The possibility that a recession is on the horizon in North America and Asia (ex-Japan) is underreported in the financial media. The same suggestion for Europe or Japan is more widely accepted, as Italy has officially fallen into a recession and France and Germany have managed to only slightly register positive growth, while Japan has suffered a decade long period of stagnation and deflation. The possibility of the lack of reporting is because economic news is most favorable at the peak of an expansion, so in the euphoria of the moment it is difficult to recognize the economic peak. A recession is described as three consecutive quarters of negative growth, and because of this definition, it is not possible to confirm that a recession is upon us until well after it has begun.
This paper will attempt to establish a case for a global recession occurring in 2006 and continuing into 2007. This feat is less onerous than it first appears, as much of the world is teetering on the fine line between positive and negative growth. Italy and Japan are or have been in recession in the past year. France and Germany expect growth rates in 1-2% range and much of Africa has not developed industrial economies and is struggling to advance past the internal strife, civil wars and disease that plague the continent. The evidence presented is based on American economic data, as it is the most reliable and readily available. However, this country specific data can be applied to the global economy because of America’s position as the driver of economic growth. American economic statistics have been mixed in the past months. While home sales, housing starts and retail sales have all been positive, industrial production, the ISM index, labour costs, and capacity utilization have all peaked. Furthermore, it is amusing to see Wall Street applaud the small changes in the core PPI (producer price index) and CPI (consumer price index) in May as signs of contained inflation, while the large increases in the broad measures that include food and energy are ignored. (As an aside in June when the core was positive, the full measures declined. This month Wall Street pointed to the full measures as indication of benign inflation, in opposition to the previous months attention to the core measures in replace of the broad measures.)
The stock market has been volatile during late April, May and these first few weeks of June. The mass of investors who move the markets on a daily basis seem to be undecided on how to act, which indicates that a turning point in the future is immanent. In the Unites States, fluctuations of 75 points in either direction on the NYSE or the DJIA have become common. On the Canadian side, fluctuations in the TSX have commonly been in excess of 50 points. Richard Russell of the Dow Theory Letters has mentioned in past missives that bull market tops are long and drawn out, with one sector fading, followed by another, and so on, which is in opposition to bear market bottoms which move up quickly. US economist Dennis Gartman has also mentioned that the volatility seen in indices lately suggests that a bull market top is nearing. If the stock market in Canada and the United States are in the process of establishing the yearly high (possibly at the end of a summer rally), the business prospects for the economy cannot be much better than they are now. See Appendix 1
Many in economics believe that the stock market is a leading indicator of the business cycle, and that it leads by six to 12 months. The rational for this is that the markets are considered to be discounting mechanisms that price future events into current prices. When the mass psychology of the market believes that future earnings will be less than current earnings, that the earning cycle has peaked, or that collectively the economic times ahead look less promising, smart money begins to liquidate equity portfolios into market strength, which applies downward pressure to a stock, sector or index. But since the economic news is still positive at the peak, once the downward pressure is relieved (i.e. the early money stops selling) prices recover. When this happens the early money again begins to sell into the strength in anticipation of poorer times ahead. This process is repeated and creates the long, drawn out volatile pattern markets make as they complete the topping process. Since the market is a discounting mechanism, it can provide insight into economic conditions. A breakdown in the market will likely lead an economic downturn or recession by approximately six to12 months.
In addition to recent stock market behavior, a number of negative indicators have appeared in relation to global economic strength. In both Canada and the United States, the spread on 10-year bonds and short-term, three month government paper is narrowing. The yield curve in both economies has flattened considerably in the last year, and appears ready to invert. The following chart shows the how the spread on US 10 year and 91 day treasuries has narrowed.
As one can see the interest rate on the 10-year government bond subtracted by the 91 day Treasury bill is less than 1%. That suggests that the enormous bond market seems fearful of investing long term. Could this be the beginning of the unwinding of the carry trade that has been so profitable for financial institutions over the past few years?  Data compiled from RBC Economics.
The carry trade consists of financial institutions taking advantage of historical low interest rates to borrow short and invest long. As you can see on Figure 1, the spread in the summer of 2003 was close to 4% and now it is less than 1%. Financial institutions have become quite used to generating income in this manner. This may weaken earning numbers for a number of large financial enterprises and put significant pressure on their balance sheets. In the United States, where financial companies dominate the S&P500, this could be disastrous to the stock market.
Currently the yield curve has not inverted, it has only flattened. The reason that attention is devoted to this indicator is presented in a BMO Economics paper entitled Is the Flattening Yield Curve Signaling a Recession? dated May 31, 2005. To quote from the paper:
“Each of the last six US recessions was preceded by an inverted yield curve, while two earlier recessions coincided with a flat curve (39 basis points in the 1957 downturn and 56 basis points in the 1960 recession – currently about 90 basis points). In all eight cases, the curve’s rotation was caused by a sharp increase in the federal funds rate.
Long-term rates rose sharply too, though not as much as short-term rates. The yield curve was inverted on two occasions (in 1966 and 1998) and was flat on another (17 basis points in late 1995), yet no recession occurred. The distinguishing feature in all three cases is that the Fed reversed course and eased policy to avert a downturn, causing both short- and long-term interest rates to decline.
The above observations suggest that an inverted or flat yield curve is a necessary though not a sufficient condition for recession. To signal a downturn, the curve flattening must be caused by an aggressive and sustained course of monetary tightening (to control inflation), which in turn drives both short- and long-term interest rates higher. If the monetary authority shifts course and eases policy in time, it may forestall a downturn. But to do so, inflation must be subdued.”italics are the authors comments
According to this quote, we have nothing to fear if inflation is contained. But is it? The core PPI and core CPI suggest that it is, but these strip energy and food prices from the calculation. I see these indicators, the core measures, as unrealistic as I do not know of anyone who does not use energy or who does not eat. A true indicator that represents consumer or producer prices must include food and energy. According to the 0.5% increase in the CPI during May and the 0.6% increase in the PPI following increases of 0.6% and 0.7% respectively, do not suggest that inflation is contained.
These figures suggest 4%+ annually in both consumer and producer price increases. With respect to the calculation of the CPI, there are other mitigating factors that suggests that it presents a tame version of true inflation. The CPI uses rent rather than house prices as the house price component. Since rent increases have lagged the increase in housing prices over the past two years, the CPI headline inflation number would be much higher and inflation would appear less contained, if rent was not used as a proxy for house prices. (As an aside, the increase in home prices has the ability to price many out of the housing market forcing these individuals to rent. This increase in the rental rate may drive up rental prices as demand outweighs supply. When these increased rent prices are factored into the CPI, inflation will increase, leading to higher interest rates which could prick the housing bubble.) These facts indicate that inflation is not subdued, which suggests the flattening of the yield curve and possible inversion is a serious concern for the global economy. The Fed has been on a “measured pace” of tightening, unable to either stop, which would show that the Fed has lost faith in the economy, or increase the pace of tightening for fear of tilting the balance toward contraction.
In economics a single indicator is never sufficient evidence on which to base an opinion of market behavior, so I will continue to offer further evidence.
The leading indicator in the United States, as reported by the Conference Board, fell for the fourth out of times in June, with April’s number registering neutral, suggesting that future economic activity will be weaker than current economic activity. Furthermore, US economist Dennis Gartman had this to say in his May 18th edition of the Gartman Letter:
“The weakness in the Empire State Index released earlier this week caught us and caught almost everyone else off guard. Certainly it sent us to other sources of economic data to justify, verify or deny what the New Yorker's had suggested: that the US economy was weakening... materially... from within. Our fears for the economy were made all the more severe when we were leafing through the wonderful daily report sent to us by our friends at the ISI Group.
One of the charts from yesterday, of the year-over-year change in the US leading economic indicators caught our eye first. From a peak in early '04, this rate-of-change indicator has been falling consistently since then and is now down to the levels last seen in early '03. Worse still, an index of US small business optimism has also "topped out" rather obviously, falling from approximately 107 earlier this year to 99 presently, and like the index above, seems headed for the lows made last in early '03.
Further still, our favourite indicator, that of the ratio between the Coincident and Lagging Indicators compiled by the Conference Board, also appears to be topping out, with a month or two wherein the ratio has "jobbed about" at new highs and appears almost certain to move lower when reported once again later this month. We shall keep a very close watch, for when that index turns down we have learned over our many years of watching it to pay heed. We shall this time also, for our bearish economic interest has been piqued and looking forward into the 4th quarter of this year, or most certainly by the 1st quarter of next, the US economy will itself have topped out and a recession shall have begun. At this point we must again note that recessions begin, by definition, at the peak of economic activity When a recession begins, all coincident data shall look strong; unemployment will be low; demands for labour will be high and those looking for recession will be called foolish. It won't be the first time we've been called that; likely it won't be the last.”
Regarding the ratio of coincident to lagging indicator and its success in predicting recessions, Mr. Gartman has presented the following data:
“One of our favorite indicators is the ratio of coincident indicators to lagging indicators. It turns down nicely and consistently before onset of recession and turns up consistently before the economic rebound. It does the job that the conference board leading indicator is supposed to do, but it does it better
Since 1960 there have been 7 official recessions in the US and on average the ratio has clearly turned down an average 7.2 months before the onset of the recession. It has turned up 5.1 months before the bottom.
This suggests that there is a good reason to pay attention to the direction of these indicators over the next few months. One must remember that a single indicator may run counter to economic output and mean nothing, but a number facing in the same direction may provide evidence of a slowdown. Let us move on to another indicator.
In my estimation, economic activity in the United States has peaked. Capacity utilization, a measure of factory capacity, turned down in April from its near multi-year high in March. Further evidencing this weakness is that the government measure of industrial production peaked in December of 2003, and has advanced three times and declined twice in the early months of 2005, but the peak witnessed in 2003 has not been approached..
Further, the ISM manufacturing index, which is an index consisting of multiple areas encompassing the industrial sector, has been declining in recent months. As pointed out in an article by Paul McCulley from Pimco Investments: “the Fed, under Greenspan, has never kept tightening once the ISM Index drops below 50, as it is virtually certain to do in the months immediately ahead. Therefore, the market’s presumption (or assumption, in Governor Kohn’s lexicon) that short-term interest rates will remain on the low side of historical averages for some time will be validated by the data that traditionally drive Fed policy.” As seen in Figure 3, the ISM index is dangerously close to the neutral level of 50”.
 BMO Financial Group and Global Insight - McCulley, Paul. May 2005. Fed Focus: Fundamentals in Technical Drag are Still Fundamentals
In addition, consumer prices (we will ignore the core measure for it is not a true measure of true inflation) have been increasing at a high rate as evidenced in
Figure 4.  BMO Financial Group and Global Insight -
The aggressive monetary tightening required to cause a recession, when the yield curve flattens, according to the BMO paper, may be developing in the inflation increases shown on the above charts, and finally force the yield curve into an inverted state and the economy into recession. Will Greenspan tighten monetary policy as the ISM drops below 50 and send the economy into recession in the final months of his tenure as Fed Governor and tarnish his legacy? Or will he allow inflation to increase in his final months leaving the clean up to his successor?
 BMO Financial Group and Global Insight -
Another measure of inflation, wage inflation, has also recently begun increasing. Wage inflation can be argued to be the true driver of inflation, as it represents the working class’s opinion of future inflation expectations, which work throughout the economy increasing the prices of goods beyond labour. In fact, an increase in the cost of labour has the ability to increase the price of every good that is produced by some form of labour. Figure 5 shows that the trend is for higher, rather than lower wages.
Adding to the price inflation data, consumer sentiment in the United States has also been declining. Much attention has been given to the increase in the cost of gasoline and the inflation affects that oil price increases have had on the economy. To drastically improve consumer sentiment, a large decrease in the price of gasoline and other necessities would be required. A large correction in the prices of necessities and oil would likely only be caused by a global recession that chokes off demand from China and India creating further ripple effects. The cure may be worse than the ailment.
 BMO Financial Group and Global Insight -
In contrast to the data presented, one area of strength has been the housing sector As you can see from the following charts, the number of starts and sales continue to increase. There is still a widespread debate about whether there is a housing bubble or whether the market is just “frothy” in select locales. The Economist’s survey of global housing prices in wealthy countries (March 2005), found that “the costs associated with home ownership have risen so high, and the benefits accruing, in terms of rents and rising property value so slight or precarious” and that “In many countries it is now cheaper to rent than to buy.”
 BMO Financial Group and Global Insight -
Figure 7Courtesy of
Although there is no sign of topping in the major US housing stocks, the Index representing this activity has entered a parabolic uptrend that could represent a period of mania before they break down, foreshadowing a deflation of the housing “bubble”. One must wonder how long this trend can continue. It appears that if a major event leads to a fall off of this industry, major damage to GDP could be inflicted. Recently, Yale economist Robert Shiller, author of Irrational Exuberance, a book that timely predicted the NASDAQ collapse, has become increasingly concerned with the housing situation in the English-speaking world. In a September 2004 missive, Shiller had this to say:BMO Financial Group and Global Insight -
Chart courtesy of Stock Charts -
“The first big city to boom was London, starting around 1996. Boom mentality spread to Los Angeles, New York, and Sydney around 1997, to Paris in 1998, to Miami, Moscow, and Shanghai in 2001, and Vancouver around 2002. These and other cities have been booming pretty much ever since; prices in most are up at least 50% in real terms since 2000. This has been a big windfall to homeowners, but has hurt anyone planning to buy. Now growth in home prices is weakening in some of these cities. The rate of price growth in London and New York slowed sharply over the past year, to only about a 1% real increase in the second quarter of 2004. In Sydney, home prices actually fell in the second quarter. Has the boom ended? Will no other cities benefit? Worse still, could the mood in housing markets soon lead prices in downward? No one predicted this boom, so predicting its end is risky. Housing prices have shown tremendous upward momentum in the face of previous warnings that the party is over.” Shiller, Robert. September 2004. Are Housing Prices a House of Cards?
An international shock of this magnitude could have devastating effects on the global economy.
All of these indicators by themselves are significant, but in addition, the balance sheet of the American economy is already weak. The current account deficit and trade deficit are expanding to unprecedented levels of GDP. In addition to these imbalances, the budget deficit has being difficult to reign in, there is a social security short fall, there is an expected deficit in the Medicare program, and the increasing cost of the war in Iraq is significant.
Figure 8 BMO Financial Group and Global Insight -
This trend is clearly unsustainable. The American dollar must continue to devalue and economic activity to slow down, which will lead to a new round of American protectionism. As America abandons trade, objections to the recent bid by CNOOC (Chinese National Offshore Oil Company), a publicly traded firm listed on the NYSE, bid for Unocal as did the Senator Graham and Schumer bill trying to force a sovereign nation to revalue their currency at the US Governments peril, these types of behaviour will create a ripple effect will be felt through the global economy, as the US consumer has mostly driven this global expansion. Even former Fed Governor Paul Volcker has weighed in on the imbalance in the American economy. In his May 16, 2005, editorial in the Washington Post entitled Economy on Thin Ice, he wrote:
“I think we are skating on increasingly thin ice. On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s -- a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.” Volcker, Paul. May, 16, 2005. Washington Post. Economy on Thin Ice.
There are global indicators that also point to a slowing global economy. The yield curve in Canada, is flattening, in Australia and United Kingdom it is already flat. New Zealand yield spreads are negative implying an inverted curve. With housing prices slowing in the markets that first showed price appreciation, I suspect the flattening of the North American yield curves foreshadow slower future economic activity on the continent and the end of house price expansion.
Europe, Japan, Africa, and the Middle East have all had stagnating economies for an extended period of time. Only a scattered few nations in eastern Europe, Asia and the credit and liquidity fueled growth in the United States have driven global growth in recent years. This “Bretton Woods II” system cannot continue. The dollar recycling by the Asian nations, a process fueled by America’s ever increasing trade deficit with Asia, to which Asia collects US dollar assets and purchases US treasury bills to maintain their currency pegs to the USD, thus keeping the USD from falling too far too fast, has been fueling monetary expansion globally. What happens, as Volcker suggested, when this process is not repeated. The asset price explosion will inevitably end badly. The full effects of the destruction of wealth from the popping of NASDAQ bubble followed by the destruction of wealth when the housing bubble deflates (it need not pop) combine to create an inconceivable destruction of wealth in a short five-year span, sending the world into a depression-like state where assets have been destroyed by an economic downturn, coupled with the loss of purchasing power through inflation created by the loose credit policy, and commerce eventually slowing because of an increase in trade protectionism. It is difficult to say what will be the catalyst for this domino effect. It could be the retirement of the Maestro, Alan Greenspan, and him being replaced with inflationist like Ben Bernanke. This has the ability to change inflation expectations amongst the bond market and drive interest rates higher, increasing mortgage rates and causing the housing bubble to deflate. Or it could begin as a trade war between China and the United States (we are starting to see this) and in retaliation to US protectionism, the Chinese begin to sell their massive holding of US Treasury bills forcing US interest rates up. (As an aside it seems the Chinese have acquired as many US Treasury bills as they require and are looking to exchange this surplus for real strategic assets, learning from the mistakes of both the OPEC nations of the 1970’s and the Japanese in the 1980’s who squandered these surpluses) Either one of these could be the tipping point of the “Bretton Woods II” system.  Bretton Woods II is a term coined by Bill Gross, to describe the international monetary system after the collapse of the Bretton Woods system in August 1971, in his June 2005 edition of Investment Outlook:The Strange Tale of the Bare Bottomed King.
Conclusion Although economics is an uncertain science, and its predictions vary tremendously, the evidence presented is credible and provides the possibility of a weaker economic future. John Maynard Keynes, a famous economist and leading socialist, noted that markets could remain irrational longer than a trader could remain solvent. This means that, although the global imbalances presented herein are factual and may eventually lead to a hard landing, it may not appear within the time frame given.  This was a phrase used by Larry Levy in his newsletter, Arts and Minds.
In light of recent economic history, massive tax cuts, federal legislation directed to encourage repatriation of dollar assets held by domestic firms abroad and interest rates near historic lows could not produce the expected job growth or new all time highs in the stock market. If these policy measures could not spur an economic recovery strong enough to influence the psychology of the masses to push the markets to all time highs, one must wonder what is needed to achieve that? The liquidity fueled boom, fueled twice, first after the NASDAQ collapsed and again after 9/11, produced a cyclical bull market within a long-term secular bear market and this bull is getting long in the tooth. The thesis of this paper is that the secular bear market has returned. The efforts to avoid this bear have only intensified the ultimate outcome and lengthened its duration. Tax cuts, monetary stimulus and federal deficits have run their expansionary course upon the US economy and the peak was reached in Q4/2004.
Since then, the decline has begun.
I believe this recession presents an opportunity to acquire financial assets correlated to the commodity markets or the individual commodities itself. A global slowdown will dampen demand for these goods, however, the long term trend of globalization and industrialization of China and India will continue driving demand. Resources will be needed in this process. With a near 20 year bear market in commodity prices ending in the first few years of the new millennium, exploration and discoveries have lagged in past two decades. Supplies of the necessities of industrialization are either near historic lows or peaking in production. Companies that produce fertilizer, copper, make steel, produce oil or gas or the companies that ship these goods or the final goods these inputs produce will prosper as global growth returns. It is quite likely the share prices of these companies will decline in the recession, and for the foresighted investor, opportunities exist to acquire quality companies at a discount. I am sure that foreign nations will be eyeing Canadian resource companies and properties if the prices fall far enough and this should be re-insuring for Canadian investors about the prospects of investing in Canada.
This could be a steep recession for the US, however, I am not sure what the effects will be to the Canadian economy, as the Canadian balance sheet is much healthier, pension reform was initiated in the mid 1990’s and discussion on reforming health care is abundant. At first the effects of the recession will be as sharp if not sharper than the US for Canada. However, I believe this leads to the eventual of decoupling of the Canadian and US economies, as new markets develop for Canadian natural resources and trade is diversified to avoid this scenario in the future. Hopefully this allows Canadian business and political leaders to realize the trump card held by Canada. As a major supplier of the worlds’ resources Canada should pursue policies of diplomacy, openness and fair trade (not only free trade but fair) and encourage those we do business to follow suit. If you are prepared a recession is not to be feared but embraced as a chance to gain.
“The intelligent investor realizes that stocks become more risky, not less, as their prices rise - and less risky, not more, as their prices fall. The intelligent investor dreads a bull market, since it makes stocks more costly to buy. And conversely (so long as you keep enough cash on hand to meet your spending needs) you should welcome a bear market, since it puts stocks back on sale.” Graham, Benjamin. HarperBusiness Press, 2003. The Intelligent Investor – Revised.