Green Shoots Turning Brown: Setback or Volatility?

Forecasting is tough, especially about the future, runs the old joke. But the dark art of prognosticating these days is no laughing matter.

Case in point: The burning question at the moment is whether the so-called green sheets of economic recovery turning brown? It's getting harder to answer "no" these days. It's not clear if we're headed for a second slump, but the risk has gone up a bit in recent weeks. The hope that the economy had at least stabilized looked increasingly persuasive over the past several months, a trend that inspired the hope that the recession might soon end.

That's still our view, although the transition from the end of the contraction to robust economic growth threatens to be a long and rocky period, as we've discussed, including here. But the outlook on the economy is in continual flux. As new information arrives, strategic-minded investors adjust their forecast and perhaps their asset allocation. No wonder, then, that expected risk premiums vary through time. Unfortunately, the current view for the economy looks a bit less encouraging these days; or, if you prefer, the future is a bit more problematic relative to what looked likely from June's vantage. In any case, the green shoots have wilted, if only slightly.

But it's too early to expect the worst (again). Indeed, the catalysts that brought us the first round of optimism are still alive and kicking, namely, massive liquidity injections on the fiscal and monetary fronts. What's more, it's clear that these twin doses of stimulus have been critical in stabilizing the economy, which is to say keeping a deep and protracted deflationary virus from spreading. But as we've discussed all along, pulling the economy back from the precipice is one thing. As policy prescriptions go, that was relatively easy. Figuring out how to play the game in the second half, however, promises to be much more nuanced and therefore difficult.

Promoting economic growth, in short, is quite a bit harder than staving off implosion of the financial system. All the more so in the deepest recession since the 1930s. No wonder, then, that as we move into the next phase of this crisis, the signals emanating from the economy won't seamlessly dispense rising doses of good news.

One example comes in today's Wall Street Journal, which advises that the generally encouraging decline in initial jobless claims in recent months may not be as potent this time around. The reason: new fillings for unemployment benefits "typically fall fairly sharply after peaking. Instead, they have hovered above 600,000 for an unprecedented 22 consecutive weeks," writes the Journal's Mark Gongloff. The implication: this data series may not be signaling the recession's end after all, as it has in business cycles over the past 40 years.

But shortly after the Journal article appeared this morning, the Bureau of Labor Statistics offered its weekly update, reporting that seasonally adjusted claims fell by a hefty 52,000 for the week through July 4, dropping to 565,000. That's the lowest since January. Of course, last week's fall may simply be a one-time drop tied to the Independence Day holiday. Stay tuned.

More broadly, the recent readings of economic activity have been sagging. One example comes by way of the Aruoba-Diebold-Scotti Business Conditions Index, published by the Philadelphia Fed. The latest reading of the index, based on data available as of July 2, shows a notable downturn relative to previous weeks.

Meanwhile, the yield on the 10-year Treasury and the price of oil have both fallen in recent weeks, suggesting that the economic outlook has softened.

Or perhaps markets have just gotten ahead of themselves. Since March, the capital and commodity markets have been pricing in economic stability if not recovery. The question, then, is whether these trends signals something more troubling, or merely represents a pause that refreshes?

Warren Buffett favors the former interpretation, arguing that more stimulus is needed. Yet it's not clear if the White House or the Congress agrees…yet.

The transition from the apocalypse to the post-apocalypse world was always sure to be a confusing, perhaps more so than some of us thought. Nonetheless, we're still optimistic that the

technical end

of the recession is near. Unfortunately, we're a bit less optimistic these days. At the same time, we're more confident that reaching the promised land of recovery will be a tougher trek than it appeared last month. Rest assured, this outlook too will change. Let's hope it changes for the better.

Comments

[Larry House:]

I hate to see that your optimism is based on government stimulus to the economy. Would you rather feel better for a while because of a drug or be cured? Stimulus is no cure. We need to work through this crisis if we want to be healthy. To our shame, we are a feel good, quick fix society that has lost some moral fiber.

Jul 09 02:19 PM

[Mad Hedge F...:]

Here's an angle. CNBC held a dynamite interview with David Rosenberg, former Merrill Lynch chief economist and current strategist at Gluskin Sheff, who offered the kind of big picture, 30,000 foot view that I love. We are well into an epic post bubble credit collapse. Deleveraging in the private sector is dramatically overwhelming any fiscal stimulus Obama can throw at it. The $50 trillion US household balance sheet is shrinking at an unprecedented rate. The unemployment rate will easily sail through 10.8% to a new high and spill over to a higher foreclosure rate. We’ve had two decades of baby boomers living beyond their means, and it is now time to revert to the mean. The stock market has already priced in an earnings recovery which we won’t see until 2012 at the earliest. Bull markets move in perfect 18 year cycles, and we are only half way through a generational washout in equity ownership that started in 2000. “Buy and Hold” is dead. An S&P 500 trading around a 13 multiple means will be stuck in a 650-950 range for years, and that’s being generous. Rent, don’t own stocks. The one place to be is commodities, because they will be underpinned by the undeniable demand coming from Asia, and have benefited greatly from consolidation. The big “Tell” here is that in last year’s huge sell off , they all bottomed at the previous cycle’s peak prices. It’s nice to hear someone reading from the same sheet of music as I. Too bad Merrill Lynch didn’t listen to David. Wow, do you think I should be selling rallies here at 886?

Jul 09 03:47 PM

[tobi:]

I agree with the bigger picture, but sadly the big stories seem to matter on a year to year basis at most, it was long clear that the american trade deficit and inbalances toward asia with all the macroeconomic problems and middle class slashing that goes along with it will undermine a society fundamentaly. I doubt americans just loved credit and were more consumerist than other nations, it was simply that people did not have other money to spent because inflation adjusted wages were stagnant or declining and jobs disappeared. As society grew more unequal, the pressure to hold your standart and set yourself apart grew and people started abusing credit. The problem is simply a chinese factory worker can not even afford the pair of shoes she manufactures and neither could people here anymore without their credit cards. That is the most fundamental underlying problem to face in the long term.

Jul 09 05:11 PM