Walter R Pierz : Northwestern Mutual - Economic Commentary - July 2010 : Article: Economic Commentary

Economic Commentary - July 2010

Christopher Bremer
Senior Investment Consultant

Double Dip Recession or Double Dip Media Attention?

With the cover of an official equity market correction after the April highs, prominent bears have emerged in full force under the auspices of an increase in the probability of a “double dip recession.” Stoked by the emergence and escalation of the Euro debt crisis, prominent bears are getting a lot of face time in media outlets and are prognosticating that problems in Europe will spread to the U.S. and derail an already fragile recovery. Our “Google Sentiment Indicator” generates more than twice as many results for the search phrase “double dip recession” as it does for “economic recovery.”

The escalation of the European debt crisis has reinvigorated fears of a double dip recession. The concern is that sovereign debt problems in Europe will spread to the U.S. and derail the recovery here. The Federal Open Market Committee (FOMC) endorsed this possibility in its June 23 statement, “Financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad.”

The Fed’s prognosis is sanguine compared with what many prominent economists and strategists are proclaiming. “Right now, we have a severely depressed economy – and that depressed economy is inflicting long-run damage,” wrote Nobel Laureate and New York Times columnist Paul Krugman on June 20. Former Labor Secretary Robert Reich says, “We’re falling into a double-dip recession.” They are not alone; prominent bears such as Nouriel Roubini, a professor at New York University and founder of Roubini Global Economics; Nassim Taleb, author of The Black Swan; and Gary Shilling, a prominent investment advisor, are predicting scenarios of a double dip recession, at best, and an economic depression, at worst.

A double dip recession, which occurs when GDP growth turns negative after at least a quarter or two of positive growth, isn’t something to take lightly. There’s only been one since the Great Depression, in 1981. It can have a devastating impact on households and businesses, knocking them off their feet again after just emerging from a recession.

Many double dip recession advocates have created successful marketing businesses by promulgating worst case scenarios. While their message delivery is certainly intended to capture media attention, many of their arguments are not entirely unfounded. The recovery has been slow to gain traction in housing and employment and the Fed has little room remaining to stimulate the economy, given that interest rates are already near zero.

Still, there are continued signs of encouragement. Businesses are starting to hire and the economy has been adding jobs since the beginning of the year. And while home sales dropped substantially in May following the expiration of the federal homebuyer credit, the rate of homeowners going into foreclosure has slowed and housing prices are likely near a bottom.

In the following commentary we present the “double dip recession” and the “recovery” arguments focusing on employment, housing, as well as monetary and fiscal policy.

Employment

For double dip recession proponents there is no sugar-coating the news; the May employment report was terrible with the economy only creating 41,000 private sector jobs. To recover the 8.4 million private sector jobs lost from December 2007, at a rate of 41,000 jobs per month, it would take over 17 years. For sure, even the most dire pessimists are not arguing that we will only create 41,000 private sector jobs per month, but this is merely an indication of how bad the employment situation remains (Fig. 1).

To merely keep up with population growth, the economy needs to generate 100,000 jobs a month, and it wasn’t even close in May. Even worse, the average length of unemployment continues to increase and is now up to a staggering 34.4 weeks. Almost one half (46%) of the unemployed have been without work for over 27 weeks, almost doubling the previous high of 26% (Fig. 2). The longer a worker is without a job, the harder it is to find one. In addition, millions of Americans remain too discouraged to even look for a job; if they were looking for work, unemployment numbers would be even worse.

Jobless claims also rose for the second week in June and the four-week moving average of unemployment claims, which smoothes out the variations in the weekly data, was flat. The level of jobless claims remains high and could signal that an earlier recovery in employment is fading.

Observers who see economic recovery believe that, while the May numbers for job creation and the early June numbers for unemployment are not all that encouraging, they are not catastrophic either. In its June 23 release, the Fed stated that the labor market “is improving gradually,” an upgrade from “beginning to improve” in the April statement.

Economic recoveries are never linear and employment improvement typically lags. There are positive signs that employment is recovering. At the beginning of 2010, 100,000 new jobs were created a month, on average, and that figure rose to around 140,000, on average, over the past three months. If this trend is sustained, it will mean moderate job growth for the economy.

Manufacturing employers added to their payrolls for the sixth consecutive month in May, according to the Institute for Supply Management (ISM). Hours worked are trending up and are 1.2 percent above their mid-2009 low. In addition, labor input is rising much faster as private employment trends up. As hours increase, after-tax wage and salary income will grow, contributing to an economic recovery. In addition, job openings have increased over the past few months.

According to a Citi review of over 600 non-financial companies, corporate executives are planning a near 5% increase in 2010 capital spending, followed by another 2% for 2011. Not grandiose for sure, but certainly an improvement over 2009’s 18% decline. A recent report from the Richmond Fed noted that manufacturers’ optimism remains and firms continue to anticipate growth in new shipments, capacity utilization and employment. Eventually, workers will be needed to fill backlogs and attend to new fixed investments.

An end to the fiscal stimulus plan does not necessarily translate into further employment deterioration. Much of the stimulus was focused on unemployment benefits and aid to states, both designed to offset the impact of lost jobs. Net layoffs have halted and personal income is trending higher, setting the stage for improvement in the overall employment situation, if only incremental.

Housing

Double dippers correctly point out that home ownership is elusive for the 9.7 percent of Americans who are unemployed and for the millions who have already lost their homes to foreclosure or who are in the foreclosure process. And these foreclosures are typically sold at depressed valuations, resulting in further deterioration in the housing market.

In May, new residential construction fell by 10 percent to a seasonally adjusted rate of 593,000 units, the lowest level in five months. If weakness in new construction continues, it could be a sign that the tax credit for first time homebuyers, now expired, failed to stimulate fundamental demand in the housing market. In fact, following the end of that program, new home sales plunged 32.7 percent in May, exceeding already dismal expectations (Fig. 3). The housing market is still extremely fragile and any major disruptions, such as a renewed slump in employment or a Europe-spawned banking crisis, could further prolong this ongoing crisis. In short, it seems clear that much of the housing demand in the last year was pushed forward by the tax credit incentive and, consequently, existing home sales are likely to weaken.

Compounding the ongoing issues in the residential real estate market are the growing problems in the commercial real estate market. Pathfinder Partners, a San Diego based buyer of distressed property loans, estimates that values on commercial properties have fallen by 40 percent and by as much as 80 to 90 percent for hotels. As commercial properties continue to default, bank balance sheets will take a further hit, which will restrict the ability and willingness of banks to lend. The commercial and residential real estate industries are likely, at best, to be a drag on growth and, at worst, may tip the economy back into recession.

While foreclosure numbers are still troubling, the numbers are stabilizing, according to recovery advocates. In May, foreclosure tracker RealtyTrac reported a 3 percent decrease in foreclosure filings from the previous month. Foreclosures are only up 1 percent since May and the number of default notices, the first step in the foreclosure process, is down 7 percent in the past month and the lowest rate since November 2008. However, bank repossessions, a lagging indicator, hit a record monthly high for the second month in a row.

While residential real estate prices continue to fall, they have already taken such a huge hit that further declines may be limited, although prices likely still haven’t hit bottom. That fall in home prices, continued low interest rates on mortgages, an easing of credit and any improvement in the employment picture will eventually spark an increase in home sales, although it will take years for the market to absorb the entire inventory available.

While the decline in housing starts in May wasn’t encouraging, it could have been worse. Although much foreclosure inventory remains to be worked out, homebuilders aren’t putting many new units into the market, restraining supplies.

Monetary and Fiscal Policy

Many of Wall Street’s pessimists say that growth will deteriorate as governments tighten monetary policy and seek to reign in runaway budget deficits. Governments across Europe are belt-tightening, with Great Britain and Germany proposing stiff budget cuts. In the U.S., Congress has so far refused to extend unemployment benefits and COBRA subsidies for the long-term unemployed.

States and cities face the prospect of further massive budget cuts and layoffs unless the federal government acts to provide more stimulus funds, which seems increasingly unlikely. While state tax revenues are beginning to rebound, states still face a collective shortfall of $127 billion over the next two years, according to the National Association of State Budget Officers. Since August 2008, states have cut more than 230,000 jobs. States could be forced to cut an additional 400,000 to 500,000 jobs in the next year without further stimulus funds, according to Mark Zandi at Economy.com.

As fiscal stimulus fades, where will GDP growth come from? With rates effectively at 0 percent, the Fed has no more room to slash rates and stimulate lending and aggregate demand. In response, markets are keeping longer-term rates for Treasuries and mortgages low, so there is not much room for the Fed to maneuver there either.

With interest rates and inflation near zero, deflation is a risk. Deflation, a sustained fall in prices, could further endanger the recovery and cause businesses and consumers to put off purchases in the hope of lower prices in the future, further constraining economic growth.

With inflation not a concern, the optimists note that the Fed is likely to hold off for even longer on raising rates. The monetary backdrop is supportive of risk assets even if the pace of economic recovery moderates. Inflation remains well below the Fed’s target. In fact, the overall inflation rate actually declined in April and May. On a year-over-year basis, prices overall are up by a mere 2 percent.

Even in Europe, the noisy, belt-tightening moves seem more symbolic than substantial. Fiscal deficits

aren’t expected to decline by much. As in the U.S., monetary policy remains easy in Europe with no prospects for tightening in the short or medium-term, which encourages growth.

The Philadelphia Fed reports that, in May, 47 states saw increases in economic activity while three saw declines. This brings the one-month diffusion index to +88 from +86 in April – the highest level since January 2007. In other words, the report indicates that the economic recovery is broadening out. Figure 4 shows the recently published state coincident index for May 2010. Figure 5 shows the same picture from a year earlier, May 2009.

What to Watch For

You do not have to have a PhD in advanced quantitative and statistical modeling to monitor signs of pending recessionary periods. The yield curve has historically been a valuable tool in forecasting recessions, or at least the increased probability of recessions. By yield curve, we mean specifically the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill. This measure significantly outperforms other financial and macroeconomic indicators in predicting recessions.

The bond markets led into the European sovereign debt crisis. Figure 6 shows that in virtually all recessions, the yield curve inverted, meaning that yields on shorter maturities were higher than longer maturities. This signifies a flight to quality and the safe haven status of Treasury bills during times of economic distress. The yield curve today remains at historically steep levels, levels inconsistent with a recession signal. It very well could be that the bond markets have priced in a stronger recovery scenario and the yield curve will flatten, and this is what interested observers should monitor.

Where Are We Headed

A prognosis of a double dip recession should start with an analysis of historical precedent. In the 11 business cycles since 1945 there has only been one double dip recession, in 1981. Even among the few cases dating back to 1920, there are few traits, if any, these rare occurrences have in common. Paul Volcker, then Federal Reserve Chairman, describes how different considerations in 1979 were, “What was plainly happening over a period of time was that both unemployment and inflation were rising, and further delay in dealing with inflation would only ultimately make things worse, including the risk that any recession would be large.” Today we have an unemployment problem with no signs yet of inflation.

Two steps forward, one step back is quite normal for the second year of an economic recovery. Recognize that we have come a long way from a year ago. Last year, recovery proponents could only point to economic data that was coming in only less dreadful than previous; they were mostly correct.

A year ago we sought an improvement in economic data accompanied by improvement in economic sentiment to revive our economy, albeit at a more moderate pace than experienced in the run up to the current recession. Where last year we were simply hoping for a deceleration in the rate of decline, now concerns have surfaced over decelerations from peaks in some economic indicators, particularly in manufacturing (Fig. 7).

Economic data do not follow linear paths, so downside readings like the last employment report should not come as too much of a surprise. Should we string a few of these downside surprises together, then concern is certainly warranted.

The long-term, steady state of the economy is growth. The annualized growth in U.S. GDP from March 1947 through March 2010 is 3.24%. Counted in months, since 1927, the U.S. economy has been in recession, as defined by the National Bureau of Economic Research (NBER), 19.5% of the time. On average, an economic observer with a bias toward forecasting recessionary business cycles would only have to predict recessions consistently for 2.9 years before being proven correct. In recent years, however, betting on contraction has been a more arduous profession. Since 1960, it takes on average 5.4 years for recessionary forecasts to materialize.

But each cycle brings unique circumstances, and we just experience the longest and deepest recession since the Great Depression. We cannot afford to dismiss the prospects of future contractions, or a reversal in the current economic recovery. But just because the economy continues to be faced with challenges does not mean we are entering a double dip recession.

For those who do not subscribe to the double dip recession prophecy, there is a simple way to bet against it - do nothing- that is, for investors with a long-term, strategic asset allocation policy. An investment policy allocation that includes a growth component allocation, i.e. equities, is inherently aligned with the long-term, steady state of the economy. For those without an investment plan, the creation of an investment policy is the next best course of action.

For sure, other considerations like valuation and entry price are of critical importance. An economy that is growing does not mean an economy free of missteps and problems, nor does it mean securities markets free of volatility and corrections.

Each cycle has its own distinctive aspects, but according to JP Morgan, “growth scares” have been common early into expansions following a crisis. In other words, it is logical, even responsible, for investors to question the sustainability of an expansion. JP Morgan further notes that the common thread among recoveries is that equity sell-offs have been fast and deep, lasting 1.8 months with an average decline of 16 percent. From the April 23 peak, the S&P declined 13.7 percent in the span of 30 trading days. The correction we just experienced so far seems quite normal.

We may have already experienced the strongest quarter of growth in this recovery from the great recession, but that does dictate that another recession is imminent. We still may have modest growth ahead while the recovery, in the words of Federal Reserve Chairman Ben Bernanke, “will not feel terrific.”

Finally, consider the possibility of a bubble in doomsday prognosticators. One of the most prominent, bearish economists today, Nouriel Roubini, has participated in Congressional hearings, and the World Economic Forum at Davos, among many other forums. Well, soon he will also appear briefly, as himself, in Wall Street: Money Never Sleeps, Oliver Stone’s forthcoming sequel to his 1987 hit film Wall Street.