Love them or hate them, when Goldman speaks you should listen. The Goldman Economic Research team, headed by Jan Hatzius has spoken out on Friday's impressive GDP numbers. Hatzius notes the two recovery "camps" that have emerged among US economic forecasts. The first camp is the "V-shaped" recovery camp which believes the crisis pushed production , employment, and consumer spending to excessively low levels and that economic activity will rebound strongly. Their key piece of evidence is the belief that deep recessions produce strong recoveries:
They illustrate their case by pointing to the historical regularity that deeper recessions have typically been followed by stronger recoveries. Exhibit 1 illustrates this point by plotting the peak-to-trough decline in real GDP against the average growth rate over the two years following the business cycle trough.1 Based on a mechanical extrapolation of the historical relationship, real GDP growth in the current recovery should average nearly 6%. To our knowledge, no forecaster actually predicts such torrid growth, but the first camp views the historical relationship as a strong indication that the recovery should be very solid.
Exhibit 1 of the V-Shaped camp:
Source: Council of Economic Advisers, Goldman Sachs
The second camp is the "U-Shaped recovery" camp, which disputes the relevance of the deep recession/strong recovery argument. They assert that the key issue for any recovery is the nature, not the depth or the recession.
In contrast, members of the second camp dispute the relevance of Exhibit 1. They argue that the key issue for the strength of the rebound is not the depth, but the nature of the recession. Most postwar recessions were due to tight monetary policy that deferred demand and activity in interest-rate sensitive sectors such as residential construction and consumer durables. But once the Fed decided to ease policy, demand in these sectors rebounded sharply, fueling rapid output and employment growth. This would suggest that the correlation in Exhibit 1 is largely due to the fact that cycles with more aggressive Fed tightening produced more pent-up demand at the trough of the recession, and hence a bigger rebound in the recovery. Thus, the second camp believes that the historical correlation between deep recessions and strong recoveries does not say much about the recovery from the Great Recession, which resulted not from Fed tightening but from the bursting of a housing and credit bubble that pushed private demand down from unsustainable levels.
Source: Dept. of Commerce, Goldman Sachs
Now that six months have passed since the trough of the recessions (sometime in mid-2009), does the data support one of these camps? According to Goldman, the evidence is leaning towards the U-Shaped recovery camp. Despite a relatively robust rebound over the last two quarters (keep in mind the substantial revision to Q3 GDP, so 5.7% figure might be coming down), Goldman notes that the recovery has received an unusually large boost from the turn in the inventory cycle.
The inventory cycle only lasts until firms have brought the level of production into better alignment with the level of demand, which typically happens within a few quarters. Since inventory liquidation has already slowed from $160 billion (annualized) in the second quarter to $34 billion in the fourth quarter, most of this boost is probably behind us. As the inventory cycle winds down, this implies a sharp slowdown in real GDP growth from an average of 4% in the second half of 2009 to only about 2% in 2010.
Goldman also points out that the improvement in financial market conditions has been somewhat offset by tightness in bank lending standards. Banks have failed to reverse much of the dramatic tightening in their standards that occurred during the recession. This tightness of lending is counteracting some of the easing in market conditions.
Source: Goldman Sachs, FED Board Senior Loan Officer Survey
We found that is statement the most interesting out of the whole research note:
Ultimately, the contrast between the financial markets and the banks may be settled by the behavior of the real estate markets. If a renewed decline in house prices causes more defaults, banks are likely to keep their lending standards tight; moreover, this would also pose a risk to the rally in the credit markets and could thereby tighten financial market conditions. However, if house prices rebound, credit quality would improve sharply, and this would presumably lead banks to lower their credit standards in order to grow their loan books. This could produce a more notable improvement in private demand.
It appears that Goldman is hinging the sustainability of economic recovery on the recovery in the housing markets. Given the rash of foreclosures that are likely to come during the second half of '10, it seems unlikely that prices will rebound. That then seems to mean lending will stay tight and the rally equity markets seems overbought. It seems evident that the S&P 500 is not currently pricing in 2% economic growth that Goldman is forecasting for 2010.
Click to enlarge
Source: Goldman Sachs
If you believe Goldman then you should be looking to either take some of your gains off the table or look to take defensive or short positions:
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