As you probably noticed, over the last two years we have experienced a lot of the so-called 'recession talks'. Commonly about the United States and the global economy but more importantly when it is gonna happen. I want to emphasize that if someone wants it or not a recession is an inherent part of every business cycle. The difficult bit is, of course, to find out the timing.

An economic downturn gives an excellent opportunity to replace old, unproductive and unprofitable companies for more efficient and innovative. This process is called creative destruction. It is also very important to note that modern cycles have been substantially prolonged, mainly due to central banks' activities. In other words their management of interest rates (cost of credit) and money supply. Currently, the former measure is close to historic lows, the latter at historic highs. In other words, money has never been cheaper. For your curiosity, below I attached the graph of interest rates over the last 5000 years.


In the current era, short-term interest rates (blue) are set by the central banks, in this particular case by the Federal Reserve (US Central Bank), and long-term rates are bond yields, usually with 10 years of maturity.

Before we dig in details into the global economy and what can we expect in the future by looking at the data, it is worth to remind us a recession definition. In the case of one country, this term is quite simple. A technical recession occurs when there are two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP). Whereas when we look at it from the perspective of the entire world, a recession has no official definition. In effect, a process of identifying a global downturn is not straightforward and it's not necessarily associated with negative growth per se. Usually, it is recognized as an extended period of decline in economic growth around the globe. The International Monetary Fund (IMF) identifies a global recession as a decrease in GDP per capita (per person) together with a weakening of one out the seven macroeconomic indicators; industrial production, trade, capital flows, oil consumption, unemployment rate, per capita investment, and per capita consumption

According to the IMF, the economy has experienced four global recessions since the World War II, in 1975, 1982, 1991 and 2009. In the case of the last global economic downturn, it was a period between 2007-2009 when the world trade dropped by as much as 29%.

In this article, I will try to find some answers regarding how close to a recession is the global economy, based on the analysis of the United States, and China accounting for 40% of world GDP, as well as some world-leading indicators.


UNITED STATES

The United States is the most-watched economy in the world. And this is despite that during this business cycle it hasn't been the biggest driver of the world economic activities. Out of $86 trillion of global GDP, the US contribution is as much as $20.49 trillion, according to the World Bank data. Let's have a look then at some leading indicators in order to find out the current stance of the US economy.

The first, which I would like to bring is LEI or the United States Conference Board Leading Economic Indicators Index, namely its year on year change. The index includes 10 different indicators, which you can find under this link:
https://www.conference-board.org/data/bcicountry.cfm?cid=1

It has to be mentioned, that this is one of the most followed indicators in order to find turning points in the business cycle.

source: zerohedge

As you can see, the index increased over the last year only by 0.1%, which is the lowest reading since November 2009, a few months after the end of the Great Financial Crisis. It is very important to note, that one of the index' components is the US Stock Market (the S&P 500 index). If you exclude stocks from the index then its change is actually negative. Moreover, it has to be pointed out that 6 out of 10 components are actually hard (factual) data, not the soft data (surveys or polls usually driven by the companies managers' sentiment). In other words, it describes the real economy. If you look more closely at the graph, you can see that every time (apart from 1995) when the index has been at these low levels, the US economy has fallen into recession in the next 12 months. There also has been an important turning point in 2016. That was the effect of massive credit creation in China which I will talk about in the next paragraphs.

Continuing the analysis, we have to also look at the US consumer conditions as their confidence which influences spending are huge drivers of the economy. In 2019, 90% of the GDP growth has been driven by consumer activities, an incredible number. In order to measure consumer shape, it is very useful to take the US Conference Board Consumer Index which is a monthly survey of 5000 US households on how optimistic or pessimistic they are in terms of their financial situation. The graph below shows the index of their expectations subtracted from the index of their current situation.


It can be clearly seen that the difference between expectations and the current situation is the largest since the 2000-2001 recession. Does that mean a recession in the US is imminent in the upcoming months? Not necessarily but this indicator is definitely worth to watch. In my opinion, a decisive point will be when the consumer confidence will start to drop very quickly as in the previous cycles, which usually takes a couple of weeks to materialize.

The last gauge I would like to bring to the table probably gives the greatest deal of excitement in financial media as well as in the Finance Twitter (FinTwit). This is the yield curve. The yield curve is a line that plots bond yields of different maturities. In the case of the US, it starts from 3 months and ends at 30 years of maturity. In this particular example, we will use the difference between 10-year and 3 months of bond yields.

In normal economic conditions, a difference between those yields should be positive, as longer-term bond yields bear more risk (an investor lends money for the longer period thus needs higher compensation), so the interest on these bonds should be higher. If investors perceive that the economy will significantly slow or fall into a recession in the near future, they start to buy longer-term bonds (10 years in this case) to protect their portfolios. As a result, yields of these bonds decline. In addition, due to those purchases, there is less demand for short term bonds – as investors fear an upcoming economic downturn which in effect drives short term yields higher. If long term yields drop below the shorter-term bond yields (e.g. 3 months) then the yield curve inverts (the difference is negative), which is showed on the graph below.


As you can see, over the last few decades (in fact over the last 60 years) each inversion has preceded a recession in the United States, and the lagging period has usually been 12-18 months. To expand that a little bit further, when an inversion occurs that means the borrowing costs are higher in the near-term than during the longer-term. In effect, corporates find it more costly to fund their day to day operations which negatively affects investments. From the consumer perspective, short-term loan costs also increase, therefore consumer spending drop. As a result, the economic activity slows eventually leading to a recession.

In the last year, we have experienced the yield curve inversion lasting for several months. To increase the usefulness of this indicator, the New York Federal Reserve has started to conduct a model showing a probability of US recession based on the aforementioned spread between 3-months and 10-year yields.


The model currently shows 23.6% of a downturn, falling from almost 40% in the last year. However, if we look at the red line from the graph, each time since the 1960s' when the probability has exceeded 30%, a recession came within 1-2 years. The Fed is also familiar with this data which is one of the reasons why they have cut rates three times and started expanding its total value of the balance sheet, forcing the curve to steepen. As a result, the difference between yields came back to positive territory, so the probability of a recession has declined. It does not mean, however, that a downturn fears have completely faded.


CHINA

In my opinion, the Chinese economy should have brought much more attention during this business cycle than it used to be in the past. Unfortunately, it hasn't. The Middle Kingdom economy accounts for 16% of the global GDP, but it's been the biggest driver of economic activity over the past decade. According to Tuomas Malinen, Ph.D. Chief Economist of GnS Economics over the last 10 years:

"More than 60% of all the new money (debt) created globally had come from China, mostly created by its commercial banks."

This data is also confirmed by the New York Fed Liberty Street Economics blog conducted by NY Fed Researchers. Furthermore, as Tuomas Malinen points out:

"China accounted for over 50 percent of all capital investments in major economies between 2009 and 2017."

Thus, it would be a big mistake if we haven't looked at China in the first place while assessing the global economic conditions.

Starting with the aforementioned data, we can certainly say that during this cycle the Middle Kingdom has been highly driven by debt, which is shown in the below chart.


source: zerohedge

The red line shows China's year on year GDP growth rate which is currently 6%, the lowest since at least 29 years. However, more important here is the green line showing China's credit impulse 12-month change (a measure of the change in new credit issued as a % of GDP - the higher the indicator the more debt has been created by China). This gauge leads the real economy by 9 to 12 months. Looking at this measure we can conclude that the effectiveness of their debt creation is significantly fading. In other words, the same amount of credit leads to less and less GDP growth. This phenomenon is called a debt saturation.

It is perfectly described by the next chart produced by Michael Nicoletos. I also recommend you to check his entire analysis about China under this link:
https://twitter.com/mnicoletos/status/1194933054286028800


Currently, to produce 1 unit of GDP China needs 7.68 units of credit (or even 9.74 units on adjusted terms). This clearly explains why Chinese growth is dropping from year to year while the debt pile is substantially increasing. The question is, how much more room the Middle Kingdom has in terms of debt creation before the economy explodes. Probably not much.

source: Institute of International Finance

China's Total Debt to Gdp ratio stands at astonishing 310%! Of course, Chinese authorities are fully aware of this very concerning issue. As a result, they have started deleveraging (a process of debt reduction) the shadow banking system (unregulated lending and financial activities conducted by non-bank financial intermediaries) as well as a process of 'controlled defaults'. As Bloomberg recently reported:

"China’s had another record year of corporate bond defaults. That’s not a crisis. It’s a plan."

And here the next question arises, how many defaults can China's financial system handle in 2020. If we'll see hundreds of billions of dollars then we surely say that controlled turned out to be a cascade of uncontrolled defaults and a collapse is around the corner.

Before I proceed to the Global economic indicators it is a must to have a closer look at how much economic stimulus has actually China done in the past. China Total Social Financing (chart below) is a broad measure of liquidity and credit in the economy. It covers metrics such as bank loans, equity financing (Initial Public Offerings) and corporate bonds issuances. It is a very useful indicator to identify trends in credit creation in the Middle Kingdom including the shadow banking system.


When we look at the top part of the chart or the China Social Financing in US Dollars in 2019, we can see that financing activity in January last year was the highest in history in nominal terms and since then has been substantially falling. On the bottom part of the chart, we also see that China has created as much as $3.7 trillion over the last 12 months where 66% of this amount were bank loans. This is an equivalent of 27% of its GDP, and it's been pulled into the economy in just one year!

As you can see, China is already indebted to its neck and the 'effect' was just 6% GDP growth. Due to these activities, we can expect some "green shoots" in economic data in Q1 2020 but I personally doubt it will be sustainable. It means only one thing, the Middle Kingdom is in trouble and along with it, the entire global economy.


GLOBAL ECONOMY

So far we have studied the current stance of the two largest economies in the world. Now it is time, to sum up, the analysis by looking at the entire global picture. I mean here, the world trade together with some leading economic indicators. At this point, It has to be emphasized that falling global trade, as well as the slowdown, have not been caused by the Trade War between China and the US. The Trade War has just accelerated the decline.


Greenline on the chart shows the moment when the first tariffs imposed by the US on China has been implemented. It can be clearly seen that exports have started to decline by more than half a year before that date. Currently, world exports volume growth is negative and despite the US and China have reached a partial deal, companies will certainly stay cautious (as the tariffs have stayed in place and there is still a lot of uncertainty about the next talks). Therefore, a final impact may not be as good as expected by financial experts. In other words, I think the global trade deterioration will continue.


To put things into a better perspective, in 2019, world trade growth was negative for the first time in a decade. In addition, World GDP growth fell to 2.9% in 2019, the lowest rate since the financial crisis. Does that mean the global economy is falling into a recession? In order to make an attempt of answering this question let's have a closer look at the world-leading economic indicators, what are central banks doing and how it's been working in the past.

As IMF managing director Kristalina Georgieva in the recent interview with CNBC stated:

"49 central banks around the world have cut interest rates 71 times in 2019 [almost the same pace of cuts as during the last financial crisis] but the problem is we can not rely on the monetary policy forever." 

This is entirely true. Central banks have almost no bullets left (apart from the United States) and the effectiveness of the recent actions are questionable. However, as history shows the previous rate cut cycles conducted by the central banks have helped the economy to recover within the next 8-12 months.


source: Shane Oliver, AMP Capital

Redline on the chart shows global manufacturing PMI (right scale), a leading indicator for the manufacturing sector (which usually leads the service sector - the first accounts for 16% of global GDP the second for 66%), below 50 means contraction, above 50 sector expansion. Whereas, the blue line shows a percentage of central banks which the last move was an interest rate cut moved 8 months forward (left scale). The chart says that more than 80% of central banks have recently decreased rates and usually, after this type of move, the economic activity in the global manufacturing sector has been rebounding.

The next chart is describing a similar case in Emerging Markets, including China.


Blackline describes the composite of OECD Leading Economic Indicators for Emerging Markets, blue line shows how loose is the monetary policy in these markets (in terms of interest rates and exchange rates - the looser the policy the more interest rate cuts and money injections have been made). This indicator was moved forward by 6 months. As it is shown. financial conditions in developing markets have not been that easy since the recovery of the Great Financial Crisis. For a better understanding of this indicator, we can remind ourselves of China's record financial stimulus in order to keep economic growth. As a result of these policies and cheap money, the economic activity of these markets is expected to increase in the upcoming months, IF the effectiveness of these actions will be similar as during the previous years.


SUMMARY

The global economy is currently experiencing significant difficulties. Authorities of the largest financial institutions in the world are fully aware of this and desperately try to avoid the repeat of one of the biggest economic meltdowns in modern human history. They also know that historically low-interest rates, as well as the gigantic amount of debt, do not give much space for further actions. Therefore, in the current environment, I see two possible scenarios:

1. China's gargantuan credit pilling will turn out to be ineffective due to debt saturation and central banks' actions will start to materialize later than it usually has been the case which eventually will lead to a global recession after the Q1 of 2020 comes to an end.

2. Global policymakers will again come out unscathed and manage to prolong the economic cycle for the third time as it's been the case in 2011-2012 and 2015-2016. In this scenario, the most concerning would be the same as in the previous attempts of sustaining economic expansion at all costs. Namely, the more you extend a cycle the bigger will be the pain when it finally comes to an end.

In terms of market positioning, there are many ways to play out the aforementioned possibilities. If you believe in the first scenario, I see US Bonds, Gold, and US Dollars as the most beneficial assets to hold. Keep in mind, however, that the timing is very crucial. During the last crisis, gold firstly increased by 55%, then within a few months dropped by 30%, to eventually end up roughly 45% higher.

If you think that the second scenario is more probable, then stocks both in the United States and the Emerging Markets (including EM currencies) should outperform as well as commodities related to the manufacturing sector such as copper. In this case, prudence will be very important. Thus, do never forget to protect your money.

I am very curious about your thoughts.

Thank you,

Seb.


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