An economic recession in the US is drawing closer. Ironically, the main road to economic recession will be through higher inflation. Higher inflation will cause a growth slowdown and that slowdown will accelerate inflation, at least for a while – so which is the chicken and which is the egg?
The recession won’t come from a traditional, consumer-led slowdown, as some believe. Right now, US wage income is far too strong for the doughty US consumer to pack up. Personal income rose 6% year on year in the first quarter and 6.4% year on year in the second. Indeed, measured by taxes, personal income is up 12.6% year on year in the second quarter of 2006. These sorts of numbers don’t fall in line with recession or disinflation.
The US national income cake keeps expanding; the Chinese (and the Indians and others) make things ever cheaper for the consumer; and the consumer can still borrow ad infinitum at low interest rates to finance his spending spree. That is what has been happening up to now.
But there are reasons why this happy coincidence of events is coming to an end. The main one is inflation. Two things can cause inflation. Too much money on offer at too low a price and a situation when resource utilization gets too tight. The world is starting to suffer from both of these.
First, the global cost of capital – which has been kept artificially low by the huge credit multipliers of derivatives and securitized debt markets, which add to liquidity – is now rising.
Also, the last crutch of the “no-inflation here” thinkers, such as Federal Reserve chairman Ben Bernanke, was that there could be no inflation as long as globalization kept competition up and labour costs down. But globalization won’t depress inflation for much longer. China is generating its own brand of it and this is already feeding through into export prices through Hong Kong.
And in any case, the US labour cost/inflation crutch has just been snatched away. US unit labour costs rose 3.2% year on year in the second quarter of 2006 from a revised 2% year on year in the first quarter of 2006 and negative territory back in mid-2004. That’s because productivity growth has slowed to 2.4% year on year from 2.7% year on year in the first quarter of 2006, and hourly compensation growth has accelerated to 5.7% year on year from 4.8% year on year in the first quarter of 2006.
| Global cost of debt capital |
| Debt-weighted average of US, eurozone and Japanese credit markets debt and bank assets |
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| Source: Datastream |
Readers will know that I am deeply suspicious of the core inflation numbers much favoured by the inflation optimists. They just take out of inflation the prices of things that go up. Unsurprisingly, that produces the syllogism of an inflation-free world. But even if I accept the core inflation measures, the news is bad. In the first six months of 2006, core CPI has accelerated from 2.2% to 2.7% year on year.
My map to recession is therefore that inflation continues to seep into the system from asset bubbles and from high resource utilization causing rising business costs. Some of this will be absorbed through falling profit margins but some will be passed on as higher output prices.
This causes the cost of capital to keep on rising and asset prices to decline. Wealth destruction then causes the consumer to retrench. As that happens, people start to lose their jobs and the process accelerates. We get back to a normal economic cycle.
The whole process will be protracted. First, the contraction of global liquidity and the fall in asset prices will be gradual. Second, even in the halcyon decades of disinflation, the lag between a slowing economy and a significant fall in inflation was longer than a year. Third, the US economy will hold up for longer because work and other forms of personal income are so strong.
But disinflation is over and the impact of globalization is waning, so a slowing economy will cause inflation to fall by less and with a longer lag. The experience will resemble the 1970s more than the disinflationary 1980s, when the trend in inflation was set firmly on a down path. That is why bonds are not a bargain.
But the outcome for equities is likely to be worse. They will have to contend with higher inflation and real interest rates eroding multiples while cost-push inflation erodes profit margins.
Is this stagflation? Well, it’s a cousin of it. It is another chapter in the unfolding story of the end of disinflation. That means a return to cyclical economies with an embedded higher level of inflation. That is something that asset markets, and most of those who play in them, have simply ignored up to now.