Is the global economy going into recession? We’ve written extensively in this forum about slow economic growth in developed market economies and pronounced weakness in China and commodity producing countries. As global manufacturing has contracted over the last year, we have pointed out that the possibility of a global recession has risen. Now we’re faced with a dilemma: a decently high probability of recession is priced to varying degrees in many financial markets; should we amp up our conservatism to the next level, and prepare for a recession (as opposed to recession risk) or take advantage of otherwise attractive expected returns to add risk?
There are signs that the persistent weakness in the manufacturing sector of the US economy may be spreading to the services sector (conventionally assumed to be more important). Note the recent downtick in Non-Manufacturing ISM versus its Manufacturing complement in Chart 1 (hat tip Mike Cembalest).
This is the sort of evolution of the data we would expect as financial conditions tighten, suppressing growth in much the same way as numerous policy rate hikes would do. However, by itself I don’t think this background data weakness is sufficient to presage a recession by itself, because the Fed ought to eventually react to the data and remove their tightening bias, and thereby prolong the muddle-through lackluster (but positive) growth to which the US was accustomed with zero percent nominal rates.
Developments abroad, however, are more concerning and might seem out of the Fed’s control. A month ago I lamented how irritating it is to have to say “everything depends on China” but I still feel like this is the case. I’ll use the price of copper to try to explain why. In Chart 2, the price of copper was well-behaved and range-bound around $1.00 per pound for many years, until the 15-year period where expansionary policy and reserve accumulation fueled unprecedented growth in China. The economic prosperity stoked demand for the metal (together with basically every other raw material), as well as sparked an investment boom in commodity production capacity all over the world. The capacity expansion was done in anticipation of persistent growth in China and elsewhere that did not materialize to the extent of the forecasts, and the fierce commodity bear market ensued.
The global financial system financed this commodity production capacity through equity and debt, and losses are mounting. With respect to the commodity producers, at least a portion of those losses are not transient mark-to-market losses, but rather are set to crystalize with defaults. The increased risk aversion that accompanies those losses causes all credit spreads to widen – investors need to get paid more spread to take the same perceived risk of loss*. This increases capital costs (in both debt and equity form) for all borrowers, even those which have nothing to do with commodities – the essence of tighter financial conditions. Commodity overinvestment has led to a commodity bear market which led to a credit bear market which led to dramatically tighter financial conditions, on a schedule and of a magnitude that the Fed could not control. It’s not just shadow banking systems (i.e. investors) that are affected, now that concerns are spilling over to commodity exposures in the traditional banks as well.
The further risk from here is that the current and future economic health of China is soft enough that all of the run-up in commodity prices over the past 15 years gets completely reversed. Look at the copper chart. Would you be terribly surprised, given that copper has declined from $4.50 per pound to $2.00, if it went down further to $1.50 or $1.00? Those levels seemed perfectly healthy and sustainable in the 1990s and 2000s, before the Chinese boom. To the extent commodity prices do continue to decline, the pain (and accompanying risk aversion) would unfortunately get worse. Prominent, formerly investment grade commodity producers and related businesses would default with once-unthinkably low recoveries. I am not predicting that commodity prices will continue to fall, but if it does happen, a recession in the US and abroad becomes probable.
There is a subtle point to make here: sinking commodity prices are not the core of the problem, but rather are symptomatic of a global economy which is still not ready for monetary tightening in any major economy. The outflows from China require domestic policy stimulus to offset the deleveraging**, and yet it’s challenging for China to do this while the Fed continues their hawkish stance. So, what happens in China isn’t completely out of the Fed’s control, and it’s annoyingly still quite relevant for appropriate US monetary policy. They need to embrace this to avoid the abyss.
* In addition, large sovereign wealth funds who have historically held large credit portfolios are forced to liquidate their holdings to fund commodity-linked fiscal deficits, which has exacerbated the spread widening.
** See: Part IV: Outflows Destroy Credit