What Will Cause the Next Recession?

John Mauldin | Thoughts from the Frontline
August 19, 2005

It's a race to see what will be the cause, or maybe better put, what will be blamed for the next economic slowdown. Will it be oil and rising energy prices? What about a slowdown in the housing market? You can't count out the Fed raising interest rates as source of economic slowdown. If China slows down and thus has less money to invest in our bonds, will rates rise? There are so many potential culprits. We run through them and more as we try to peer into 2006.

One of my favorite cartoons is a picture of two scrawny vultures sitting on top of a cactus in the middle of the desert. One turns to the other and says, "Patience, hell. Let's go kill something." Patience is what we are going to need for the rest of this year.

$70 Tank of Gas

It happened to me for the first time this week. My gas tank topped out at over $60. Texans are not used to $2.65 a gallon. The local good old boys can now spend over $70 to fill their Ford F-150 pickups. Let's work the numbers on that. The truck gets 14 miles per gallon. In Texas, you can have a long commute to work. If you do 20,000 miles per year, you will need 1428 gallons. That is $3,785 or $72.80 a week. For a guy making $15 an hour or $600, less taxes, with say a take home pay of $500, that would be almost 15% of his paycheck! Tough to support a family on that! Can we say a second job?

The US trade deficit in June was $58.8 billion or 6.1% of GDP. A little more than a third of that deficit was due to oil, or $19.9 billion. Mind you, that was at an average price per barrel of $44. Today oil is well north of $60. Assuming an extra $15 dollars a barrel in August, that could mean another almost $6.5 billion in oil and energy imports. And that is if the average oil price in August drops to $60. It needs to drop pretty quick if it is going to do that.

If oil stays near today's level that would mean over $300 billion per year going outside the US. That is an extra $150 billion over where it would be at $30 oil. Even backing off to $50, that would take an extra 1% of GDP out of the country. That is 1% less that US citizens would spend on consumer goods, which is not a big number in the grand scheme of things, but is enough to slow things down at Wal-Mart, which is where the good old boys driving F-150's buy their food and other supplies.

The rule of thumb is that for every $10 rise in the price of oil, you will see a loss of about 0.4% of GDP. Thus the recent rise in energy is enough to slow down the economy but not enough to push it into recession. Yes, nine out of the last ten recessions have been associated with rising oil prices. But nearly all of those were supply driven. Today's rise in oil prices are demand driven. Prices are rising because demand in the US, China, India and everywhere else in the world is rising. Rising demand is because the world economy is relatively strong. And that is a good thing.

Except there are signs it may be starting to take its toll on US consumers. We see a new correlation with consumer sentiment not just with housing and market prices, but what looks like the pump price at the gas station. Wal-Mart announces softer forecasts as the price of gas rises.

And with natural gas rising, we are going to see much higher costs for heating homes this winter. Another way for consumers to get squeezed. Not a lot, but here and there.

Now, we need to realize that oil usage as a percentage of GDP is less than half of what it was 30 years ago. We are much more efficient. But it still has an effect. My take is that oil prices, even where they are today, are not high enough to push us into recession. It will just slow things down a bit.

As an aside, and for something else to add to your worry closet, my friend and expert natural resource analyst and economist, Don Coxe recently wrote about a fascinating report by the Association for the Study of Peak Oil and Gas, which refers to 1985 when OPEC members were "competing with each other to be allotted bigger OPEC quotas." Coxe writes "OPEC has always allotted quotas to members in proportion to their proven reserves. Kuwait's geologists must have had a pretty good year, because their reserves climbed from 64 bn bbls to 92 bn. But the Kuwaitis were pikers compared to their brethren in the Emirates, who said that, upon reflection, they needed to boost their reserves from 31 bn to 92 bn. Not to be outdone, Iran announced its real reserves were 93 bn, up just a tad from a previous 47 bn. The 1985 champ, though, was the savvy Saddam, who was not content with double digits: his reserves went to 100 bn, up slightly from the previous 47 bn." According to the Association for the Study of Peak Oil and Gas, those reserve figures remain today.

There are serious reasons to doubt the truth of OPEC oil reserves, or there ability to increase production fast enough to keep up with projected world demand. Oil prices may not be dropping back into the 30's or low 40's again, without a sharp worldwide recession lowering demand big-time.

The Housing Market Starts to Show Signs of Weakness

Can you open a financial paper today without an article on the slowing housing market? Everyone is looking for signs of an impending fall in housing prices. From the Sacramento Bee we read:

"Jim Eggleston, owner of Sacramento's biggest residential 'For Sale' sign installer, predicts this will be his busiest week in 21 years in business. He's had to hire an extra worker and buy a new delivery truck since his crew planted a one-day record of 225 signs on Monday.

"'There are whole lot of houses going up for sale,' says Eggleston, who promises next-day installation when a real estate broker orders a new sign. 'The number of 'For Sale' signs we're removing keeps going down relative to the number we're putting up.'"

And from the Palm Springs Desert Sun we read (and note the last sentence!)

"Price rises come as local sales counts have recently been falling, and the inventory of unsold resale homes is up dramatically from a year ago. According to DataQuick, the total 1,259 new-construction and resale homes sold in July was down 12.1 percent from a year ago.

"And unsold resale inventory is currently at around 3,452 properties, according to Greg Berkemer, executive vice president of the California Desert Association of Realtors. That figure is up 63 percent from a year ago and is more than twice the 1,400 seen in April 2004." (Thanks to blogger CalculatedRisk)

"The number of listings of single-family houses in 17 towns in Greater Boston was up 25 percent or more last week compared with one year ago. And those houses are taking longer to sell. In four towns, listings increased 50 percent or more." (MSN.com)

As I noted last week, the Wall Street Journal did a cover article on rising home inventories all over the "hot markets" in the US. The median price in the past five years has risen at triple the level it did on the previous thirty, which included a powerful inflationary period. Trees don't grow to the sky, and the housing market is due for a breather, at the very least.

But if home building starts to slow down, you will see the economy soften. GDP in the second quarter was 3.4%, but the increase in residential investment was 11%. Dean Baker tells us "The jump in residential investment raised the share of housing construction in GDP to 6.0 percent, surpassing the peak hit in the late seventies, when the baby boomers were first forming their own households. If the housing bubble persists, this share will grow even higher in future quarters.

"...The immediate path forward looks very shaky as the economy is ever more dependent on the housing boom and debt. If wage growth does not begin to pick up, it will be difficult for this cycle to continue much further. However, if wage growth does pick up, then inflation will accelerate, pushing up interest rates, which will burst the housing bubble." (Center for Economic and Policy Research)

Residential construction typically accounts for about 20% of GDP growth in the US, although it can swing dramatically. It was in the 20% range in the first quarter. It dropped during the 1990-1 recession only to rise to 30% in the following year. And when residential fixed investment turns down it usually leads the economy into a recession.

If we take the experience of the slowdown and flattening of both the UK and Australian housing markets, it would suggest that consumer spending would slow significantly if housing prices in the US were to stop their relentless rise. Forget about what would happen if housing prices actually started to fall.

My take? Housing will slow down over the next year. How much? Right now mortgage rates are roughly where they were one year ago, except for ARMs. The answer lies in how much rates rise or how much the economy slows down. Greenspan and the Fed are determined to slow the rise in housing prices down. As we will see in the next section, one of those two events (or both) are likely to happen. The Fed can engineer a slowdown in housing prices if they decide to do so.

When 20% of the growth in GDP is housing, that is significant. A modestly slowing housing market could tip the economy into recession, especially if consumer spending is also being impaired. And besides oil what else can hurt consumer spending?

Greenspan - Where's the Fire?

That question brings us to our final culprit - the Fed. Rising interest rates do hurt the consumer. It takes more money to pay credit card bills, adjustable rate mortgages go up, it costs more to borrow money and so on. And rising short term rate are not good for the profits of most corporations.

This Fed is determined to raise rates. There are three more Fed meetings this year: September 20, November 1, and December 13. Right now it looks as if they are going to raise rates at each meeting. The market certainly thinks so, and recent speeches and Fed releases suggest so as well, at least for two more hikes.

Three rate hikes would take the Fed funds rate above the current price of the ten year bond if longer term rates stay where they are today. What worries me is that if the bond market is convinced we are going to see three rate hikes to 4.25%, why would they take a mere 4.21% on a ten year bond, unless they thought that ten year rates were going to drop at some point?

Today, the economic data is fine. August is going to be another solid month in GDP growth. Jobs will be ok. Housing, while slowing, is still at a torrid pace. The Fed will meet this September and feel they have plenty of cover to raise rates.

I think they should hold off for at least one session and let's see some more data. Let's see if the rise in housing inventories is for real or just an end of summer slump. Let's see if energy prices are going to slow things down a little on their own without piling on with another rate hike. I don't see the need to be in a rush. They have taken over a year to raise rates slowly, at a very measured pace. If there was a need to curtail inflation, they should have acted faster. In fact, core inflation is well contained. Yes, energy costs are way up, and understated in CPI, but they are ultimately a drag on the economy.

If November comes around and the economy is still strong or inflation is rising or the housing market is still too strong, then go ahead and raise rates. Raise them 50 basis points if you feel the need to "catch up."

The trends (and forward data) suggest the economy could be getting soft late in the year or early next year. More than one economist, many of them normally quite bullish, thinks we see a slowdown to 2-2.5% GDP in the first quarter of next year. If that is the case, we do not need to slow the economy down any more by raising rates.

Add in concerns about a very flat growth in the money supply in both the US and Japan and you have even more reasons to pause for a meeting.

If the Fed keeps on this path, we are at risk for a recession in the second half of 2006. I cannot imagine the Fed raising rates until they invert the yield curve on their own. But if on November 1 we see a 4% Fed funds rate, or on December 13 a 4.25% rate, it would not take too much in the way of a slowdown for the bond market to push long rates down.

My take? The Fed is going to ignore everyone calling for a pause and go right on until at least a 4% rate. Friend Barry Ritholtz of Maxim said today on CNBC (Kudlow & Company) that he thinks Greenspan wants to give the next Fed chairman some room to cut rates in the next economic slowdown. Maybe, Barry, but I don't think so. It is a secondary benefit. The real reason Greenspan and company are raising rates is that they are worried about a housing bubble. They want to make sure it does not get much bigger.

I agree that is a very serious, even worrisome, concern. But if the data is showing the problem may be correcting itself, through gravity if nothing else, then we don't need to shove it faster down the hill. Patience. We don't need to kill anything yet. It may be dying of its own accord.

In short, I am worried about the Fed doing what they have done so many times in the past. They raise rates too much and for too long and we slide into recession. There is no need for us to go into a recession next year. Recessions are a bitch. Just a mid-cycle slowdown like 1994-95 would be fine with me. We will of course see what happens in the fullness of time, and my guess is that we will have some warning. We won't just roll over and find ourselves in recession one month. It will creep up on us just like the last few times.

We will watch the yield curve, watch the housing and the bond markets, consumer spending, energy and all the rest. The clues will be there.

And if we have a slowdown, we can blame energy and housing. If we have a recession with short rates at 4.25% or higher, we can blame a too aggressive Fed.

In any event, slowdown or recession, you do not want to be long the stock market, except for certain select stocks and sectors (like energy). This is the time to be cautious. There is another major bull market in our future. Save your powder. It is hard, I know. But you will be happier than trying to make something happen.

Malta? New York, London, Brussels, Sofia, Toronto, Etc.

I am enjoying being home this month, but in the middle of September my schedule gets crazy. The next two months I am on the road way too much. Starting Sept 15, I go to Palo Alto, San Diego, back home, then Toronto and Houston. Home to write my letter, then off to London, a day trip to Malta (I am on the board of directors of a fund there), back to London, Copenhagen, Sofia (Bulgaria for some fun with friend Phil O'Rourke), then on to Brussels and back to London and home. A quick trip to Denver for a speech at Mile High Stadium (details later) and then to New Orleans and Detroit.

I then get to be home for 12 days before I go to New York. I have just agreed to speak at a value investing conference which looks to be a very solid value. There are some really great speakers and I am excited to be part of it. If you are interested, you can go to www.valueinvestingcongress.com and register. My readers can put in the code RVICJM and you will get an extra $100 off the registration price.

I am not sure, but I think this next European trip means I have now been to 50 countries. Lots of memories and good times, with a lot of the usual travel stories. The only time I have been truly scared was that one late night taxi ride through the country in Mozambique. I thought I had been kidnapped and was being taken to rebel territory. LOOOONG story. But it turned out ok, I finally got to the hotel and found a bar. I told the story and got so many laughs from the local Africa hands I did not have to buy a drink all night.

Next time we get together, maybe I will tell you a story or two and let you buy a drink. But if yours are better than mine, I buy.

Your has a few good stories analyst,

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