GDI Sends A Recession Warning
Restrictive policies, such as higher interest rates and tighter lending standards, will curtail the consumption that drives economic growth. Unsurprisingly, tight financial conditions always precede weaker economic growth rates and recessions. We often speak of the consumption side of the economic equation; however, consumers can not consume without producing something first. Production must come first to generate the income needed for that consumption. As analysts increase earnings estimates, the earnings derived from corporate revenues are a function of consumer spending. Such is a crucial part of the cycle. Of course, if you bypass the production phase of the cycle by sending checks directly to households, you will get a strong surge in economic growth. The massive spike in economic growth in the second quarter of 2021 directly resulted from those fiscal policies. However, once individuals spent that stimulus, the economic activity subsided as the production side of the equation was still lagging. While the media touts the "strong employment reports," such is mostly the recovery of jobs lost during the economic shutdown. As shown, full-time employment as a percentage of the working-age population has only recovered to pre-pandemic levels. In other words, we have NOT created millions of new jobs, but rather only recovered the jobs lost and the increase in the working-age population since the economic shutdown. However, higher inflation and interest rates require more income to maintain the same growth rates. The production side of the equation is now ringing a loud alarm. Let's review the economic cycle equation once again. Production => Incomes => Consumption => Demand => Increased Employment => Increased Wages. However, there are two measures of economic activity. The most common measure is GDP, which is simply the sum of Personal Consumption Expenditures (PCE), Business Investment, Government Spending, and Net Exports (Exports Less Imports). The other less observed measure is Gross Domestic Income (GDI). The calculation of GDI is as follows: GDI = Wages + Profits + Interest Income + Rental Income + Taxes - Production/Import Subsidies + Statistical Adjustments. Given that GDI measures the income side of the equation (derived from production), it is logical that GDI should track pretty closely to GDP over time. Furthermore, it should be logical that deviations between production and consumption should indicate a shift in the economic underpinnings. In 2021 and 2022, real inflation-adjusted GDI supported economic growth. With $5 Trillion in stimulus supporting incomes, the consumption side of the equation rose. However, beginning in the 4th quarter of 2022 and persisting through the 2nd quarter of 2023, GDI has turned negative as stimulative monetary measures have become exhausted. Again, logically, GDI and GDP should track closely to each other given the economic relationship. The question is whether this is an anomaly or has it occurred previously. The chart looks at real GDP and GDI back to 1947. With the only exception the late '70s, a recession followed each time GDP deviated from GDI. Currently, the deviation of GDP from GDI is the largest on record. We reviewed many indicators that typically preceded recessionary onsets: falling tax receipts, inverted yield curves, student loan payments, leading economic indicators. As shown, based solely on the inverted yield curve alone, the probability of a recession is at one of the highest levels since the 1980s. Given the wide range of confirming indicators, betting on the "avoidance" of a recession, particularly given such tight financial conditions, seems risky.
