Rough patch or double dip? That’s the debate going on these days, from executive offices to local malls. Business owners, workers — and yes, even economists — are trying to decide whether the US economy has hit a speed bump or is heading for a collision.
We all know growth is tepid, unemployment is a bear, and housing ... well, stinks. That’s why major Wall Street firms, the International Monetary Fund, and, on Wednesday, the Federal Reserve all slashed their estimates for US GDP growth this year.
Housing remains critical, so I looked up one of the few people who saw the housing bust and financial crisis coming years before they happened: Gary Shilling, economist and author of The Age of Deleveraging. While his steadfast bearishness didn’t surprise me, his blunt assessment did.
“I’m predicting another recession next year,” he told me.
Not a double dip, he emphasized, because we’re already two years from the end of the last recession and 3½ years from the business cycle’s previous peak, in December 2007. Historically, he said, economic expansions last about three years, especially in long down cycles of the kind he thinks we’ve been in since 2000. So he’s looking for a brand new, cyclical recession beginning in 2012.
Many Americans will be forgiven if they can’t see the difference between that and the recovery we’ve been experiencing. That’s Shilling’s point. Usually, deep recessions like the one we just lived through are followed by strong snapbacks, like a growth slingshot.
This time, however, the recovery has been “distinctly subpar,” in his words. “As of the first quarter, real GDP is barely above its peak in the fourth quarter of 2007, whereas earlier recoveries were well above their previous tops 13 quarters later,” he wrote in a recent edition of his newsletter, INSIGHT.
Translation: More than three years after the peak, we’re still not back to where we were.
Problems in the Engine
There are good reasons for that, beyond the particularly tough toll financial crises take on growth. The economy, he says, is like a four-cylinder engine, and a recovery usually requires all four to be firing. They are consumer spending, employment, housing, and the reversal of the inventory cycle.
Shilling thinks only the last is really recovering — i.e., companies that brutally liquidated inventories during the recession have had to rebuild them through boosting production and some additional hiring, as demand bounced off its lows.
But consumer spending has made only a partial comeback, concentrated among more affluent buyers. Everyone else has been weighed down by weak job and income growth, and the continued housing catastrophe.
We have seen some improvement in employment, albeit slow of late, and it’s nowhere near what we’ve had in past recoveries. Mostly employers have just stopped laying people off, and when they hire, it’s often on a part-time or temporary basis.
And then there’s housing. Year after year, many have predicted the bottom of the housing market (and, for the record, I was one of them in 2011), and year after year, housing prices have kept falling. Shilling, of course, isn’t one of the optimists. He’s actually looking for another 20% drop in housing prices before we hit bottom in 2013. (Read more on that here.)
Since housing prices nationally already have fallen by a third from their peak, that means that, if he’s right, they’ll end up a stomach-churning 45% off their early-2006 highs. Yale professor Robert Shiller, co-creator of the Standard & Poor’s/Case-Shiller Home Price index, has a similar prediction.
For Shilling, it’s all about inventories: He estimates there are upwards of 2 million homes on the market that people want to sell, but can’t. That has deflated housing starts, which now stand at about a third of their normal 1.5 million a year.
From a high 6.3% of GDP in the fourth quarter of 2005, residential construction now represents only 2.2% of GDP. Not only is that a half-a-trillion-dollar gap — housing’s volatility makes it an important force in a cyclical recovery, said Shilling, and the paucity of new home building has clearly taken a toll on this one.
A further 20% decline in home prices would raise the percentage of homes worth less than the value of their mortgages to a stunning 40%, from the mid-20% range now. Shilling estimated it would also cut homeowners’ equity to a mere 8% of total home values, from 19% now and 50% in the early 1980s.
Lenders have foreclosed on 3.5 million American homes since 2007; Shilling expects millions more foreclosures in the years ahead. If this happens, “you know what that will do to consumer spending,” said Shilling. “That’s a recession — an easy forecast.”
And once housing markets hit bottom, it can take a decade for them to recover, as in Texas after the oil bust or Southern California after the end of the Cold War. That could mean subpar growth — average annual GDP gains of 2% — for years to come, he predicted.
What Can Be Done?
The government and the Federal Reserve have thrown everything at the economy, with minimal results. The Fed’s quantitative-easing programs did little except boost commodities prices and stimulate the stock market, he said, and he thinks the commodities mini-bubble already has burst.
The Obama administration’s own attempt to “fix” the housing market — the Home Affordable Modification Program — was, in Shilling’s words, “a miserable failure.” (Read Howard’s report card on President Obama’s economic policies and grade him yourself on The Independent Agenda.)
But slow growth will get politicians of both parties antsy to “do something” in an election year. “If the economy is still weak going into next year, we could have fiscal stimulus,” he told me. Politicians do not “want to face voters with a weak economy,” he said.
As for investing, Shilling has returned to an old favorite: the 30-year Treasury bond, which is currently yielding around 4.21%. “I think they’re going to 3%,” he said. “I think [the ten-year’s] going to 2%.”
The 10-year Treasury note was yielding near 3% Wednesday. Take that, Bill Gross!
Naturally, Shilling isn't looking for much from equities, and he recommends only blue-chip dividend stocks. Shilling’s not infallible, of course. He has been predicting deflation since the late 1980s, and in earnest since 1998. We’ve had two potentially deflationary episodes — in 2002, and after the financial crisis — but the Fed was able to dispatch them.
He also was very bearish on stocks, expecting new lows in early 2009, and pretty much missed the recent bull market. So he’s not the guy who’s going to call bottoms or identify bullish inflection points.
I think we’ll probably get by with slower growth but without a new recession, based on strong overseas business and spending by affluent consumers here. Recent strong reports from companies like FedEx (FDX) and CarMax (KMX) show the economy may not be nearly as bad as Shilling thinks it is. (Read my recent market outlook here.)
But I hesitate to second-guess him on housing, where his track record has been stellar. That’s why his predictions should be sobering indeed for homeowners, investors, and policymakers alike.