The Inoculated Investor

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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 National Bureau of Economic Research (NBER) to formally identify the beginning and end of a recession. Specifically, the NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real [inflation adjusted] GDP, real income, employment, industrial production, and wholesale-retail sales.”2 But, for the purpose of investors focused on the economy’s impact on financial markets, a recession can simply be defined as two consecutive quarters of a decline in real GDP. Accordingly, those who fear a double dip recession will be paying special attention to whether or not GDP growth turns negative relative to the previous quarter. As such, it is imperative to keep in mind the components of GDP and 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 as asset values declined and unemployment rates spiked. As a result of the subsequent reduction in consumer spending, the government increased its spending in order to make up for the reduction in consumption. In the short run this strategy has worked as the stimulus 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 values fall, unemployment levels remain elevated and consumers retrench even further? What happens 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 marked impact on corporate profits and thus the stock market, at least in the short run. Fears of a double dip have already helped fuel a 12% decline in the S&P 500 since May, but the ultimate outcome remains to be seen. The Ongoing Housing Correction According to lagging data from April 2010, the 10 city Case-Schiller home price composite was up 4.6% and the 20 city composite was up 3.8% versus April 2009. On the 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 since expired (in conjunction with a dwindling of stimulus spending throughout the economy). Even with 30 year fixed mortgage rates hovering around 4.5%, mortgage application volume has dropped precipitously since the tax credit expired.

The Inoculated Investor

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So, now that the government has pulled forward housing demand and stimulated short term buying, what are we left with? If you believe housing guru Mark Hanson of M. Hanson Advisers,3 we are left with a gigantic shadow inventory of homes that are in some stage of the foreclosure pipeline which will eventually come on the market and push housing prices back down. Let us also not forget that 2011 represents the peak in mortgage resets (see adjacent chart) and even with historically low interest rates available today, many people who took out loans with teaser rates may not be able to afford their new payments. When those two factors are combined, it seems likely that housing prices will be under pressure during the next year or so and the impact on consumers could lead to a decline in spending that hurts GDP growth. Of course, the direction in housing prices could be positively affected by another round of government tax cuts or stimulus aimed at preventing a further decline in prices. Additionally, banks have the option of working with borrowers to offset the impact of rate resets and limit the number 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.”4 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 reading above 50 suggests that manufacturing is expanding. The WLI, on the other hand, is a composite index of 19 key weekly economic indicators such as home prices, stock market activity and employment trends. Unfortunately, this index has fallen for five consecutive weeks, prompting people who follow it closely to wonder out loud about whether the economic recovery is slowing or the U.S. is heading towards recession. Grey bars in the chart represent recessions and just a quick glance at the picture leads to the unmistakable conclusion that there is some correlation between a large drop in these indices and recessions. Unfortunately, after a 6.9% drop recorded for the week of June 25th, the next week produced an even worse 7.6% decline. For the week of July 23rd, the index plunged 10.5% further (excluding revisions to previous figures). But what is the

The Inoculated Investor

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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 level of -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 and should 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 tax increases imposed in 1932 as one of the main reasons the Great Depression lasted as long as it did. Given that our current leaders are familiar with this argument, there is no way they 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 the recovery? Unfortunately, in this case they may not even have to. If the last administration’s tax cuts expire, the highest marginal tax rate will expand to 39.6% from 35% and the estate tax will reemerge in all of its glory. In a paper written in 20075, Obama’s own adviser Christina Romer concluded that a dollar in tax cuts raises GDP by about $3. However, what that analysis also implies is that a $1 tax increase could reduce GDP by $3. Therefore, with the gridlock in Congress, the ongoing discussions about reducing the budget deficit and the ever louder calls for fiscal austerity, there is a nontrivial risk that tax rates will increase in 2011 and have a negative impact on GDP. Where Has All the Credit Gone? The Federal Reserve no longer tracks the M3 measure of money supply, but John Williams of ShadowStats.com6 continues to provide his own estimates of M3. This measure, which includes M1 (physical currency), M2 (M1+ savings accounts, money market accounts, retail money market mutual funds & small time deposits) 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 Telegraph7, the money supply contracted at an annual rate of 9.6% in Q1 2010, falling to $13.9 trillion from $14.2 trillion. What this means is that despite the Fed’s vigilant efforts to create inflation by doubling its balance sheet, the money supply is still contracting.

The Inoculated Investor

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Falling money supply is concerning because it signals the potential for outright deflation, a decrease in the general price level of goods and services. Ben Bernanke would be the first person to acknowledge that GDP growth is hard to come by when credit and the money supply are contracting. In a deflationary environment, businesses have little access to growth capital because banks reduce their lending activities as a result of increased risk aversion or regulatory requirements. Further, deflation causes the debt burden on consumers to become even more crippling as wages fall and the real cost of debt payments rises. This is why Bernanke vowed to throw money out of a helicopter, if necessary, in order to prevent deflation. But, the Fed Chairman’s dilemma is that banks are not lending and, even worse, credit lines are being reduced for businesses and consumers. Accordingly, Bernanke may have to go door to door with a sack of money in order to produce inflation and growth in spending. A Persistent Dose of Unemployment Data from the July 2nd employment summary8 put out by the U.S. Bureau of Labor Statistics (BLS) indicated that in June there were approximately 14.6 million unemployed Americans. The headline unemployment rate of 9.5% was down from 9.7% in May even though nonfarm payrolls actually dropped by 125,000. How does that work exactly? Well, in June the labor force dropped by 652,000 people. If not for that, the unemployment rate would have been around 10%. In addition, the employment to population ratio fell to a four month low of 58.5% and the number of people who have been unemployed for longer than 27 weeks (with a mean of 35.2 weeks as seen in the aside chart9) came in at 45.5% of the total. Unfortunately, studies regarding long term unemployment indicate that worker skills deteriorate over time and the longer someone is out of the workforce, the less likely he or she is to become re-employed at a similar caliber job. But aren’t things getting better? In reality, the evidence is mixed. The headline unemployment rate has been steadily dropping due to people falling out of the labor force. When those people begin to look for jobs again, the unemployment rate will increase even if employment stays flat. In addition, many of the jobs created so far in 2010 were due to temporary hiring for the U.S. Census, and that hiring has already run its course. Also, just to keep pace with employment-age population growth, the U.S. needs to create 125,000 jobs each month. Therefore, at a job growth rate of 225,000 per month, it would take almost 3 years to re-employ the 8 million workers who have lost their jobs

The Inoculated Investor

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in the past few years. Of course, this is on top of the 125,000 jobs needed to facilitate the entry of new workers. In summary, it appears that at least for now, the U.S. economy has stopped losing jobs at a rapid pace, but the overall unemployment situation is not improving very much. The ultimate risk is that once unemployment benefit payments run out, people will have to cut back even further on consumption and potentially stop paying their mortgages and credit card bills. At that point, the vicious cycle of lower spending impacting businesses and defaults hampering financial institutions starts again, leading to a contraction in both consumption and investment which limits GDP growth.
References 1. http://www.nber.org/cycles.html 2. http://mhanson.com/ 3. http://www.hussmanfunds.com/wmc/wmc100628.htm 4. http://www.econ.berkeley.edu/~cromer/RomerDraft307.pdf 5. http://www.shadowstats.com/ 6. http://www.telegraph.co.uk/finance/economics/7769126/US-money-supply-plunges-at-1930space-as-Obama-eyes-fresh-stimulus.html 7. http://www.bls.gov/news.release/empsit.nr0.htm 8. http://economix.blogs.nytimes.com/2010/07/02/bleak-outlook-for-long-term-unemployed/

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