The Great Recession is over - but dont expect a boom

I am confident the economic data will show that the US recession ended in June or July, or at the latest it will be August. Of course that is an economist's technical view of an "ending". It wont feel like it has ended for many people as people will still lose jobs, companies will still go down and the good times pre-2008 will take a long time to return.

But this is almost conventional wisdom now - everyone believes that the economy could show a temporary lift but will then subside again - as over-indebted consumers struggle to boost their savings and business holds back on investment. My guess is that this pessimistic medium-to-long term outlook will fade in coming months because the upturn will be much stronger than people realise. BUT THE UPTURN WILL ONLY BE STRONG FOR A WHILE. Then it will fade again and we will be in for a new dive in confidence.

So why such a strong upturn? First, there is the inventory cycle which has been much misunderstood in my view. Companies dont have to rebuild inventory to create an economic lift, they merely have to cut inventory at a slower rate. But to cut inventory at a lower rate requires an INCREASE in production. It is only because production has been lower than sales that inventory has been running down.

Then there is the government effort. Eventually all that stimulus spending has to have some impact and it looks like the second half of the year is it. Also the cash-for-clunkers scheme is getting people spending.

So I dont rule out GDP reports of 4%, 5%, 6% or even more by Q4. This could be enough to get everybody throwing out the pessimism and talking of a V-shaped recovery. But I dont think so.

Watch final demand - which means consumer spending (including cars), housebuilding and business fixed investment spending. Unless they show meaningful improvement the recovery will slow down again. I think that will happen in 2010.

US recession likely ends this month

US recessions are always heavily influenced by the inventory adjustment and the current recession has been so severe partly because of an unusually violent inventory cycle.

Some analysis focuses on the inventory/sales ratio and, finding it still high, concludes that the inventory adjustment has a long way to go. But the inventory/sales ratio is high because business sales are so low.

Companies have cut orders drastically as they struggle to cut inventories. Once they have reduced inventories to a comfortable level they will raise orders again to keep output in line with final sales and so keep inventories stable. That in turn will show up in a rise in business sales, taking the inventory/sales ratio lower.

A better way to assess the inventory cycle is to look at inventories in relation to GDP. Overall, business inventories were down 9.2% or $139 bn by May, compared with the peak in August last year, taking inventories back to July 2006 levels. Meanwhile monthly business sales were down 29% over the same period, or $225 bn. As a result inventories have been reduced to a record low relative to GDP.

Reaching a record low for the inventory/GDP ratio is not a huge surprise. The long-term trend is down anyway and the shock of the current recession as well as deep pessimism on the sales outlook and problems in obtaining credit for some companies, clearly point to inventories being pared to the bone. That is why I expect this ratio could go lower still as data emerges in coming months.

But remember that the data we have so far is for May. I reckon inventories fell again in June and will most likely fall again in July. Industrial production was down again in June, by 0.4% mom, (though of course it did not even need to fall for inventories to go down since production was already below final sales).

We also know that GM and Chrysler have had many plants closed in recent weeks as they work down auto inventories. One reason for seeing July as the low for the economy is that most of those plants will be open again in August helping to lift the economy.

Once business no longer needs to shed inventories, orders rise and GDP picks up. The ISM manufacturing new orders index has been around 50, the neutral level, for three months now. If I am right, look for it to move clearly higher in the next couple of months. The ISM Manufacturing index itself should soon follow.

This recession officially started, according to the NBER, when the ISM first dipped below 50. Another important indicator, one that the National Bureau of Economic Research gives particular weight in its assessment of the timing of recessions, is industrial production. That should show the first increase in either July or August.

Finally, to back up this view look at the leading indicators index. It rose strongly in April, May and June. Three strong increases as well as the jump in the 6 month rate of change is usually a good indicator that the economy is about to turn.

As always, there is a reservation – the index has improved almost entirely due to the expectations components of the index, particularly the stock market and yield curve. I would certainly not ignore market and consumer expectations but they could be premature. Still, the leading index has signalled well in the past and it supports the rest of our analysis.

The inventory cycle can provide only a temporary lift. Once companies have stopped cutting inventories they need to be confident of a rise in final demand to follow through with further increases in output.

As I have argued repeatedly, final demand is likely to stay weak for some time. Consumers enjoyed a 4% rise in real disposable income between November and May (not annualised), largely courtesy of higher social security payments (due to indexation adjustments), tax cuts from the stimulus plan and lower gas prices. But almost all of this extra income was saved.

In the latest couple of months real income growth has probably gone negative as miniscule new gains in earnings are eaten up by higher gas prices. I think the savings rate will move higher still, probably to the 8-10% range, from 6.9% in May, implying very weak consumer spending in coming months. The US consumer is still making the adjustment away from high borrowing based on a housing bubble. Even though I do see the economy recovering, house prices will likely continue to fall for another year, keeping up the pressure on both households and banks.

Will Quantitative Easing Work

The critical questions for monetary conditions going forward are whether/when quantitative easing (QE) will succeed in boosting the economy and when and how it will be withdrawn. Nobody knows where Agency and Treasury yields would be without QE but I think the Fed is content that Agency spreads over Treasuries have come back to about 55bps compared with 90bps and higher in January while 10 year Treasury yields have held near 3% despite very heavy issuance.

In theory QE works by pulling down long term yields and then lowering risk spreads as investors go out on the maturity and risk spectrum. This, in time, should lead to more borrowing, lending and spending. A rise in stock prices is also to be expected and, hopefully, the rally we are seeing is part of the process. However, the time lags for QE are probably the same as for monetary policy generally, long and variable. Much also depends on confidence.

Assuming the economy is expanding again in 2010 how quickly will the Fed move to reverse course? I expect that the Fed will move slowly because of the danger of a sudden lurch higher in long-term yields. To reduce the danger of such a rise, the Fed will probably want to withdraw much or all of the QE purchases made this year before it starts raising the Funds rate. The Fed might even give guidance that it will be in no hurry to raise the Funds rate. This would help to anchor short rates at low levels for longer and if inflation is between 0-1% as we expect, there will be little risk in doing this.

A further way to reduce the tendency for long yields to rise sharply would be for the Fed to hold on to some of the long term bonds and instead sell shorter debt into the markets. I do not expect a rise in the Funds rate until 2011.

My views on Canadian house prices

I recently provided a guest blog on MSN Sympatico Finance arguing that Canadian house prices would fall 30%. It generated a lot of comments with about half agreeing and half angry that I am talking down the market.

http://everydaymoney.finance.sympatico.msn.ca/2009/04/most-canadians-too-complacent-about-housing-prices.html

A few days later I did a follow up, disagreeing with those doubt a market decline and arguing that there are always cycles. I further argued that the time from top-to-bottom could be several years.

http://everydaymoney.finance.sympatico.msn.ca/2009/04/calverley-responds-to-your-housing-comments.html

Inflation or deflation?

The combination of a double digit fiscal deficit with Quantitative Easing by the Federal Reserve Board, i.e. printing money is potentially inflationary. A few die-hard monetarists are already forecasting a surge in inflation within the next 18 months, while many economists are concerned about the long-term risks. So is the economy going to bring us deflation or is the government going to create inflation?


Inflation arises in three possible ways. First, there is the danger of an overheating economy, when the economy is operating at full capacity and unemployment is low, so wages and prices are bid up by shortages. Fortunately, or more likely unfortunately, this scenario is years away and, if we get anywhere close to it in a hurry the Fed will be raising rates to head it off. Our expectation, however, is for a sluggish economic recovery, with no risk of an overheating economy.


The second way inflation develops is when investors lose faith in the country’s economic policy, particularly fiscal policy, leading to a collapse in the exchange rate, driving imported inflation. But we believe US policy-makers will recognize the limitation on fiscal policy (as the UK government has already been forced to do) and not allow a currency crisis to develop. There is another problem with the dollar collapse scenario. What is it going to collapse against? If the US economy is weak, Europe will be weak and indeed much of the rest of the world too. So, unless the US economy and policy balance looks a lot worse than other countries, the US dollar can certainly weaken but looks unlikely to collapse.


The third route to inflation is when an economy becomes locked into a wage-price spiral, despite a weak economy, as happened in the 1970s. But in that era unions were strong and wage contracts were frequently indexed to inflation. At times, too, there were formal prices and incomes policies which locked wages and prices together in a rising spiral. But in the modern globalised world, international competition is intense and unions are weak. A wage-price spiral therefore looks unlikely unless protectionism becomes much more of a problem than we expect.


All in all then, it is not easy to see the mechanism for inflation to take off again. Of course monetarists argue that all the quantitative easing will inevitably feed into higher spending and higher asset prices. Let us hope that they are right and it does indeed cause the economy to recover. But this will not necessarily unleash inflation, rather it will help the recovery to get underway as business responds by increasing sales and boosting capacity. Moreover, even if inflation does start to pick up again in 2010-11 it will be from a low level. The Fed will have plenty of time to respond by raising interest rates before inflation gets out of hand.


So, rather than worry about inflation moving back up to 3% or higher, the greater risk is almost certainly deflation. Past experience suggests that inflation finally bottoms some 2-4 years after the economy starts to recover . This is because, although output is rising again there is still plenty of slack in the economy. Unless we enjoy a very robust economic upturn in the next couple of years, the pattern is likely to be repeated. Thus sometime in 2011-12 we should expect a major deflation scare. We saw something similar in 2003 (almost two years after the recovery started from the 2001 recession). Then, the core inflation rate dipped to about 1% and US 10 year yields fell to 3.1%. This time, the risk is that we see outright deflation.

Themes from my new book

My book 'When Bubbles Burst: Surviving the Financial Fallout" has just been published (Nicholas Brealey, 2009). I have set up this blog to follow up on the book's themes as the financial crisis and recession unfold. What follows here are the Key Messages from the book:

-First of all BUBBLES MATTER. They have become the driver of booms and busts in economies around the world over the last 20 years and, this time, have nearly destroyed the banking system while causing probably the worst recession since the Second World War. That bubbles matter is widely accepted now (though it wasn't when I published the first edition of this book in 2004).

CAUSES OF THE CRISIS
-The prime cause of the financial crisis and economic downturn was the US housing bubble and the way it was financed.

-The US housing bubble was part of a worldwide housing boom and was the leading edge of a wider credit bubble which led to excess leverage and under-pricing of risk. But the primary mistake, and still the source of most of banks’ losses, was the belief that house prices would not fall back.

-The UK is suffering badly because of its own housing bubble and the weakness of the financial industry, London’s leading sector.

-The extent of other countries’ downturn is dependent on two factors: the size of their own housing bubble (especially bad in Spain, Ireland, Iceland, New Zealand, Australia, parts of Eastern Europe but also a problem in many other countries including China and Canada); and the extent of their dependence on exports, (a major problem for Singapore, Hong Kong, Taiwan in Asia as well as commodity producers worldwide).

-The origins of the housing bubble go back to low interest rates, BOTH short-term and long-term, which can in turn be traced back to earlier bubbles. Low short-term rates in the US (and the UK and elsewhere) in 2001-4 were put in place to deal with the aftermath of the stocks bubble. Low long-term rates were the consequence of capital inflows from Japan and East Asia due to their excess savings. This excess savings (with the exception of China) follows the collapse of their bubbles in the 1990s.

-Lax regulation was a major cause of the crisis, though much of the problem was poor implementation rather than inadequate rules. Allowing banks to have off-balance sheet assets which were not truly off-balance sheet was one major mistake. Another was the US Federal Reserve’s failure to regulate the sub-prime mortgage market.


OUTLOOK FOR HOUSE PRICES
-House prices in both the US and UK are likely to fall at least 40% peak-to-trough. This will take them back to sensible valuations in relation to incomes and rents but there is a risk of an overshoot on the downside.

-House prices in Canada (where I live now) should fall a bit less, maybe 30% on average, with the biggest falls in the West (Vancouver, Calgary, Edmonton).

-The adjustment in the US is already well-advanced. Latest data (Case-Shiller index) show about a 29% drop so far, but prices have been falling rapidly through the winter so the total decline will already be nearer 35%, because the data lags by several months. The UK adjustment started a year later and has much further to go. Canada started even later.

-House prices are falling world-wide currently and will continue.

-A key driver of falling home prices is tighter credit requirements, particularly the need for higher down-payments. Others are foreclosures (especially in the US), rising unemployment and negative price expectations.

-More than one-third of Americans and one quarter of Britons will end up with a mortgage loan greater than the value of their home.


ECONOMIC OUTLOOK
-We are in a worldwide recession, which could be the worst since the Second World War for the US and Europe. Tighter credit and lower asset values have triggered a widespread cutback in consumer and business spending. A sharp inventory recession in the US and Europe is being transmitted around the world through the global supply chain.

-Highly active government and central bank policy as well as the natural cycle should mean that 2010 is a year of recovery, with the first signs probable before end-2009.

-But in the US and UK the recovery is likely to be weak with unemployment rising into 2010. The upswing will be held back by consumers’ desire to increase their savings rate from the low levels during the housing bubble. Asia should recover more vigorously.

-Deflation is likely in the US but may be avoided in Britain through the lower pound. Wage growth will slump in 2009-10 as salaries are frozen or cut, while company pricing power will be very limited and commodity prices will stay weak. The US will likely experience deflation (on core indices) in 2010.


GOVERNMENT POLICY
-Measures to prevent the full adjustment in house prices are doomed to failure and could delay economic recovery. There will be a case, however, for trying to avoid a major price overshoot through policies such as mortgage modification.

-Hyperactive monetary and fiscal policy will be slow to gain traction because the monetary transmission mechanism has been broken by the credit crunch while tax cuts will mostly be saved and new infrastructure spending will take time.

-Restoring the financial system to health requires both removing the bad debts and recapitalizing the banks. One, without the other, will not work. This is slowly being recognized but again will take time to implement and will have a substantial fiscal cost.

-The biggest legacy of the crisis will be large fiscal deficits and much higher government debt ratios. Starting probably in 2011 governments will face the huge task of reducing deficits. A period of rapid economic growth would help but, despite the deep recession, this is unlikely as consumers will continue to prefer saving to spending.

-There is little risk of new bubbles in the near future, at least in US and European stock or property markets. But a new regulatory structure, focused more on credit growth, the extent of leverage and identifying bubbles early, is required.

-We need explicit tools to recognize and limit bubbles – for example anti-cyclical capital or reserve requirements. Also, bubbles almost always bring innovations in financing and new lending institutions, so it will be vital to have regulatory agencies able to respond quickly and decisively to changing circumstances.


FOR INVESTORS
-Bear markets in housing typically last 3-5 years so there is no rush to buy. Moreover investors need to remember that just because a property can be bought for half its value a few years ago does not make it cheap.

-Investors should focus on rental yields and not expect a quick recovery in capital values. The book explains how to judge rental returns.

-Although stock markets have fallen 40-50% or more around the world they are not wildly cheap. Some Asian markets were in a bubble in 2007 and even the major markets were pricey then, with profits at unusually high levels. Profits will be very weak in 2008 and only recover slowly after that.

-A new leg down in stocks is very possible. It would damage confidence and hurt the economic outlook but would then open up very good investment opportunities. Investors need to focus on value and take a contrarian approach.

-The decline in asset values since 2007 has upset many people’s savings and retirement plans. It has also opened up a huge gap in company pension schemes which will need to be filled in coming years. The good news is that, from lower levels, there is a better chance of achieving higher investment returns in future.