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5 Reasons the U.S. Could See a Double Dip Recession

Fluctuation in gross domestic product (GDP) growth is an indicator used by the NationalBureau of Economic Research (NBER) to formally identify the beginning and end of arecession. Specifically, the NBER defines a recession as “a significant decline ineconomic activity spread across the economy, lasting more than a few months, normallyvisible in real [inflation adjusted] GDP, real income, employment, industrial production,and wholesale-retail sales.”

But, for the purpose of investors focused on the economy’simpact on financial markets, a recession can simply be defined as two consecutivequarters of a decline in real GDP. Accordingly, those who fear a double dip recessionwill be paying special attention to whether or not GDP growth turns negative relative tothe previous quarter. As such, it is imperative to keep in mind the components of GDPand what could cause it to decline.GDP equals consumption plus government spending plus investment plus net exports(GDP=C+G+I+NX). In the aftermath of the financial crisis, consumption decreased asasset values declined and unemployment rates spiked. As a result of the subsequentreduction in consumer spending, the government increased its spending in order to makeup for the reduction in consumption. In the short run this strategy has worked as thestimulus has contributed meaningfully to the recent growth in GDP. But going forward,what happens if the government cuts back on spending? What happens if asset valuesfall, unemployment levels remain elevated and consumers retrench even further? Whathappens if banks continue to curtail their lending and no capital is available for investment? The answer is that U.S. GDP could once again contract.In this context, below are five reasons to be concerned about a rare double dip recession.The reason investors should pay attention is that such an outcome could have a markedimpact on corporate profits and thus the stock market, at least in the short run. Fears of adouble dip have already helped fuel a 12% decline in the S&P 500 since May, but theultimate outcome remains to be seen.

The Ongoing Housing Correction

According to lagging data from April 2010, the 10 city Case-Schiller home pricecomposite was up 4.6% and the 20 city composite was up 3.8% versus April 2009. Onthe surface, the release of these figures appears to represent very encouraging news for homeowners and investors throughout the U.S. The concern, however, is that much of the purchase activity in April was driven by the $8,000 homebuyer tax credit that has sinceexpired (in conjunction with a dwindling of stimulus spending throughout the economy).Even with 30 year fixed mortgage rates hovering around 4.5%, mortgage applicationvolume has dropped precipitously since the tax credit expired.

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So, now that the government has pulledforward housing demand and stimulatedshort term buying, what are we left with? If you believe housing guru Mark Hanson of M. Hanson Advisers,

we are left with agigantic shadow inventory of homes that arein some stage of the foreclosure pipelinewhich will eventually come on the marketand push housing prices back down. Let usalso not forget that 2011 represents the peak in mortgage resets (see adjacent chart) andeven with historically low interest ratesavailable today, many people who took outloans with teaser rates may not be able toafford their new payments. When those two factors are combined, it seems likely thathousing prices will be under pressure during the next year or so and the impact onconsumers could lead to a decline in spending that hurts GDP growth. Of course, thedirection in housing prices could be positively affected by another round of governmenttax cuts or stimulus aimed at preventing a further decline in prices. Additionally, bankshave the option of working with borrowers to offset the impact of rate resets and limit thenumber of additional foreclosures.

Can the ECRI Leading Index Predict a Recession?

The aside chart was taken from John Hussman’s piece for the week of June 28th entitled“Recession Warning.”

It shows a recent plunge in the ISM Purchasing Mangers Index(PMI) and the ECRI Weekly Leading Index (WLI). The PMI is an important indicator of economic activity and any readingabove 50 suggests thatmanufacturing is expanding. TheWLI, on the other hand, is acomposite index of 19 key weeklyeconomic indicators such as home prices, stock market activity andemployment trends. Unfortunately,this index has fallen for fiveconsecutive weeks, prompting people who follow it closely towonder out loud about whether theeconomic recovery is slowing or theU.S. is heading towards recession.Grey bars in the chart represent recessions and just a quick glance at the picture leads tothe unmistakable conclusion that there is some correlation between a large drop in theseindices and recessions. Unfortunately, after a 6.9% drop recorded for the week of June25

, the next week produced an even worse 7.6% decline. For the week of July 23rd, theindex plunged 10.5% further (excluding revisions to previous figures). But what is the

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historical relationship between these figures and recessions? From Hussman’s piece:“Taking the growth rate of the WLI as a single indicator, the only instance when a levelof -6.9% was

not

associated with an actual recession was a single observation in 1988.”Recent declines in both of these indices certainly do not guarantee a return to recession.However, investors globally should be aware that risks of a double dip are elevated andshould consider whether or not the U.S. equity market has properly accounted for that possibility.

Herbert Hoover Revisited

With the benefit of perfect hindsight, many historians and economists blame the taxincreases imposed in 1932 as one of the main reasons the Great Depression lasted as longas it did. Given that our current leaders are familiar with this argument, there is no waythey would try to enact anything as draconian as an increase of the income tax from 25%to 63%, right? Surely members of Congress would not go out of their way to torpedo therecovery? Unfortunately, in this case they may not even have to. If the lastadministration’s tax cuts expire, the highest marginal tax rate will expand to 39.6% from35% and the estate tax will reemerge in all of its glory. In a paper written in 2007

,Obama’s own adviser Christina Romer concluded that a dollar in tax cuts raises GDP byabout $3. However, what that analysis also implies is that a $1 tax increase could reduceGDP by $3. Therefore, with the gridlock in Congress, the ongoing discussions aboutreducing the budget deficit and the ever louder calls for fiscal austerity, there is a non-trivial risk that tax rates will increase in 2011 and have a negative impact on GDP.

Where Has All the Credit Gone?

The Federal Reserve nolonger tracks the M3measure of money supply, but John Williams of ShadowStats.com

continues to provide hisown estimates of M3. Thismeasure, which includesM1 (physical currency),M2 (M1+ savings accounts,money market accounts,retail money market mutualfunds & small timedeposits) and all other CDs,is still tracked by economists in Europe. Disturbingly, as the adjacent chart highlights,M3 is declining at rapid pace. In fact, according to an article in The Telegraph

, themoney supply contracted at an annual rate of 9.6% in Q1 2010, falling to $13.9 trillionfrom $14.2 trillion. What this means is that despite the Fed’s vigilant efforts to createinflation by doubling its balance sheet, the money supply is still contracting.