16 October 2018
Despite an improving labor market, the US economy is not out of the woods yet. Photo: Xinhua
Despite an improving labor market, the US economy is not out of the woods yet. Photo: Xinhua

Why we can’t rule out a US recession

The minutes from the last Federal Open Market Committee (FOMC) meeting have provided no clear clue with regard to the timing or the pace of the US central bank’s future rate moves.

I noted last year that the Fed has little room for further hikes in policy rates, given the weak economic data.

But the world’s largest economy finally showed signs of uptick after three rounds of QE and a prolonged period of ultra-low interest rates.

The unemployment rate has dropped to 5 percent and non-farm payrolls have seen significant growth in recent months.

Now, we come to this question: Can the US sustain the growth regardless of the external economic environment?

There is reason to believe that the risks to the US economy haven’t abated, and that there is even the danger of it falling into a recession.

Let us examine some data.

The nation’s industrial output has fallen for more than eight months in a row.

The US has gone through 17 recessions since 1920. In each case, barring the one in 1980, industrial output saw month-on-month decline eight times out of 12 months.

Right now, this criteria has already been met.

Meanwhile, company earnings are deteriorating. The US has suffered 11 recessions since 1948, and each time corporates’ overall would post year-on-year drop or negative growth in pre-tax profit.

That means company earnings would suffer during each recession. Over last 60 or so years, there was only one exception — in 1986.

Besides, S&P 500 constituent stocks have witnessed their net profit margin fall by 160 basis points from the peak level, which also points to higher recession risk.

The inventory-to-sales ratio has spiked to a record high. The benchmark has soared to 1.36 after tumbling to a trough in 2011. Current level is even higher than that during the 1998 Asia Financial Crisis and 2001 dotcom bubble burst.

The rising inventory-to-sales ratio reflects gloomy economic growth and waning demand.

It’s quite interesting that each time when the ratio rises above 1.34, either the US economy swings to recession or a global financial crisis is around the corner, as we’ve seen in the Asian Financial Crisis in 1997 and European monetary crisis in 1992.

Also, toughening bank credit has further worsened the economy’s growth prospects. The net tightening ratio has swung to 11.6 percent, the highest since late 2009, according to the Senior Loan Officer Opinion Survey (SLOOS).

By contrast, US banks were in a mode of net loosening, with a ratio of negative 7 percent, in the third quarter of last year.

The SLOOS report also shows medium-and-large companies actually have less credit demand. In the past, if US banks tightened lending to companies and credit demand kept shrinking, it was usually a prelude to recession.

In fact, the odds for the US economy to slip into recession have increased from zero in third quarter of last year to 1.78 percent at present, according to various economic indicators compiled by the Federal Reserve Bank of St. Louis.

The good news is that the odds are still very low at present, and there is little chance to see a recession in the near term.

However, if company earnings growth stays poor and credit remains tight, the economy could slip into recession in the last quarter of this year or early 2017.

That might prompt the Fed to launch a new round of QE.

This article appeared in the Hong Kong Economic Journal on May 12.

Translation by Julie Zhu

[Chinese version 中文版]

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Hong Kong Economic Journal chief economist and strategist

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