Recession Talk Has Gone From 'If' to 'How Bad'
It's remarkable how the debate on the economy has shifted in the last week. Previously the speculation was more on IF there would be a recession. This week it's shifted to how bad it will be.
Several times I have noticed, especially in the last few days, the word "severe" being used by thoughtful and respected economists. Nouriel Roubini, an economist at NYU and head of his own research firm, insists we are already in a recession and that it will be severe. There are others who join him in this view, including Bill Gross, head of PIMCO. Martin Feldstein, a Republican economist, also uses the "severe" and "prolonged" words to describe his fears on the current situation. We'll call these folks "The economy is in the tank" group.
To be balanced, there are plenty of others who take the position that we will enter a slow-down but will still avoid an actual recession. This is "The economy is fundamentally sound" group, and it includes everyone in the Bush Administration, many government-paid economists, and some in the private sector.
The scenario of the "economy is in the tank" group usually stakes its position on the world financial crisis related to the subprime fiasco, and its effects on consumer spending. Tied in with the bursting of the real estate bubble and its effects on local economies is a release on Tuesday by the Federal Reserve Bank of Philadelphia: ". . . that the economy shrank in 23 states last month, including Ohio, Missouri and Arizona, and was stagnant in seven others. California and Florida, with their plunging home values, may soon join the recession list." (NY Times 1/23/08)
A further contribution to the downside scenario is the fact that many banks have yet to release the extent of their losses from subprime holdings. This is not a conspiracy, but a reflection of how deeply buried this crisis is in the holding of financial institutions all over the world. They will eventually discover the extent of their holdings, but it will take more time. This leaves policy makers in the dark as to what or how much to do.
There is also the fear that both stocks and real estate prices are too high as currently valued. Real estate prices could continue falling slowly over several more years, and the stock market may continue falling for another 10% or so on large cap stocks. The earnings multiples are simply too high, given the current earnings outlook.
The implications of a recession for investors are profound. If you understand the role that expected earnings play in determining an individual stock's price, then all you have to do is relate the reduced consumer spending that follows closely in the path of an economic downturn. Unemployment is the inevitable by-product of a recession, as businesses who employ people to produce and distribute their products find their unsold inventories piling up. They cut employment, which reduces consumer spending, and a spiral of sorts may be set in motion.
Now, jump ahead of this spiral and forecast what will happen to corporate earnings in a period of rising inventories and falling production. For those firms affected, and it will not be all of them, it is hard on their balance sheets. As their outlook for the following quarters is downgraded, their stock prices tumble. It always happens that way—that is the way the stock market works. Some particularly astute investors may be able to guess which firms are most affected by the downturn and stay away from them as they increase their holdings in those firms that may not be affected.
This is also true of sectors. Some sectors are more adversely hurt than others. If you know which are which, then you can do better than the average investor in the downturn. I can't tell with any accuracy, and I don't know anyone who can, but there is never a shortage of those who say they can.
There are also the effects on the international markets. We talked for quite a bit over the last few years of decoupling, which states that now the economies of the world are more self-sustaining than in the past, so that an American slowdown will not necessarily drag everyone else in the world down. This may or may not be true—we can only guess. But it is hard for me to believe that there is a complete decoupling. What happens here will affect the rest of the world, to some degree. And some will be more affected than others. Mexico, for example, is hard to decouple, as is Canada—they being our biggest trading partners. So I take with some skepticism the claim that we will not affect the rest of the world.
The only question remaining is, will monetary policy and fiscal policy be effective in reducing the severity of the recession, if one occurs? Many hold the view that it is already too late for monetary policy to prevent a downturn. What the Fed did Monday morning will help, but many feel it is too late and not enough. As for fiscal policy, the proposals offered so far, both by the President and those on the campaign trail, are, as Roubini said, "just peanuts." The $150 billion offered by Mr. Bush is around 1% of GDP. Even Mrs. Clinton's is not far above that, as is Mr. Obama's. Mr. Edwards has a higher figure, but less than 2%. Only Mr. Romney has something around 2%.
In the last recession fiscal policy inducements were as high as 6% of GDP, and they helped keep the recession short and shallow. But, we have no room for this kind of intervention this time, given the huge budget deficit. Contrast the situation now with the multi-billion dollar surplus we had to play with at the start of the 2000 recession, and you get the picture.
Also, keep in mind that most fiscal policies have a long lag time. Even monetary policy may take six months or so to work its way through the economy and produce good results. This does not leave me with a strong feeling about the economy or the stock market for the first half of 2008. If it does fall, I hope it will begin to recover by the second half of the year, but there are possible scenarios that say it will be worse than last time. I don't make this as a forecast, but it does weigh heavily on my mind and on my investing outlook for this year.
Disclosure: Author is long SPY, DIA, FXI, EFA and EEM.
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This article has 5 comments:
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johnheiderscheit
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5 Comments
Jan 24 06:22 PM-
steven West
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5 Comments
Jan 25 01:42 AMsorry Ray you have the story wrong wrong wrong.. lets see Unemployment is historically low, interest rates are VERY low - oil is coming down hard, inflation is tame, Earnings are mostly beating ( ex- financials) and companies have more cash on their balance sheets than ever before
REPEAT AFTER ME : THERE IS NO RECESSION..
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Robster
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45 Comments
My Website
Jan 25 04:08 AM-
Danial Magid
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9 Comments
Jan 25 02:27 PMGreat article. I really don't need to follow any posted inflation stats. All I need to do, is go to the market and see how much I pay for groceries vs. how much I paid for them 2,3,4 and 5 years ago. We are certainly experiencing a higher than normal/healthy inflation! The stimulus package will surely not help, but at least it puts a little money in people's bags, so they can sleep better for the next 4 months.. awaiting the check :) The real problem is with affordability and disposable income. Until those home prices drop significantly, consumers hands will be tied and as we can already observe, low funds rate does nothing for consumers, it is simply out there to help banks stave off a bankruptcy.
Empirically, speaking to friends, I have noticed that DINKS (double income no kids) can't even tell that most consumers are in rough waters.
Well written, Ray.
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Ray Hendon
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65 Comments
My Website
Jan 25 04:29 PMjohnheiderscheit and seven West, it is never the absolute rate of employment or unemployment that we look to as signs of recessions; it is the rate of change. I'm afraid that today's unemployment rates are almost a full point higher than this time last year. This is not a good trend. Also, keep in mind that unemployment is a lagging indicator, not a leading one.
The same is true for inflation. It is at a higher rate this last year than in previous years--again, not a good sign. Also, consumer spending, the ultimate culprit in our drama, has not held up well. December sales were far from robust--an ominous sign, to me.
But, I hope both of you are right. I certainly don't want a recession. Although I am free of job market constraints myself, it never does my portfolio any good to go through a downturn.
robyt and Danial Magid, thanks for the good words. And, thanks, Danial, for introducing me to a new acronym, DINKS.
Best wishes,
Ray