Short and Shallow or Long and Deep

The combination of aggressive Federal Reserve rate cuts and Washington’s fiscal stimulus would suggest officials believe a recession has begun. The media also seems to be playing up the recession story. It would seem like a forgone conclusion, but it is not, no matter how loud the talking heads on TV scream about it or how many times the word recession is used in the press. In fact, because of the lack of an agreed upon definition of recession in real time, it might be best to avoid its use. Across asset classes, the main issue is what kind of landing the US economy will experience. Will it be short and shallow or long and deep?

The case for a long and deep downturn is clear. Although there were some observers who had been playing up the risk of a hard-landing for the US economy before the end of last year to be sure, such a prognoses appeared limited to a vocal minority. What really caught the market’s imagination were three economic reports for the month of December: a weak jobs report, a drop below the 50 boom/bust level for the ISM manufacturing report and a decline in retail sales.

Subsequently there has been other data that pointed to a hard landing. There is the evidence, including the Fed’s own survey of senior lending officers, confirming a tightening in credit conditions. Leading economic indicators have declined for three consecutive months through December, which is another rule of thumb signaling a recession. The wealth effect of falling equities, which by midweek had seen nearly $2 trillion of market capitalization disappear since the start of the year and falling home prices is also seen as a shock to the system.

Of course, these developments are taking place after a series of other negative shocks like the rise in oil, gasoline, and heating oil prices. The housing market remains depressed. Corporate profits have been crushed and financial intermediaries have reported nearly $100 bln in write-downs, losses, and loan-loss reserves. Through January 24th, the S&P 500 companies that have reported Q4 earnings have seen a 45% average drop in profits.

Former Federal Reserve Chairman Alan Greenspan has opined that the risks of a US recession have increased to better than 50/50, but there is a reason why he told the Financial Times that “the hard data that we are in a recession is by no means conclusive.”

Weekly initial jobless claims have been much lower than one would expect if the US economy were contracting. In fact, the strength of this admittedly noisy time series suggests that US jobs growth rebounded in January. Job growth could be 3 to 5 times greater than the 18k reported in December, which is subject to revisions. A net rise of around 100k in non-farm payrolls would single-handedly take the recession talk down a notch or two. That said, job losses in construction, credit intermediation and real estate sectors look set to continue.

Noted economist Martin Feldstein, who heads up the National Bureau of Economic Research, which is the entity that is the official arbiter of recessions in the US, has long warned that the US was likely headed for a recession. He had been an early advocate of a fiscal stimulus plan. However, he argued it should be drawn up but not implemented until private sector jobs fell three consecutive months. Private sector payrolls fell in December for the first time since around mid-year 2003. An increase in this time series would also suggest hard landing talk may be getting a bit ahead of itself.

Often past hard landings for the US economy have taken place when monetary policy is tight. This does not seem to be the case now. The Fed began cutting rates nearly 5 months ago and real rates (adjusted for inflation) are below zero. This applies not just to the Fed funds but also to nearly the entire US Treasury curve. It is not just the price of money that suggests that Fed policy is not tight, but the supply of money (M2) has also accelerated in recent months.

Another imbalance that is often associated with hard landings is excessive inventory accumulation. This also does not seem to be the case at the present. Automakers reduced inventories in the fourth quarter and this would seem to minimize the need to cut production in Q1. Overall business inventories are relatively low compared with sales. The inventory-to-sales ratio is at the lower end of a multi-year range.

The US dollar remains weak, even though it has stabilized in recent weeks against most of the major currencies. The US dollar is well below its purchasing power parity level (according to data from the Organization of Economic Cooperation and Development), which is that level that economists say currencies gravitate around in the long-run. The OECD calculation suggests the euro is as much as 27% overvalued and sterling is almost 30% overvalued against the dollar. By this measure, the dollar is about 14% undervalued against the Japanese yen.

US exports have been expanding at a double-digit year-over-year pace with only one exception last year (Feb). In recent quarters, the net export function has contributed almost as much to US growth as residential construction has subtracted from it.

While leading economic indicators have fallen for three consecutive months, the coincident indicator rose in both Nov and Dec after being flat in Oct. This would suggest that if the US economy is contracting, it did not begin to do so in December. And thus even before the purported contraction of the economy began the Fed had slashed interest rates by 100 bp and now has cut another 75 bp with an additional 50 bp likely to be delivered on January 30 at the conclusion of the FOMC’s two-day meeting.

Although there has yet to be a final agreement, the government is moving toward a fiscal stimulus package and as currently constructed, it may help boost the economy on the margins in the second half. There have been some reports that the Senate may not be fully aboard the apparent White House-House of Representatives deal, but given the political cycle the risk seems to be for a larger package rather than a smaller one.

Given the monetary and fiscal stimulus in the pipeline and the fact that real interest rates and inventory levels are already quite low, there still seems to be good reason to expect that the economic slow down is short and shallow rather than long and deep. The US reports the preliminary Q4 GDP estimate on 30 January, a few hours before the FOMC announces its decision. The Bloomberg consensus is that growth was about 1.2% at an annualized pace. Growth in Q1 might not be that far from that either, according to early estimates. If this is even close to accurate, it is difficult to see which two quarters will print negative numbers.