Submitted by Tyler Durden on 02/22/2016 10:27 -0500

“When it rains, it pours.”

That is most assuredly one of the most heavily used cliches in the history of the English language but a failure to understand it apparently causes Citi’s economics team to get it wrong when it comes to forecasting the depth and trajectory of recessions.

In a new note, the bank looks at what happens when mean reversion fails, pushing a struggling economy even further into the abyss. Here’s a list of some of the mean reverting forces that help economies to correct and pull themselves out of trouble:

“Both economic theory and practice establish that business cycles are self correcting. Of course, policies can help engineer a quicker recovery (and even altogether prevent a recession) but most economies and markets, under normal circumstances, eventually return toward mean growth. High unemployment puts pressure on wages which, in turn, reduce labor costs and eventually increase the demand for workers. Sustained low investment ultimately results in a low capital stock, which increases the return to capital, eventually driving up investment. Weak growth typically results in real exchange rate depreciations, which eventually increase net exports and aggregate demand. These are some of the mean-reverting forces that ensure that a market economy will normally go through a business cycle, but that it will seldom face an economic depression.”

But an overreliance on the assumption that these forces will everywhere and always lead economies out of the recessionary doldrums has apparently caused Citi to be “too optimistic” in their forecasts on EM growth - and that’s putting it nicely:

In an effort to figure out why their forecasts have consistently missed the mark as multiple EMs head toward severe corrections, Citi took a look at 55 recession episodes in emerging markets during the last few decades and discovered a funny thing: when things are going bad they tend to get worse, not better:

A first test of the nonlinearity hypothesis for recessions consists of estimating the probability of an additional decrease in output of, say, 2% or 4%, given the accumulated fall in output since the previous peak. Under the mean-reversion framework, this probability should decrease the bigger the cumulative fall is. Our estimates show that this is not the case. Once the cumulative decrease in output surpasses certain thresholds, the slope of the curves becomes positive. The Ushaped curve illustrates that the probability that output falls further bottoms out and eventually increases. As the output fall grows large, nonlinearities emerge, increasing the probability of another negative growth year.

As shown below in Figure 2, the probability activity falls an additional 2pp is decreasing for moderate declines in output, reaching a (local) low after an accumulated drop of around 4.5%. For instance, after activity has fallen 6%, the Ushaped probability curve suggests that an additional 2pp contraction has a 67% probability. In the case of the probability of an additional 4pp drop, the curve reaches a low at around 6%, increasing after that. In the case of “very deep” recessions (accumulated falls in output between 9 and 10%), both curves are upward sloping. This suggests that, eventually, after a certain threshold is exceeded, activity is likely to further contract quite meaningfully, i.e., the probability activity falls by an additional 4pp after a 10% depression-like contraction is no smaller than in the initial phase of a recession.

Now to someone without a PhD in economics this would have been obvious, but as anyone who's ever done any academic research knows, the "very serious" people spend quite a bit of their time discovering things that largely belong in the realm of common sense. 

A slavish adherence to the notion of predictable business cycles has led professional economists astray on any number of occasions and indeed, the entire thesis behind the machinations central banks are currently going through rests on the notion that these cycles can be smoothed and manipulated. Far from being able to successfully tinker with them, it would appear economists don't understand them at all. 

*  *  *

Below, find Citi's take on what the above means for Brazil, the poster child for EM malaise.

Take for instance the case of Brazil. When we use quarterly GDP data (available up to 3Q15), activity has shrank 5.8% from the peak. Thus, the country currently sits in the area where the blue line in Figure 2 has a positive slope. This means that the more output falls from this point (at the margin), the more likely it will contract by (at least) an additional 2pp. In other words, Brazil seems to have entered a stage where negative spillovers could offset mean-reverting forces. Given the preliminary Q4 data available, it seems that growth has remained negative. This could conceivably place Brazil beyond the trough of the light blue curve, indicating that even a 4% further contraction may be increasingly likely. In sum, this first exercise suggests that in Brazil, the accumulated fall in output may already be enough to trigger negative spillovers and nonlinearities. 

Submitted by Tyler Durden on 02/22/2016 09:53 -0500

On the heels of weakness in the rest of the world's PMIs, US Manufacturing just printed 51.0 (missing expectations of 52.4) and tumbling to its lowest since October 2012... followed rapidly by Bernanke hinting at QE3. While Markit does 'blame the extreme weather', it notes however that "every indicator from the flash PMI survey, from output, order books and exports to employment, inventories and prices, is flashing a warning light about the health of the manufacturing economy."

Not good...

Even worse...

Chris Williamson, chief economist at Markit said:

“US factories are reporting the worst business conditions for over three years. Every indicator from the flash PMI survey, from output, order books and exports to employment, inventories and prices, is flashing a warning light about the health of the manufacturing economy.

“Output and order books are growing at one of their slowest rates since late-2012, with exports falling amid weakened global demand and the strong dollar. Hiring has weakened as a result. With backlogs of work slumping to the greatest extent since the height of the recession in 2009 and inventories rising for the third successive month, it’s likely that firms will come under increasing pressure to cut payroll numbers and production in coming months unless demand revives.

“Prices are meanwhile falling at the fastest rate since mid-2012 as firms compete to win or retain customers.

“The one caveat is that the survey was conducted in a month in which parts of the US suffered extreme weather. However, few survey respondents reported that the weather had a material impact on business over the month, instead often simply observing a general slowdown in trade and the economy.”

And with Services now tumbling also, what excuse will the permabulls have next...

Charts: Markit and Bloomberg

Submitted by Tyler Durden on 02/22/2016 12:31 -0500

Earlier today, we highlighted the noticeable weakness in European PMIs which largely missed expectations on - what else? - sluggish global demand and generally anemic economic growth.

Specifically, Germany’s PMI fell for the second month in a row in February, declining to 53.8 from 54.5 the previous month. Worryingly, the manufacturing PMI slumped 50.2, missing estimates by a wide margin and hitting its lowest level in 15 months.

Services looked ok, but as anyone who follows global macro knows, it’s all about manufacturing for the world’s fourth largest economy. The health of Germany’s manufacturing sector serves as a useful barometer not only for the health of the European economy for the pace of global growth and trade in general. Indeed, that’s one of the reasons why the Volkswagen emissions scandal was (and still is) so troubling. It has the potential to dent Germany’s manufacturing juggernaut.

In the wake of Monday’s data, Goldman is out asking if perhaps German manufacturing “has lost its mojo.”

“German real GDP grew a moderate 0.3%qoq in the fourth quarter of last year, and by 1.5% for the whole of 2015,” Goldman writes, adding that “part of the relative disappointment can be located in the manufacturing sector, which has shown a sub-par performance since 2011.”

What’s to blame, you ask? Why sluggish global growth of course:

The relative sluggishness of German manufacturing can be partly explained by slower global growth, which has resulted in weaker German export growth (Exhibit 2). In real terms, German exports have grown on average by only 3.5%pa over the past four years, compared with 8.8% in the four years prior to the financial crisis.

Using a model that explains German exports using global demand and Germany’s trade-weighted exchange rate, we find that German exports over the past two years have developed broadly as the model would have predicted. This suggest that it is indeed weaker global demand and not other, more fundamental changes in German manufacturing performance – such as a loss of international competitiveness – that lies behind weaker German exports.

 

Yes, "it is indeed" weaker global demand, a fact which underscores one of the key themes when it comes to assessing the state of the global economy. Depressed aggregate demand, anemic growth, and sluggish trade have become endemic. It's now a structural rather than a cyclical problem. 

But everyone knows that by now (or at least they should). What puzzles Goldman is that manufacturing employment is on the rise and capacity utilization doesn't all that bad either. 

So what gives? When in doubt, just say the numbers are wrong. "Together with the relative strength of the employment figures we see a possibility that the price-adjusted figures under-report the strength of the German manufacturing sector," Goldman posits.

Perhaps. But if the problem is subpar global growth, then analyzing the sub-components is futile. Either aggregate demand and trade pick up or the German economy sinks with everyone else. "Barring any sharp slowdown of the global economy, we would expect a continuation of the solid, though not spectacular, growth of the German economy," Goldman concludes.

About that whole "barring any sharp slowdown of the global economy" thing...

...note the red arrows...