In this month’s blog, we try to map out the global credit cycle (various leads and lags of data) to show where we are at in terms of the expected trough (Q4/2023) of global business activity by looking at recent data from the U.S. and China.
We continue to see deflationary trends coming up in leading data (commodity prices) and lower credit growth ahead (U.S. Commercial Bank weekly data) due to deposit outflows, despite lagging data such as inflation and employment continuing to show above-trend growth, though starting to see some signs of weakness in recent reports.
The global business/manufacturing cycle and liquidity cycle tend to follow a somewhat predictable pattern over time (every 3.7 years or 44 months), which is based on the average global debt maturity profile. The last economic trough at April/May 2020 (as measured by the ISM Manufacturing PMI). The current cycle trough is expected in Q4/23.
Central Bank Policy Rates: The liquidity cycle (central bank raising/reducing overnight rate) is used to re-inflate the business/manufacturing cycle due to recession or credit event (i.e. large bankruptcies/insolvency) and usage of the Central Bank balance sheet to manage long-end of the yield curve to meet the policy objective. The impact of rate hikes takes between 12-18 months to have full effect. We saw maximum policy tightness in September 2022. Most central banks appear to be close to ending the hiking cycle. Inflation has been controlled via rate hikes/lower money growth in the real economy.
We note that Private sector money growth in the U.S. has been negative over the last few months and does not appear to have bottomed. Our central bank diffusion index leads the ISM Manufacturing PMI by 12 months and points to the continued decline of the ISM Index. Private Sector Global Liquidity and ISM Manufacturing New Order Index tends to lead S&P Operating EPS by 12 months and 10 months, respectively. We believe over the next couple of quarters, we believe a pivot may occur, and will not be a bullish sign in the economy as deflationary signals will be even evident than they are today.
Central Bank Balance Sheets: Since October 2022, Global Central Bank liquidity has risen, which has increased valuations (Price-to-earnings ratio) to reduce risk/maintain financial stability (i.e. UK Pension Crisis), and real interest rates have fallen. Equity markets have appeared to bottom as a result. Equity markets have not tended to bottom before an actual recession. Historically, private sector money growth and re-steepening of the yield curve have been associated with equity market bottoms when a bear market has lasted longer than 1-year and results in a recession, we have been in the current bear market for the past year or so. This is done to re-inflate the business cycle and earnings through the flow of credit into the economy. We have yet to see an inflection of private sector liquidity or re-steepening of the yield curve and only started to see continuing claims starting to grow.
Aggregate U.S. Commercial Bank Balance Sheet: Deposit drawdowns of >3% have preceded each equity market drawdown of > 20% (ex-COVID-19) since 1973 (earliest data is available). Banks are highly levered businesses (10-25x), and instability of funding profile, causes banks to pull back in maintaining the continuous flow of credit into the economy through deleveraging (i.e. tightening of credit standards). Credit availability appears to have declined post-U.S. regional bank failures in the last two weeks, as credit drawdown is ~1% and credit is only growing at 3% (3-month annualized), which is lower than trend growth of 7%. Historically when loan growth has gone to 0% or below (1975/1991/2002/2009/2011/2020), economic growth has slowed dramatically. This is a significant area to watch going forward, as the economy relies on the continuous flow of credit/money to real economic growth over and above population growth. When credit growth declines significantly, bankruptcies/higher credit losses and higher unemployment have followed historically. We expect the cycle to play out very similarly to history.
U.S. Labor Market growth is still positive (potentially a late-cycle peak), but decelerating: There were significant revisions to prior data for jobless claims (revising upwards) this past week, which brings the trend much closer to private survey data such as Challenger Gray/NFIB. Looking at last Friday’s payroll report the U.S. labor market appears to be rolling over, consistent with our expectation of lagged impacts of interest rates. We note that the payroll survey occurred before the U.S. regional banking crisis and may not yet reflect the potential credit crunch that is currently occurring. Once continuing claims start increasing YoY beyond the current level, they tend to continue to accelerate upwards in a non-linear fashion. With higher debt-to-income levels, changes in interest rates have led to non-linear spikes in unemployment historically. Constant restatement of employment data makes calling a recession in real-time difficult, though appears that we could be close based on current continuing claims data. We will continue to monitor weekly jobless claims to determine if further weakness persists.
China’s re-opening stalls on weak factory demand: China’s Producer Price Index continued to fall in March (down 2.5% YoY), as a result of weak demand (lower exports) amid worsening economic conditions across the globe. The spread between PPI and CPI in China gives us a preview of continued weakness in China’s industrial profits, which are expected to fall further in March. Previous earnings cycle troughs are between a 15-20% decline in 12-month rolling earnings and we are currently at 8%, so appears more room to go in this cycle. We have yet to see consumer spending pick up dramatically in China to offset the weakness in the rest of the world. Increasing housing prices, may increase consumer confidence via the wealth effect, to help spurn further spending in the economy, but we have yet to see this play out.