It becomes clearer every day that the economy is headed for a renewed recession or a recovery so slow it will seem like one. Initial unemployment claims climbed to 500,000 last week for the first time since November while the Philadelphia Fed index dropped below the zero line for the first time since July 2009. This follows a pattern of generally softening economic data over the last two or three months.
As we have long expected, the economy is tracing out a trajectory typical of a balance sheet induced recession rather than the garden-variety inventory recessions typical of the period since the end of World War ll. In a balance sheet recession the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy as is happening now, and the economy undergoes a lengthy period of deflation, sub-par recoveries and frequent slowdowns as the U.S. experienced during the 1930s and Japan over the last 20 years.
While the massive stimulative measures undertaken by the Fed, Congress and the White House have succeeded in averting a financial collapse, they are being more than offset by the deleveraging now taking place. The effects of inventory replenishment are winding down without any other major drivers to sustain growth. Typically a new economic expansion is led by inventories, consumer spending, employment, housing and readily available credit. This time only inventories have performed their usual function, meaning that the economy has been acting on only one of five cylinders.
The Fed has already used all of its conventional weapons and will undoubtedly resort to untried unconventional measures with unknown outcomes and the possibility of unintended consequences. The most likely measures will probably be further large purchases of Treasury securities and mortgage bonds together with a ceiling on Treasury bond yields as outlined in Chairman Bernanke’s famous 2002 speech that earned him the nickname “Helicopter Ben”. This is commonly referred to quantitative easing or QE2. We doubt, however, that this will have any more effect than QE1 as it would be more than offset by debt deleveraging in the private sector.
We also believe that the market is currently too complacent about the global economy. China is attempting to prevent a bubble by engineering a soft landing that will at best result in a substantial slowing of imports, and at worst a full-fledged recession as often happens when governments aim for soft landings. Japan, too, is undergoing renewed economic weakness following two decades of deflation and minimal growth. Europe is going through a short period of temporary calm after the EU and the IMF threw a lifeline to the struggling southern tier. However, the authorities have failed to deal with the underlying structural debt problems that will continue to be a major problem while the austerity measures that that are being implemented will be a major drag on the various economies.
For example the German magazine, Der Spiegel points out that the austerity measures applauded by the EU are already having dire effects on the Greek economy. The Greek government has reduced its budget deficit by an astounding 39.7% and spending by 10%. This has had a drastic effect on income, consumption, employment and bankruptcies, leading to a “mixture of fear, hopelessness and anger”. According to the article another wave of layoffs is likely in the fall and this could have “extreme social consequences.” Such an outcome could come as a severe shock to a U.S. market that has factored in a quieter Europe.
In sum, we believe that the market is still discounting a continued U.S. recovery as well as a supportive global economy. In the current climate such hopes are likely to be disappointing and corporate earnings estimates for 2010 and 2011 will probably be revised down sharply. The market peaked in late April and is now trending down amid a lot of volatility.