Economic Growth Forecasts Lowered; SOGEN Says Profit Downturn to Cause U.S. Recession

by The Curmudgeon


Amidst incredible investor complacency, low stock market volatility, overly bullish investor sentiment, speculative excesses everywhere (e.g. virtual currency), and an aging/ correction-free bull market, we have a global economy that continues to tread water or deteriorate.  The CURMUDGEON has repeatedly stated that most of the non-financial economy has been struggling, while Wall Street fat cats and selected social media/Internet super-stars are raking in the dough.  Meanwhile, global equity markets trend higher with no fundamental underpinnings.   The great disconnect continues to widen, even as growth forecasts are cut.

In this article, we provide updated economic growth forecasts, examine the trend in profits vs. stock prices, and highlight the key messages from a new Societe Generale (SOGEN investment bank) report that suggests a U.S. recession will occur in 2014. 

Victor and I have previously stated that the odds for an economic contraction have increased in 2014 due to: higher taxes, excess government regulation on business, Dodd-Frank's tighter lending standards, and the very costly, problem packed ACA (ObamaCare) rollout.  The SOGEN report offers much more support for a U.S. recession.

Economic Forecasts and Reports:

1. A mid-November Bloomberg survey of 73 economists forecast a median U.S. GDP estimate of 1.7% this year, improving to 2.6% in 2014.   Bloomberg also reported that confidence among U.S. consumers unexpectedly declined in November to a seven-month low as Americans grew more pessimistic about the labor-market outlook.

“The economy just has not performed very well this year and has been disappointing relative to what most people were hoping for and expecting through the course of the year,” said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. “It’s one thing when you have one or two years into the recovery and things aren’t progressing in the job market, but here we are four-plus years in.”

2. On November 25th, Reuters reported that economists trimmed their forecasts for U.S. economic growth in the final quarter of the year and the first three months of 2014, but predicted a slightly higher rate of job growth over the next four quarters.  Analysts see the economy growing at an annual rate of 1.8 percent in the current quarter, down from a previous estimate of 2.3 percent. 

3. On November 19th, the OECD stated that world economic output would expand 2.7% this year ("the lowest number since the crisis of 2009") and 3.6% in 2014. Those figures are down from the group's May forecast of 3.1% growth this year and 4% next year.  In OECD countries, economic growth is predicted to be only 1.2% this year- half of the world's growth- improving to 2.3% in 2014.  OECD's forecast for U.S. growth was cut to 1.7% this year from May's 1.8%.  The unemployment outlook is bleaker with an 8% average in the OECD region and 12% unemployment in the Euro area.  Long term, structural unemployment is considerably worse, according to the OECD spokesman.  Readers are encouraged to watch and listen to the very informative yet sobering OECD video here. 


Former Fed Chair Alan Greenspan told Bloomberg he's only predicting 2% U.S. growth next year. The "maestro" said the economy is being held back in part by the banking system, as some of the largest banks are not operating efficiently.  “We’re supporting banking institutions who are not only very large, but not very efficient and they are using the scarce savings of the society, which is critical for economic growth,” he said. He declined to identify which banks had become inefficient.

Corporate Profits are Nothing to Write Home About:

3rd Quarter U.S. company profits were up only 4.7% Year over Year (Y-o-Y), but that was almost entirely due to cost cutting and accounting gimmicks.  For example, H.P. outperformed diminished Wall Street expectations for its 3rd quarter profits and HP stock rose strongly this past week.  But revenue was lower in five of its six business segments, while demand for key products like personal computers collapsed.  Specifically, 4th Quarter net revenue was $29.1 billion, down 3% from the prior-year period and down 1% when adjusted for the effects of currency.  Is that something to brag about?

After tax corporate profits as a percentage of GDP are at an all-time high (see graph below), without much (if any) top line growth.  How long can that continue?


European stock markets have done very well this year (e.g. the DAX -Germany's stock market index- is up 22% YTD). But that's not because of increasing corporate profits.  3rd Quarter profits in Europe were down 5.1% Y-o-Y!  


And the future doesn't look any better on "the other side of the pond."  ECB data released on November 28th showed loans to the private sector shrank by 2.1 % in October from the same month a year ago, equaling the biggest fall on record!  "Even though the ECB just cut its refi rate, the pressure to do more will build, especially on the back of faltering credit supply," said Peter Vanden Houte, economist at ING.  That certainly doesn't augur well for future European economic growth or profits, which depend on credit expansion-not contraction!

SOGEN's Albert Edwards Stunning Report:

In his latest note to clients, SOGEN's long term bearish strategist Albert Edwards hints that a recession in the U.S. is coming sooner, rather than later.  "U.S. equity participants continue to enjoy the intoxicating effects of the elixir of QE. This blow-off phase can go on for quite a while longer...."

"Despite investors enjoying this equity cyclical bull market, I continue to firmly believe we are locked in a structural valuation bear market. We know from both the U.S.'s own history and Japan's lost decade that these secular bear markets take many economic cycles to fully play out. In the Ice Age, with equity and bond yields inversely correlated, recessions are the catalyst that brings each round of de-rating to lower lows. But a recession seems a distant prospect in the minds of most investors. Yet one key precursor for a recession has now fallen into place. Slowing productivity growth means that unit labour costs are now running well ahead of output price inflation (see chart below). This means a margin and profits downturn is now about to unfold. That typically is a key precursor of recession."


Edwards continues, "I have never ever seen the sell-side predict a recession. There are a number of reasons for that, but key among them is the personal career risk of calling a recession and being wrong. Both the sell-side and the buy-side tend to do much better when the economy and the markets are doing well, so who wants to be a party pooper. That is the nature of the beast.... many feel the current US S&P forward PE of 15x is fair value as it is just below the average PE of the past 25 years. But 15x can only be considered cheap in the shadow of the Nasdaq bubble. But to those who work in the markets now, it still does not feel expensive, whereas any long-term analysis suggests it is."

Edwards writes that corporate profits should be watched closely, not for their direct impact on equity valuations, but their impact on the economic cycle. They are a key driver of the economic cycle.  He states, "Growth in profits determines the growth of investment, inventories and employment....Over the years I have tended to focus on U.S. pre-tax domestic non-financial profits as a best lead indicator for US-based company business spending.  Profits typically lead investment spending."

Edwards focuses on the business investment, because it is one of the most volatile elements of GDP (see left-hand chart below).  Swings in business investment almost always determine recessions he claims (see right-hand chart below).



Many investors believe a recession will not occur unless the Fed triggers one by monetary tightening. Edwards response: "That is of course nonsense. A credit bubble can burst without any monetary tightening and similarly the profit cycle can turn down due to a variety of factors."

Edwards concludes, "The margin squeeze that is unfolding as unit labour costs climb above company selling price inflation leaves the U.S. economy extremely vulnerable to a downturn in the investment cycle. Business output inflation is measuring a wider basket of goods and services than the Fed's favoured measure of inflation- the core personal consumption expenditure (PCE) deflator....Low pricing power is leaving the US economy more vulnerable than many suppose. In my view, a full-blown profits and investment downturn is most likely to be triggered by Asian and EM (Emerging Market) devaluations releasing surplus capacity onto the West and crushing pricing power even further....Watch the profit cycle closely. We ignore it at our peril."

CNBC notes that other investment banks have also released bearish stock market outlooks for next year. In early November, Nomura strategist Bob Janjuah said in a client note that he expects a 25-50 percent sell-off over the last three quarters of 2014 in global stock markets. Steen Jakobsen, chief economist at Saxo Bank has explained on several occasions to CNBC in recent weeks that bullish investors are "chasing the tail" of the recent equity rally, indicating that now is not the time to be risky.  All that plus an enlightening and refreshing discussion of Mr. Edwards report can be viewed here.

Victor Sperandeo's Opinion:

Bearish sentiment for U.S. stocks is at 1987 lows.  It follows that if any unknown event occurs, the large amount of bulls will sell to very few bears covering shorts, and to those few waiting for a correction to buy stocks.

While the bullish move can continue for a while longer, the key point is that it might end very badly with huge gap downs in stock prices.  In October 1987, after Treasury Secretary James Baker threatened Germany with U.S. dollar devaluation, there was a race to sell stocks when the opening bell rang.  A retired friend put in an order to sell 500 shares of Polaroid at the market. The stock was quoted at $26.25, but his order was filled at $18.00 - down 31.4%.  Hedge fund manager George Soros sold his firm's long position in S&P futures (on the CME) and wound up suing Shearson due to a similar type of bad execution.

Those that are long stocks should understand that you are betting on the Fed and the U.S. federal government to protect your "investments."  The economic fundamentals are not going to help at a 20 trailing P/E (and an even higher Shiller P/E of 25.52).  The U.S. stock market is in "weak hands," which is dramatically illustrated by record high margin debt and very low relative volume numbers.  When you consider the increased role of HFT's (that have largely replaced the specialists as market makers), the odds of a very sharp market decline increase dramatically.

Any type of geopolitical event could shock the equity markets into a complete collapse.  For example, China selling U.S. debt if the U.S. invades their airspace or interferes in their affairs?  Or Israel invades Iran to take out their nuclear plants? Or Saudi supports pricing oil in a basket of currencies rather than the U.S. dollar?  Any such bad news could cause the global equity markets to return money to its rightful owners... Those who are prudent to understand the risks of the moment. |

Caveat Emptor and good luck!


Till next time........................


The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies.  As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.