IFO Weakening Trend Still in Force

IFO climate is changing…for the worse! The IFO climate gauge for Germany weakened month-to-month but the all-sector reading fell to -18.2 in July from -14.7 in June. Current conditions also stepped back in July with the all-sector reading at 8.1 compared to June’s 13.5. The expectations index weakened marginally with July falling to -25.0 compared to June’s -24.3. The IFO survey falls over each of the three broad categories and the weakness in each category is shared across each one of the industry components. There are five separate industry readings for the three survey concepts implying 15 observations overall for July. Among the 15 observations, all of them weaken month-to-month except for retailing under current conditions and services under expectations.

The chart tracks a wild IFO ride The chart shows the roller coaster ride that the IFO survey concepts have been on since COVID struck. 2020 brought a sharp down move to each of the three IFO concepts of climate, current conditions, and expectations. They rebounded through mid-2021 and then underwent a slight deterioration until early 2022 when Russia invaded Ukraine. At that point, another relatively steep drop in the components was recorded, taking some of them back down to lower readings than had been experienced in the depths of the Covid situation. However, after bottoming out in late 2022, these industry metrics staged a recovery into early 2023 and now that recovery is giving way to a series of weaker readings over the past three or four months depending on which of the IFO concepts we track.

Climate Climate weakens broadly with weaker reading in July than in June across all the categories and with net negative readings in all the industries except services; that industry posts a +0.9 reading but still marks a decline from its value in June. The queue rankings of these readings are telling, with all the industry level rankings below their respective 50th percentiles, marking them as below their historic medians back to 1991. The all-sector climate reading has an 11.7 percentile rank, marking it as weaker less than 12% of the time; among industries the strongest reading is construction with a 40.5 percentile standing and in retailing with a 32.7 percentile standing- and those are both weak.

Current conditions The current conditions index fell month-to-month to 8.1 in July from 13.5 in June. It weakens across all industries except retailing, where the July reading of -2.3 is stronger than the June reading of -4.0. However, the rankings for the current index are weak; two of them are above the 50th percentile: retailing has a 65.7 percentile standing and construction has a 60.6 percentile standing. Manufacturing, wholesaling, and services all have standings below the 50th percentile but the all-sector current index is clocking an 18.8 percentile standing. Interestingly, the 18.8 percentile standing appears relatively strong compared to the sector rankings: there's only one sector standing slightly weaker than that (services at 17.3%). But this phenomenon reflects the unusual coincidence of all the industries being relatively weak at the same time.

Expectations While the current index in July shows firmer readings than either the climate or the expectations sectors, the fact that the current economy is least impacted is only one aspect of the German situation. The counterpart is that expectations are extremely weak as the all-sector reading for July has a 6.3 percentile ranking with manufacturing at a 3.5 percentile ranking and with wholesaling at a 2.7 percentile ranking. The strongest sector ranking in July comes from services with an 8.7 percentile ranking. Deterioration is across the board except for the services sector that has a -14.1 reading in July, slightly higher than its -15.4 reading in June. However, the weakness and expectations are clear, severe, and broad.

Challenges remain The IFO survey shows ongoing challenges for the German economy; there is a worsening deterioration across sectors. Interestingly, this comes at a time when a lot of investors and onlookers seem to be losing their pessimism about the global economy. Stock market performance is helping people to reassess recent weak data and to set aside what has been an enduring negative yield curve signal in the U.S. along with ongoing weakness globally, weak leading economic indicators, and weak or soft consumer confidence measures. I suppose when there has been a long drum beat of negative news and markets have performed well, at some point, it's natural that markets would begin to look at these signals as unduly pessimistic. That’s where we now find ourselves.

Are economic signals in error or are we impatient? However, one thing to bear in mind is that one of the great jokes in economics is that when you make a forecast, be sure to forecast a rate, or forecast a date, but never forecast the two things together. This bit of economic wisdom/cynicism simply reflects the limitations of science. It would appear for now markets are choosing to set aside negative signals because they've been misleading at least in terms of stock market investing for quite some time. Unfortunately, this could just be a timing problem rather than a true disconnection of time-honored signals. Furthermore, in the U.S., the yield curve inversion signal has not even reached the point of stretching past historic norms…

Timing is everything When it comes to the timing of a recession, it is more to the point to note that the Federal Reserve, the ECB, and the Bank of England have been late and far more timid than their historic selves used to be in fighting inflation. There is what could be termed a cottage industry that has grown up and is trying to dismiss the usefulness of calculating ‘real’ interest rates by comparing current rates to 12-month lagging inflation- a practice that has always served at least as a benchmark for monetary policy. Everyone realizes when you compare our current inflation rate to a 10-year note yield, you're comparing a 10-year-span interest rate to a 12-month lagging inflation rate. Academics would have you look at expectations. And if we could find good measures of that, that might make sense. But the manifestations of expectations that we can create all do an extremely poor job of predicting future inflation and that makes it hard for me (at least) to believe that anybody is making decisions about the future using those expectations.

Everything old is new again...including making mistakes More to the point is the fact that currently core inflation is quite stuck and quite high. In my view as people set their forecasts for future inflation in place, they're putting great weight and what current high core inflation is now. To me, recessions, in this cycle, are not delayed as much as aggressive recession endangering strategies by central banks are being avoided. And, if central banks are tippy-toeing around the edges of inflation-fighting, it's not surprising that inflation hangs around longer or the economic performance remains solid for longer, and that recessions are pushed out into the future, or even avoided. But if recessions are avoided at the cost of inflation being higher and above target for longer, that's the price that's paid. That monetary policy will go on paying a price for that in the future - will central bank credibility suffer as a result? The question is whether central banks have discovered a new enlightened approach for monetary policy? Or are they back to their same old tricks, being swayed by politics, and making the same old mistakes, under a new set of labels, that look fresh but will once again fall flat and repeat old mistakes? Only time will tell.