What Will the Next Recession Look Like? Pt. III

So, now that we've established that the traditional causes of a recession probably won't be in play this time around and that the next recession stands a high probability of being shallow, let's consider when might cause the next recession and the effects thereof.  I believe there will be two potential causes: weak income growth will lead to a contraction in personal consumption expenditures and/or the slowdown in the EU will lead to a drop in export orders.  Let's start by looking at the slow growth of wages over the last recession:

While inflation has been low, it's still just enough to take a fairly large bite out of the above number.  This low level of income growth is the direct result of higher unemployment; a lower level of labor utilization leads to less upward pressure on wages.

Another way to look at the data is to analyze median incomes in the US.  As the above chart show, real median household incomes have dropped since 2000, with a pretty sharp drop since the beginning of the great recession.

At some point, weak income growth will lead to a drop in personal consumption expenditures; as consumers realize their incomes aren't increasing or keeping pace with inflation, they will "tighten their belts" and slow their purchases of "stuff."

The above graph shows the relationship between the year over year percentage change in PCEs and GDP, going back to just after WWII.  Notice the relationship is very strong, meaning a drop in PCEs (personal spending) will have a pretty strong impact on GDP.

Another way to look at the relationship is to look at the year over year percentage change in real retail sales and real GDP growth.  While the real retail sales data only goes back to the early 1990s, we do see a pretty strong relationship.

Put directly, with consumers accounting for 70% of US GDP growth, a slowdown in consumer spending would lead to an overall slowdown in the economic expansion.

The second most likely cause of a slowdown will be a drop in export orders caused by the European slowdown.  While exports only account for 13.78% of US GDP, they impact manufacturing, which can have a ripple effect in the economy as a whole.

The best way to show this effect is to graph the ISM's new export orders index and the year over year percentage change in exports:

The above data -- which regrettably only goes to 1992, does show a close relationship between the two data points.

The above chart shows the year over year percentage change in exports and GDP.  The relationship isn't as strong as that between GDP and PCEs.  However, there are times when some type of correlation does exist.

Looking at the data and composition of the economy, I think the most likely slowdown will come from a drop in PCEs; there is simply not enough income growth to warrant continued consumer spending expansion over the near long term.