ECONOMIC INSIGHTS
Charting The Business Cycle
GDP is still weak but not nearly as weak as it was in late 2008 and the first quarter of 2009. Given all the stimulus that has been thrown at the economy, there will be a recovery. But what will it look like? EI sees a number of possibilities. We call them the alphabet recoveries.
First, there is the V-shaped recovery. This is where a sharp decline is followed by a sharp rebound. Hardly any forecasters expect this type of outcome. Yet, that is what has typically occurred. Shallow recessions have been followed by weak recoveries and deep recessions, like this one, have been followed by strong recoveries. Deep recessions tend to purge the problems that caused the recession in the first place setting the stage for strong growth. For example, in the first year after the shallow recessions in 1990-91 and in 2001 GDP grew an average of just 2.8%. But in the first year after the severe recessions in the mid-1970s and early 1980s GDP grew an average of 7%.
Another choice is a W. There is a temporary upturn as the economy gets a jolt from all the stimulus but it quickly wears off and there is a relapse. This type of cycle occurred in the early 1980s. There is also the possibility that we get a variation of the W. It isn’t really a letter but try to visualize something like the first half of a W followed by a flattish or horizontal line. In other words, the economy rebounds but then flat lines. The initial benefits of the government stimulus are offset by constraints such as the effects of deleveraging as the huge debt burden on the economy in general and the consumer in particular weigh on growth.
Another choice is an L where the recession ends but the economy doesn’t respond for years. Instead, it creeps along the bottom with painfully anemic growth. The precedent for this outcome is Japan that experienced “the lost decade” after its stock market and real estate bubbles burst in 1990.
Finally, there is the U. Eventually, the economy does experience a reasonable recovery but only after an extended period of sub-par growth. Consumers, who drive the economy, decide to prepare for an uncertain future by saving more and spending less because they have learned that neither their 401(ks) or home values are the source of saving they once were.
Where does EI come out on the alphabet recoveries? That is discussed in our monthly newsletter to clients.
The ISM index is a good barometer of what is going on in the highly cyclical manufacturing sector. It is based on responses from purchasing agents in a wide range of industrial firms that have their fingers on the pulse of the economy. Given the cyclical nature of manufacturing, it is not surprising to see such a plunge in this index during such a severe recession. Manufacturing production has declined much more than GDP.
There is depression like conditions in the auto industry which is still an important part of manufacturing. Equipment output is the largest segment of manufacturing and it has been hurt by cutbacks in capital spending. Then there is the freefall in the housing sector that has impacted manufactured goods related to home building and home sales. Add it all together and it is easy to see why manufacturing has been so hard hit.
But the hopeful news is that, given the recent pattern in the ISM index, manufacturing is headed for some redemption, as is the economy in general. The ISM index hit its low in December 2008 and has staged a modest revival. The index has bottomed out prior to or coincident with each of the last eight recessions. The average lead-time has been three months.
The long slide in housing began in January 2006. The plunge has been devastating for the economy. The fact that housing topped out two years before the recession hit is not that surprising because housing has always been a very long leading indicator. On average, it has been topped out nine quarters before recessions. Since it led the economy into the recession, it will have to lead it out.
It is not just the freefall in demand for homes that is important, it is that home prices are down double digits from their peak in 2006. Housing has been at the core of the economy’s problems since day one and that continues to be the case. Unfortunately, the rescue packages by the government and liquidity injections by the Federal Reserve have not been able to turn housing around. The basic problem is one of excess debt. A lot of people who never had any plausible chance of repaying their loan were granted mortgages.
Foreclosures have soared and that has had a devastating effect on prices. As prices fall, a larger and larger share of homes are worth less than their mortgage. That results in even more foreclosures and so the vicious circle goes. Homebuyer psychology is negative because they keep hearing how bad the housing market is. So they sit on the sidelines waiting for prices to fall further. No one wants to buy a home and find out a few months later that it is worth less than what they paid for it.
The encouraging news is that sales are beginning to stabilize. Also, affordability has shown marked improvement. That is because of low mortgage rates and much lower home prices. Nevertheless, affordability is only part of the story. The affordability measures do not reflect the big decline in household net worth. Also, borrowers are reluctant to take on more debt because their balance sheets are so stretched. Unemployment is also a big problem as is the fact that credit is difficult to come by. These negatives continue to weigh on home demand regardless of what the affordability measures tell us.
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