Joestradamus says, I think there is a 20% probability we fall into another recession by the end of 2016.  There are sectors of the US economy that look strong enough to withstand another shock, so that’s why I’m not going to go ballistic and say something like 50+%.  20% is pretty high considering Q3 is looking to be like +1.3%, so we only have five quarters to get the two consecutive negative GDP prints needed for a recession.

 

As background, I was reading about the Great Depression in Wikipedia, and the description of the beginning was eerily familiar:

 

Economic historians usually attribute the start of the Great Depression to the sudden devastating collapse of US stock market prices on October 29, 1929, known as Black Tuesday…  Even after the Wall Street Crash of 1929, optimism persisted for some time…

 

… consumers, many of whom had suffered severe losses in the stock market the previous year, cut back their expenditures by ten percent. Likewise, beginning in mid-1930, a severe drought ravaged the agricultural heartland of the US.

 

By mid-1930, interest rates had dropped to low levels, but expected deflation and the continuing reluctance of people to borrow meant that consumer spending and investment were depressed. By May 1930, automobile sales had declined to below the levels of 1928. Prices in general began to decline, although wages held steady in 1930; but then a deflationary spiral started in 1931. Conditions were worse in farming areas, where commodity prices plunged, and in mining and logging areas, where unemployment was high and there were few other jobs.

 

The decline in the US economy was the factor that pulled down most other countries at first, then internal weaknesses or strengths in each country made conditions worse or better… By late 1930, a steady decline in the world economy had set in, which did not reach bottom until 1933.

 

Now I’m not saying we’re going to get a Depression.  But it seems like if we got a sustained equity correction, you could see some serious retrenching.  China has a two month head start on us, and it is the economy that could “pull down most other countries.”  Considering they are one of our top three trade partners, the second largest economy in the world, and the primary growth engine of the world in the past decade, what happens there is critical to many sectors of the global economy.  Here are the relevant factors:

  • Retrenching consumer. If we get a shock to the system (equity correction, etc), how are people who don’t have enough money to retire and have to work (the bulk of recent job gains), or people who can’t pay their student loans, be expected to keep on spending?  As it is, with rents going up and medical costs going up, the consumer has less disposable income – in other words, inflation is currently overstated.  We are getting inflation in the wrong places (I will discuss in a future issue of the CA).
  • Retrenching businesses. When was the last time you heard a business say they were increasing R&D or investment, other than a start-up (tech) company?  China is a huge revenue source for many businesses – tech companies in particular.  You can be sure earnings are going to take a hit.  Goldman says the S&P only has a 2% exposure to China.[1]  However, information technology has a 10% share and another 12% share in the rest of Asia.  You shouldn’t forget the impact and exposure to “rest of Asia” AND Emerging Markets, which are both strongly linked to China.  That’s the total the markets should be concerned about – the world is increasingly linked.
  • Downside risk to inflation. The Fed Staff said so in the last minutes.  As I’ve mentioned in previous CAs, if you take out housing and medical (neither of which are what I would consider liquid discretionary items), inflation has been non-existent to negative for a while.
  • Plunging commodity prices. This is terrible for manufacturing and employment in those industries, and is terrible for inflation.  More importantly, in a “healthy” economy, you generally do not see collapsing commodity prices.

 

It won’t take much to get a severe retrenching of the economy.  Will we get the catalyst?  And if so, how long would it take?

[1] http://www.bloomberg.com/news/articles/2015-08-10/here-are-the-s-p-500-stocks-with-the-highest-exposure-to-china