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Recession? These 2 Things Will Let You Know...

By Costas Bocelli October 20, 2011 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

Are we headed for another recession?  For many families and households, it already feels like a downright depression. 

Unemployment is stuck above 9%, with companies very reluctant to bring on permanent new hires...  Prices for everyday necessities like food and energy continue to rise... The housing market remains challenging to say the least.

But the reality is that, as of today, the economy is still technically expanding -- albeit at a very moderate pace. 

What about tomorrow?  What does the economic future portend?  After all, the economy and global growth are at a perilous juncture, walking on eggs shells with every step.

I don't have all the answers for you here today.  Nobody does.  But I do know this:  The next couple of weeks could very likely decide if we’re headed for recession. 

One of the biggest economic headwinds we've been facing has been coming out of Europe, where they've been stalling and procrastinating for months over how to handle the sovereign debt mess and Greece’s new bailout.  

By dragging their feet, the uncertainty has weighed heavily on the global business community.  Without a concrete plan or firm measures put into motion, Greece will soon go broke, sparking a massive financial shock that would send ripples throughout the global banking system.  Other vulnerable countries like Italy and Spain would succumb to extreme duress.  The damage and aftermath would no doubt tip the economy over the edge into recession.

Global leaders have placed a firm deadline of November 3-4 for the Eurozone to implement an actionable plan when the Group of 20 leaders gather in Cannes, France.  A European Union summit in Brussels this weekend will give the 17 members time to hash out their differences and finally make some tough decisions.

Many feel that if Europe's leaders are able to find a solution, we can avoid a worldwide recession. 

However, there are others who think that the damage has already been done, that the fate of falling back into recession has already been sealed...

According to the Economic Cycle Research Institute (ECRI), a recession is a “done deal”.

They go on to say:

“We are going into a recession.  The U.S. economy is indeed tipping into a new recession.  And there’s nothing that policy makers can do to head it off.”

Not encouraging news from this highly respected think tank that doesn’t make these types of calls lightly.  However, it’s a forecast, and no forecast is 100% accurate.

But another indication that a recession may be on the horizon would be to analyze the U.S. Treasury yield curve.  Looking at interest rates along differing durations can offer clues as to where an economy may be heading.  But the problem is that the Federal Reserve has made a mess of the yield curve, between its implicit language meddling in interest rate policy and, most recently, “operation twist” to further manipulate interest rates by shuffling $400 billion worth of Treasuries around like a deck of playing cards.

If you were a bond analyst quant (which I’m not) and had some pretty cool software, you could make some calculations and adjustments discounting the effect of Fed manipulation on interest rates and the yield curve, and make some interesting conclusions.

What you would find is that shorter term rates would be slightly higher than longer term rates, implying an inverted yield curve which is characteristic of a possible recessionary scenario.  The model spits out a 60% chance of recession under these conditions. 

On the bright side, that means that there’s a 40% chance against it.  The odds are indeed pretty close.

However, there are some variables to consider that can certainly refute these economic predictions. 

For one, the recent batch of manufacturing and labor data has been fairly positive -- not robust, but expansionary, or at the very least showing signs of stabilization.  Yesterday, the Fed’s beige book, which gauges economic activity across the 12 districts, continued to show expansion and growth.  (Although many districts admitted the pace was “modest” or “slight”.)

So while the recent batch of economic data has been sluggish, it still has not deteriorated to the point of showing signs of an imminent recession.

Second, the corporate environment continues to show remarkable resiliency.  We’re nearly one-third the way through 3rd quarter earnings season, and the reports continue to “beat the street” by 75%.  As a group, the S&P 500 is on its way to record profits in 2011.

Management guidance has been mainly cautious, but upbeat about future prospects and coming quarters.

The head of FedEx Corp. (FDX), Fred Smith, does not see contraction and does not see a recession.  “It’s steady as you go, slow growth.”

Warren Buffett, who runs the Berkshire Hathaway conglomerate consisting of dozens of companies, also does not see deterioration along his vast business lines.

And, CSX Corp. CEO Michael Ward also was upbeat about the state of business in remarks made yesterday after a solid earnings report.  He went on to comment regarding economically sensitive coal exports that are transported throughout his rail system:  “Export demand has been strong all year with good, robust growth and we should see continued modest growth in coming quarters.”

So -- Are We Going Into Recession or Not?

You can certainly lay out the argument for both sides of the Recession debate.  As a trader and investor I tend to look at price action to deliver clarity.  After all, price is the ultimate truth teller, especially in greedy and efficient capital markets like we play in everyday.

When I am looking to gauge the economy's health or formulate an answer to the recession question, I look to the commodity space for answers.

Particularly, Copper and Crude Oil will give you a solid read.

Copper is an industrial metal seen as a bellwether for global economic growth.  Generally, where copper prices go, the economy is not too far behind.  And with China having a monster appetite for this metal, the price action gives you a global feel.

Copper futures recently bottomed at 3.00 per pound in early October, when recession fears were very high.  If Copper retraces and falls below that level, my conclusion would lean towards recession.

December Copper Futures closed yesterday at 3.25 per pound, down 0.10 on the day.

Crude oil is the life blood of economic activity.  The world is addicted to oil and, until that changes, it’s a very powerful commodity and an excellent gauge of economic health.

Although an essential energy source, a slowdown in growth or economic contraction will have a destructive effect on demand for and price of a barrel of crude oil.

The most liquid and most transparent oil market is WTI (West Texas Intermediate), which trades on the NYMEX.

WTI Crude Oil Futures recently bottomed around $75 a barrel in early October, like Copper, again when recession fears were very high.  A break below that level will probably convince me that we’re likely headed for recession.

December WTI Crude Oil Futures closed yesterday at 86.29 per barrel, down 2.24 on the day.

While there are many forecasts, reports and data points trying to predict if the economy is heading into recession, I tend to look at key price levels of economically sensitive commodities like copper and oil to formulate my opinion.

So I ask you, do you think we’re heading into recession, and what indicators sway your reasoning?  Feel free to share your comments, debate, and let your fellow readers know what you're thinking.