at least a couple of those markets, the uptick in the price trend may be too recent to confirm oversold conditions – we must remember that one or two months do not a trend make). This means that as many as 15 of the 20 markets that make up the composite index may be in bubble territory.

Looking at some of the largest credit unions in each of those markets, we find that their net real estate loan charge-offs are negative. We can infer from this that, in these markets, while delinquencies and charge-offs may be trending somewhat higher (a trend we’re seeing across collateral types nationwide), recoveries from selling REO in a sharply appreciating market exceed loan balance losses. This is a divergence from the normal state of affairs. And that, according to the concept of anecdotal economics, may be significant.

However, the last housing bubble resulted in catastrophe due to a perfect storm of conditions: overbought conditions across a broad swath of markets (a situation that may be emerging today); a dramatic increase in demand for subprime mortgages; an increase in the securitization of those loans; growth in the collateralized debt obligation (CDO) market – in which the worst tranches of those securitized loans were packaged into garbage securities that received triple-A ratings; and a sharp increase in credit default swap (CDS) spreads.

Today, the demand for subprime mortgages is nil, CDO issuance is down, and CDS spreads are narrowing for junk bond categories, and are not spiking for higher credit quality obligations. In other words, in spite of the bubbly appearance of housing prices in many markets, and the trend in net charge-offs, another catastrophic house price bubble does not appear to be a threat. Worst-case, we could be setting the stage for a credit-driven recession along the lines of that experienced in 1990-91, and even that could be a year or more away. And there are other, more significant threats over that horizon. Notably, the upcoming election, which presents perhaps the most significant risk of any presidential election in history, in economic (and other) terms.

Manufacturing

One of the most reliable indicators (leading to concurrent) of economic downturns has been the Industrial Production (IP) index (should this be IPI Industrial Production Index) viewed on a YOY basis. This is hard data that is far more reliable than survey-based manufacturing indices, such as the regional Fed indices or the national Institution for Supply Management index. Other than in 1998 – when IP YOY suggested a downturn, but unexpected Fed easing to stave off the failure of a large hedge fund propped up the economy for another couple of years before the dot-com bubble burst – this measure has reliably predicted, or correlated with, recessions.

Today, IP YOY is -2.0%, and has been negative since last September, which saw the lowest YOY rate since 2009.  Negative readings on IP YOY have traditionally suggested recessions. Yet, the domestic economy continues to grow. (While the 2016 Q1 GDP growth rate was a relatively paltry 0.5%, recent years have seen weak first-quarter output growth numbers, only to be reversed in subsequent quarters.)

What can we infer from this? It appears from the manufacturing data that conditions suggest we should be in recession, but – as in 1998 – central bank intervention is preventing that occurrence.  (We must avoid the temptation to believe that we are in a “new economy;” the rules of supply and demand that drive the economy are immutable, and we have not been in a “new economy” since we were wearing animal skins and trading rocks.) The Fed’s ongoing easy-money policies are sustaining an otherwise weakening economy, and the Fed is increasingly responding to the stock market. The tail is wagging the dog, in other words. And the biggest risk is that when some exogenous shock drives the economy over the edge, the Fed (Barney Fife) will have no bullets in its pocket to stave off or recover from a recession.

What might drive that recession? Weakness in China? Consider that when Japan – then the second-largest world economy – encountered weakness in the early 1990s, US GDP grew throughout that decade while Japan’s growth was decimated. We will survive a slowing of growth in China, a common occurrence in maturing emerging markets. The UK exiting the EU? This will be a bigger concern for the weaker members of the EU than for the major players in the developed world. The energy sector? We are seeing firming in domestic energy prices, and the downturn in that sector has resulted in improved efficiencies in domestic energy production that can only be seen as beneficial in the long run.

The most significant exogenous risks on the horizon are, again, the upcoming US presidential (and, by extension, down-ticket) elections, and the potential for a catastrophic terror event.

Employment

Finally, let’s look at the latest US jobs report, from April 2016. The report was largely panned as being weak:

• Nonfarm payrolls “only” grew by 160k, the smallest increase since September and below the Q1 average of 200k/mo.  However, that’s still a pretty healthy gain, better than three of the months in 2015 and not far off January’s 168k gain.
• February and March combined payroll growth was revised down a total of 19k jobs, but both months’ gains remained above 200k – a steady, sustainable growth rate.
• The unemployment rate remained at 5.0%, mainly due to a decline in the labor force participation rate (more on that later). Note that the jobless rate has only been at or below 5% – Fed Chair Yellen’s “target” – about a third of the time since 1939.
• Average hourly earnings were the bright spot, growing 0.3% for the month and 2.5% YOY (vs. 2.3% in March, and against virtually non-existent inflation).
• The labor force shed 362k jobs.

But things may not be as they seem, if we examine the underlying demographics.  Regarding labor force participation, the baby boom generation (born 1946-1964, a 19-year span) totaled 76.4M people. The average US retirement age is 62. Thus we can assume that the first eight years of boomer births (assuming they’re roughly equally distributed over those 19 years) have retired, and the last of the boomers will retire in 2026, ten years hence. So about 32.2M, or 42%, have already retired, with another 44.2M to retire over the next ten years. That’s 4.42M/year, or 368k/month.  That number looks awfully close to the decline in the labor force in April; in fact, it suggests that net of retirements, the labor force may have added about 6,000 jobs in April – not stellar, but still growing. We can expect to see pressure on the participation rate until the boomers are all retired.

The upshot of all of this is as follows:

• We are likely in an economy that is sufficiently weak, given the fundamentals, to be considered in, or approaching, recessionary conditions. However, Fed policy is already easy to the point that the risk of recession is being kicked down the road, at least for now.
• The domestic housing market is approaching bubble conditions, but improvements in the underlying credit quality – both on a granular and the broader securitized levels – suggest that any ensuing crash will be muted, and would result in a downturn along the lines of the 1990-91 credit-driven downturn, as opposed to the more recent Great Recession.
• The employment picture is relatively positive, in light of demographics.

So what are the most significant risks to the current scenario?

• The upcoming US election cycle, which could result in increased regulation, high tariffs, high domestic tax rates, increased global exogenous risks, and increased acrimony among the electorate.
• An unforeseen exogenous shock, most likely related to increased risk of terrorist activity.
• The unwinding of bloated global central bank balance sheets – as those central banks have increasingly engaged in quantitative easing to address recessionary concerns, the failure to carefully coordinate unwinding those assets by price-insensitive central banks could result in a fire-sale mentality in those asset markets, which could result in sharply higher market interest rates. However, this is likely many years away, especially given the other exigent prevailing risks.

The bottom line is that, as long as Fed (and global central bank) policy remains accommodative, the economy will likely continue to perk along at a sustainable pace.  The real risks will emerge after the next US President is sworn in next January, and may not fully emerge for a number of months thereafter.