Feature Stories | Apr 16 2008
By Greg Peel
The most recent minutes of the US Federal Open Market Committee revealed the Fed is now expecting “a contraction of real GDP in the first half of 2008 followed by a slow rise in the second half”. In other words, a recession by any other name, if only a brief one. While Fed governors are not really politicians, it is still in everyone’s interest for them to play a bit of “small-p” politics in not sounding alarmist, should the Fed, by its very warnings, become itself the catalyst for weakness.
US Treasury secretary Hank Paulson has been even more reluctant to use the R-word, while the president just says what he’s told to. So far the government is sticking stoically to the technical definition of recession – that of two consecutive quarters of negative growth. Given that the final GDP numbers for the first half won’t be known until about August, the US could actually go in and out of recession before economists can technically declare one. “Yes everyone – you were right. We did actually have a recession”.
That’s hardly very helpful. In the meantime, everybody else is happy to accept that a recession by any definition began at the end of 2007 and is still going on now. And despite every political attempt to push the “slowdown only” line, forward-looking confidence measures suggest businesses and consumers in the US believe they are in recession, which is itself enough to cause one. The easiest way to cause a recession is to stop spending money because you fear a recession.
Even if US GDP numbers never actually reach the negative – if they manage to hang on by their fingernails to some tiny positive reading – it makes little difference what you call it. It is a big, big contraction from the 4.9% annualised growth figure of the third quarter 2007. So let’s stop talking about “are we or aren’t we” and start realistically talking about how deep and how long.
Since WWII there have been ten recessions in the US if you go by the opinion of the US National Bureau of Economic Research. The NBER ignores the “two quarter” definition and calls a recession “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales”, which is exactly what’s happening now. As BMO Capital Markets points out, three of the NBER’s post-WWII recessions did not meet the two quarter rule.
A typical downturn lasts ten months and occurs on average every six years. Nevertheless, the last two recessions (90-91 and 01) were shorter than average and a decade apart. 2001’s recession – and bear in mind everyone agrees it was a recession – did not satisfy the two quarter rule. What this is all leading to is that if the first quarter GDP number is a small positive, the best strategy is to completely ignore all those bull-hopefuls who will no doubt dance around singing “No recession, no recession!”. Goldilocks is not just having a comfort break. She remains hog-tied in the bears’ basement trying to slowly chew through the ropes.
Taking the NBER definition, BMO Capital markets points out that (a) US real personal income peaked in Sep-07 and has been flat ever since, (b) payroll employment has fallen steadily since its Dec-07 peak, (c) industrial production posted a large decline after its Jan-08 peak, and (d) real business sales have continued to ebb ever since the Oct-07 peak.
Moving beyond NBER, the Conference Board index of coincident indicators (which is as good as identical to the NBER gauge) fell in Nov-07 and has been flat since, which is faintly recessive. The Chicago National Activity Index of 85 separate economic indicators marks a recession at a reading below -0.7. It fell below this level in Dec-07 and scored a -0.87 in Feb-08. This is a stronger recessionary signal.
BMO Capital markets thus suggests “as the recession debate continues, one conclusion elicits very little controversy; the US economy has entered into a period of sub-par performance that could persist for a long time”.
BMO’s Sherry Cooper goes on to address some more nitty-gritty, in the form of the recently announced first quarter result for iconic Dow stock General Electric. Despite its name – unchanged since its inclusion in the original index of 1896 – GE is now a sprawling conglomerate with a finger in many pies across financial, industrial, retail, health care and entertainment sectors. As long as anyone can remember, GE’s quarterly results have come in at no more than a penny away from previous guidance. Yet in the first quarter 2008 GE shocked the market by missing the estimate by a full 14%. This sent the Dow into a panicked 250 point slide. For GE effectively IS the US economy, or at least a very close representation of it.
Why hadn’t GE issued a profit warning earlier? Because it never has had to before? It was this uncertainty that spooked the market, even more so than the weak first quarter result and the accompanying weak second quarter guidance. If you can’t trust GE guidance, what can you trust? There were disturbing echoes of Bear Stearns here. General Electric is America’s biggest corporate borrower.
The other point of concern is that GE is a truly multi-national enterprise. In announcing the result the CEO noted that the greatest weakness was seen in the US, but that global demand had also slowed. There are a lot of investors in companies with large proportions of offshore earnings, as a defence against US weakness. The hope is that the booming markets outside the US will offset the losses from within. However, the largest diversified conglomerate in the world has not seen this. This is not a good sign.
Says Cooper, “Apparently the suggestion earlier [last] week that the stock market had turned a corner has proven to be premature”.
TD Bank Financial Group (parent of Australian subsidiary TD Securities) has an interesting spin on the forecast for the US economy over the next year or more. TD believes the US will indeed see two quarters of negative growth – the second quarter 08 and the first quarter 09. Hang on – they’re not consecutive. What’s going on there?
The good news is that TD does not expect a deep recession. The bad news is the economists expect a shallow but lengthy recession – all the way to the third quarter 09. The two negative quarters – spaced three quarters apart – have to do with the upcoming US government stimulus package.
A while back the Bush Administration signed off on a stimulus package that effectively hands a US$600 cheque to every taxpaying American as a “rebate”. The stimulus is the fiscal companion to the Fed’s monetary measures. The idea is that Americans will spend that US$600 on anything they like in a shop and thus apply the paddles to the chest of the US economy. The US consumer represents 70% of the economy. Clear!
Of course, there is nothing to stop Americans doing something sensible like putting the money towards their mortgage, or their credit card, or simply saving it in these troubled times. If that happens, the package would largely backfire, even though it would actually go a little way to relieving the US debt burden. But we don’t want to worry about such things do we? We want to spend, spend, spend like every patriotic American should! Let the rest of the world suffer the fallout from our debt-fuelled indulgence!
So the likelihood is most of this money – all US$150bn of it – will indeed be spent, and thus have an impact on the economy. Americans are not like Australians, who spend their $4,000 baby bonuses on sensible things that baby needs – baby’s first widescreen TV for example, or its first home theatre system.
The cheques will start arriving shortly over a period of time and will thus impact upon US consumer spending in the third and fourth quarters of 2008. That is why TD is predicting what one might call a “recession interrupted”. Were it not for the stimulus, TD believes the second and third quarters of 2008 would see actual negative growth before a slow climb back. The following chart shows that both scenarios have the US economy reaching the same point in 3Q09 – the neutral point of 2.8% “potential” growth. This means the stimulus package will do no more than interrupt and distort the cycle. By Q109 the cheques will have run out.
What it will likely do, however, is send a false signal. If the TD economists are accurate in their predictions, the third quarter of 2008 will show positive growth. Huzzah! The recession is over! Buy, buy, buy!
This would be a trap. Although it would tie in with the current Fed forecast – Q1 and Q2 negative and Q3 and Q4 slowly positive.
(If you need anymore convincing that Americans will indeed lash out with their rebate cheques, note that retailing giant Sears has been the first to institute a marketing campaign to ensure they do. If you spend the entire cheque on a Sears gift voucher, Sears will throw in an extra 10%. Just wait for the rest of the working girls to line up along the alley with their own deals!)
TD is forecasting an annual average US GDP growth rate of 1.1% in 2008, and 1.1% again in 2009. While positive growth in 2008 is better than negative growth, soft negative growth in 2009 is not what the doctor ordered. History shows US recessions are usually followed by strong stock market performance in the first and second years thereafter. Under TD’s scenario any strong performance will prove a false start. It would almost be better to have a deep, swift recession, that would sent stock prices down to good value entry levels, ready for the solid bounce, than it would to have a long, slow, grinding return to positive territory with lots of set-backs and disappointments.
However, an even worse scenario would be a deep recession that is not swift, but enduring. Already the credit crunch era has been compared to the Great Depression, and Grandpa will tell you those were crippling times back in the 30s. But TD does not see a depression. Rather, it sees a fall in activity on more on par with the recession of 90-91, or of the (deeper) recession of 81-82.
The economists predict five quarterly contractions in US employment for a total of one million jobs lost. This would be of a similar duration to 81-82, but back then 2.8m jobs were lost. They also see four quarters of consumer spending contraction and six contractions of non-residential investment. These are closer to 90-91 than 81-82. The graph below from Nomura Securities gives an indication of recession comparisons.
But while comparisons have their obvious value, no two recessions are identical and the next recession can always be the one that rewrites the history books. For example, while the current recession has its roots in a credit market bubble, just like most recessions, this one involves a level of leverage and a complexity of financial instruments never experienced before. Who is to say history’s value is not diminished under such circumstances? Nevertheless, TD’s economists, like many before them, are quick to point out just what “positive” differences there are between this and past recessions.
Typically in the past, the Fed had been increasing the cash rate right up until the time some unexpected “shock” brought the US economy to its knees. Given it accepted monetary policy actually takes 12-18 months to have its desired effect, not only must the Fed then slash rates to save the economy it must slash more to offset 12-18 months of heading in the wrong direction. However in this case, the Fed stopped tightening a full year before the credit crunch hit in earnest in July 07. There’s not much to catch up.
The second point – and this one is of manifest importance according to many an economist, including the researchers at GaveKal – “shocks” have typically caught businesses loaded up with inventory in the good times, and completely stuck having to make desperate price knock-downs as the recession unfolds. This naturally exacerbates and lengthens the recession. However, the rapid information age of the twenty-first century has brought about a huge leap in the process of inventory management. So sure can businesses be of their sales projections and supply chain recognition that a “just-in-time” production system has evolved. Excessive stockpiles are a thing of the past.
In a typical US recession over the last 50 years, two-thirds of GDP contraction was as a result of inventory overhang. While back in the eighties inventory size had fallen to 10% of GDP, today that number is 4%. This fact bodes well for only a shallow recession.
The other “overhang” factor of your common or garden recession is employment. In good times, businesses typically put on lots of workers to cope with the increased demand. When the shock hits, suddenly they’ve got a lot of workers to retrench. But again (and again this is a common argument amongst economists today) the twenty-first century is one where traditional production growth has either been met by deploying more robots, or by shipping the production process off to China. Thus employment growth in the lead up to this recession has been minimal. What growth there has been has been centred on service industries, such as financial services. Wall Street needed to employ more and more people to help package up and sell all those lucrative subprime mortgages. Now they are being retrenched in numbers. Doesn’t your heart just break?
Another lesson of history is that the government of the day will usually only introduce a fiscal stimulus – such as a tax rebate – when a recession has just about run its course. It is the final ditch effort to restart the economy, and will thus be self-fulfilling to an extent. This time the government is pulling out its fiscal stimulus package even before it is fully agreed the US is actually in a recession, let alone near the end of it. Again this is a positive.
The other chestnut of recent thinking is the aforementioned offshore earnings argument. GE result aside, the benefit of a weak US dollar is a boon to US exports, and the current 8% export growth number is well ahead of the 1-2% growth numbers experienced in previous recessions. Once again, this time it’s different. Ahead of previous recessions the US dollar was strong, reflecting the good times. But the US dollar in this case has been weak for three years as the current account deficit has grown. That 8% earnings growth was achieved in the past two years as well. This time exporters do not have to wait for the recession to send the US dollar lower and make their goods more competitive. It’s already happened.
The last point is that while past Feds and administrations have dithered and dallied and exacerbated the situation with either a slow response or the wrong response (in the Great Depression the government responded by raising the cash rate and introducing import tariffs, which is why it was the Great Depression and not just the Bad Recession), this time both the Fed and the administration have acted swiftly and announced they stand ready to do whatever it takes as soon as possible if needed. This would suggest a deep recession is unlikely.
(What it does suggest is that we can probably all meet in the same place in a few years time and do this all again.)
Yet another factor, which TD hasn’t pursued in its report but others have, is the question of productivity. The solid growth of an economy is dependent upon output per man-hours worked. If the workforce is held steady, but productivity declines (as it did in the union-controlled and recessive era of the seventies), then economic growth will slow despite high employment. And the reverse is also true. But if productivity is still increasing as the employment level falls (as it might do when robots replace workers) then employment has to fall a lot further before unemployment has an actual impact on the economy. And currently US productivity growth is still solid.
Add all of the above up, and what you have is the argument for the Shallow Recession rather than the Deep Recession. But the TD economists note that even their forecasts of “shallow” negative growth are below consensus. Consensus – like the Fed – is still holding on to weak but not negative growth in the first half. That was until the IMF came out with its latest assessment. TD is forecasting 1.1% annual growth for 2008 and 1.1% for 2009.The IMF is now forecasting 0.5% for 2008 and 0.6% for 2009.
Thus the IMF’s recession is effectively deeper, but given it sees a return to growth in 2009, while TD says not until the third quarter, the IMF’s recession is shorter.
It’s all about the lesser of the evils.
TD’s economists are quick to qualify, however, and suggest there are several factors at play which can yet render their forecasts inaccurate, and send the US into a much deeper recession than anticipated. Quite a lot of factors actually.
The first are all financial. This is indeed a financial sector-driven recession, and if you had to sum up why the global financial sector has collapsed into just one line it would be “Because no one knows what a CDO is worth”. This lack of transparency is behind all global uncertainty, and who knows what horrible beasts are still lying at the bottom of the murky pond?
The IMF has already suggested that total write-downs will reach US$1 trillion, while to date that figure is about US$235bn. This means financial balance sheets are more likely to worsen through 2008 than improve. This then threatens ongoing lines of credit to non-financial corporations. And despite what the Fed has been doing, there could yet be another Bear Stearns.
The other big financial risk is that of the credit default swap. This danger has been gaining a lot more currency in recent weeks, although FNArena did flag the potential problem back in November. While credit default swaps were created as a means of protecting against corporate default, their value has been multiplied and leveraged. If the insurance itself defaults, this can set off another house of cards. In the six months to June 07 the notional value of total CDSs (and like CDOs, the CDS market is an opaque one) supposedly grew from US$29 trillion to US$45 trillion. The real basis of fear here is that CDSs increased not because of an increase in underlying debt, but because of an increase in the number of CDSs written on the SAME debt. If one CDS writer itself defaults, there will be a nuclear reaction of exponential collapses.
However…and this is a “however” that we just cannot be sure about…writers of CDSs point out that their instruments are not all created facing in the same direction. You can have CDSs on CDSs which “hedge” the original CDS, just like the total number of outstanding options positions on any asset include both puts and calls. Hence it is suggested that for a total of US$45 trillion in CDSs written, there is only about US$1 trillion of actual exposure. Let’s hope that’s right, but the natives are sure getting restless.
Outside of the financial sector specifically, other risks which may bring about a deeper recession include those from the US housing market, the global economy, and inflation.
So far estimates suggest about 15% of US mortgages are underwater on what has been about a 10% average slump in house prices. Should house prices fall a further 10%, this figure will rise to 25%. The problem then is that the effect can snowball, if it isn’t already doing so, and a shallow recession could merely be a dream.
The world is polarised as to whether emerging markets such as China and India, and to a lesser extent developed markets such as Japan and Germany, are “de-coupled” from the US in this globalised age. While Japan and Germany will no doubt suffer along with the US, if the domestic economies of China, India et al can keep powering along, oblivious to the debacle in the US, then the world need not fear a deep global recession. But if not…
Finally, there is the issue of inflation. Under normal circumstances, high inflation leading into a recession will be tempered by the recession itself as demand falls. That is why stagflation is a very rare beast. It only occurred in the seventies because (a) central banks at that point didn’t think fighting inflation was important, so they had already allowed inflation levels to drift up before (b) there was huge exogenous shock when America’s Middle East enemies introduced an oil embargo.
This time inflation has been held under control by central banks where necessary for quite some time, and there are no exogenous shocks (yet). High food and energy prices are all part of straight forward global demand which should, in theory, diminish if the mighty US economy recedes. But will it?
If the global demand spike for food and energy (exacerbated by Bush’s ridiculous ethanol policy) is here to stay, then inflation could easily remain at high levels while the US economy recedes. This would put even more pressure on the US consumer, and thus deepen the recession.
Oh there’s nothing like a nice, happy camp-fire chat, is there? It seems whichever way you look at it the prognosis for the US economy comes under the categories of either BAD or WORSE. Shallow and short would be the best outcome for a recession, but the least likely. You can then argue which is better – shallow and long, or deep and short. The worst outcome is deep and long, but that appears to be the least likely.
We hope.
