Why a US recession seems more and more likely

For all the Fed's tough talk about the inflation threat, the hard data suggests an interest rate cut is more likely than a hike. So does the Federal Reserve know something we don't?

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Does the Federal Reserve see something in the US economy that nobody else does? The next rate-setting meeting on Tuesday has been preceded by weeks of tough talk about inflation being a bigger threat than growth. Yet a look at the hard data would suggest that a cut is a more imminent prospect than a hike.

When the Fed left rates on hold in August we felt it had made a mistake by pausing too early. We still do. Yet realistically we can't see the next change being anything other than a cut sometime next year.

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But that's far from good news for the markets. Investors seem to be taking the Fed's words as a sign that the outlook for next year is bright, despite a flurry of gloomy numbers. History suggests that may be a mistake...

A quick look back at recent recessions suggests that the Fed doesn't have a great track record of calling them in advance: it missed both 1990 and 2001, remaining unequivocally upbeat until it became clear that things were unravelling.

To be fair, missed' may be a little harsh. After all, for the Fed there's no upside in publicly forecasting a recession; it just makes it more likely to happen. Perhaps it's more true to say that it was not moved to warn the markets that the recession risks were growing. And it looks as if the same scenario is playing out this time. Despite growing evidence to the contrary, the Fed continues to insist publicly that the main risk is inflation.

Lest there be any misunderstanding, MoneyWeek's view is that inflation in the US is still running higher than official statistics show and that by failing to wring it fully out of the system, the Fed is storing up more trouble for the next cycle. Nevertheless, the trend appears to be heading down for now, which means that if the Fed is acting consistently it should be thinking about cutting rates. Most significantly, the spectre of a wage-price inflation spiral seems to be receding. Third-quarter unit labour costs were revised down to 2% year-on-year from 5.3% last week, after large downward revisions for the second quarter as well.

Of course, although that's good news for inflation and good news for corporate profit margins, it may not be not so hot for the economy. Unless Joe Worker starts getting a bigger slice of the profits from this boom, he'll struggle to keep spending while trying to deal with the fallout from the housing bust. And if this show is to stay on the road, the consumer has to remain strong: he will be sorely needed in the months ahead.

While it's generally easy to find things that could go wrong in an economy, things usually muddle through in the end. But there's no doubt that plenty of red lights are beginning to flash this time. Housing shows no sign of bottoming, automakers are in severe trouble and manufacturing dipped into contraction territory on the last ISM manufacturing index. Consumer spending is not yet picking up as hoped and business investment shows signs of faltering.

Meaningful good news seems increasingly scarce. Take the ISM non-manufacturing index, which rose strongly last week and was taken as a sign that the service sector will pick up any slack left by construction and manufacturing. The problem is that history doesn't back that up. People watch the ISM manufacturing index because it has a long history and a solid leading relationship to the whole economy - not just manufacturing. The same isn't true of the non-manufacturing indicator: it's a volatile series that seems to have no predictive value at all.

Payrolls also came in stronger than expected last Friday, with 132,000 jobs added and upward revisions made to previous months. But, as we frequently grumble when people get excited about this, employment is a lagging indicator for the economy and tells us nothing about the outlook. What's more, the payrolls number is so unreliable and prone to revisions, that it's nonsensical to make investment decisions based on it. Tim Bond of Barclays Capital sums it up best: "bussing in grannies for a monthly Bingo-Friday would be the more optimal way to allocate capital in the global bond market".

If you do want to look for information in the payrolls data - and as non-bingo players we'd advise against it - consider this: manufacturing apparently lost 15,000 jobs and construction shed 29,000. If that's in any way correct, it suggests that the labour market in those sectors is starting to weaken, just as would be expected as the impact of a slowdown filters through.

Maybe what the Fed sees is exactly what everyone else sees; if so, it's understandable that it's trying to talk up its book, keep confidence and spending up, and avert a slump. It would be nice to think this ploy could succeed. But the risk that it fails seems much greater than most investors will allow themselves to think.

Turning to the markets

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The FTSE 100 ended Friday 20 points higher, at 6,152, as positive jobs data and bid talk surrounding Barclays boosted sentiment. For a full market report, see: London market close.

Across the Channel, the Paris CAC-40 closed 4 points higher, at 5,394. In Frankfurt, the DAX-30 ended the day at 6,427, a 14-point gain.

On Wall Street, stronger-than-expected November jobs data and bargain-hunting in the technology sector saw shares close higher. The Dow Jones closed 29 points higher, at 12,307. The Nasdaq was 10 points higher, at 2,437. And the S&P 500 ended the day at 1,409, a 2-point gain.

In Asia, the Nikkei closed 110 points higher, at 16,527, today.

Crude oil was slightly higher this morning, at $62.14 a barrel, as was Brent spot which last traded at $62.62.

After a volatile session which saw it hit a high of $626 and a low of $622.60, spot gold was trading at $623.80 this morning. Meanwhile, silver was unchanged at $13.67.

And in London this morning, oil major Royal Dutch Shell is to cede control of its £11 liquefied natural gas project Sakhalin-2 project to Russian state energy supplier, Gazprom. The agreement to reduce its stake from 55% to a quarter comes after a high-profile campaign of licence withdrawals and fine was waged against Shell by the Russian environmental agency. Shares in Royal Dutch Shell were down by as much as 0.7% this morning.

And our two recommended articles for today...

What buyout fever means for markets

- Private equity is on a roll. November has seen unprecedented activity levels in the buyout market. What's going on? And what are the implications for bonds and equities? For Niels C. Jensen's analysis of what the latest wave of M&A will mean for your investments, read: What buyout fever means for markets.

The Pre-Budget Report: Mind the Gap

- In what what will probably be Gordon Brown's last budget before, he hopes, he becomes PM, he had considerably more latitude than last time round. But will he - or his successor - have to slow down public spending at some point in the near future? Jeremy Batstone of Charles Stanley looks at how the figures add up: The Pre-Budget Report: Mind the Gap.

Cris Sholto Heaton

Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.

Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.

He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.