U.S. Economy: 4 Simple Reasons Recession Lies Ahead

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by: Eric Parnell, CFA

The U.S. economy is likely headed toward recession. This has actually been the case for some time. For were it not for the powerful forces of fiscal and monetary policy, chances are we would already be there. And while policy makers may attempt to delay the inevitable even further in the months ahead, the economy will likely have its way in the end.

The performance of the U.S. economy, of course, is measured in terms of Gross Domestic Product (GDP). And one way to measure GDP is through the Expenditure Approach, which is the sum of the following four components of the economy.

C : Consumer Spending

I : Business Spending

G : Government Spending

X-M : Net Exports (Exports minus Imports)

A brief look at each of the four main components of GDP reveals an economy that is likely headed toward recession. I'll examine each in reverse order. And instead of getting into the weeds with the data, my objective here is to keep it simple. For sometimes the best conclusions are those that just get straight to the point.

We begin with Net Exports (X-M). Europe is on the brink of crisis and many countries are now falling into recession. And growth in Asia is also slowing. This suggests that exports by the United States abroad is likely to decline, as foreigners purchase fewer U.S. products.

Next is Government Spending (G). The scope for further substantial increases in fiscal spending in the U.S. is minimal. The debt-to-GDP ratio in the U.S. has risen to disconcerting levels and political pressure is mounting for fiscal policy makers to rein in spending. And in the coming months, the U.S. economy is facing the prospect of heading off a "fiscal cliff", as many of the stimulus programs enacted to stem the economic impact of the financial crisis several years ago are set to expire at the end of 2012. As a result, Government Spending has the potential to be less, perhaps considerably, than it has been in the recent past. And the economy will likely have little clarity on this point until after the election at the very end of the year.

On to Consumer Spending (C). U.S. consumers are still in the process of deleveraging from the financial crisis several years ago, so the scope for further spending increases here is limited. And while we have seen some job creation in recent months, it remains woefully below the levels needed to sustainably reinvigorate consumer spending appetites. This is due to the fact that labor force growth remains stagnant and a good portion of these new jobs have workers in positions where they are either underemployed are partially employed. A great number of new jobs must be created to support Consumer Spending, but the decline in economic activity resulting from the weakness in Europe and Asia may eventually result in the exact opposite effect in the coming months.

What about Business Spending (I)? After all, corporate balance sheets are in fine shape and profits have been growing, albeit at a decelerating rate. All of this is true, but the "I" component is a relatively small percentage of total GDP. And what incentive will U.S. businesses have to increase spending in an environment where export demand is evaporating, government spending is about to potentially go over a cliff and consumer spending is set to fade. Any prudent business is likely to take a wait and see approach with any additional spending until greater clarity forms around many of these concerns. And the fact that corporations are already operating with profit margins that are more than two standard deviations above their historical average, the scope to cut costs any further to support profitability is all but exhausted at this point. Thus, Business Spending is likely to provide little support if any in the coming months.

So when thinking of the equation GDP = C + I + G + (X-M) for the U.S. economy, a majority of forces are working in the direction that results in a GDP number that is smaller than what we've seen in recent quarters, hence a recession on the horizon.

Such an outcome bodes ill for the stock market (NYSEARCA:SPY). This is due to the fact that GDP growth is the primary driver of corporate earnings. So in an environment where GDP is shrinking, it is very difficult for corporations to increase profits. And if profits are in decline, stock prices quickly follow to the downside.

So how can one protect against the potential for a U.S. recession? High quality fixed income positions provide an ideal way. This includes Long-Term U.S. Treasuries (NYSEARCA:TLT), Agency MBS (NYSEARCA:MBB) and Build America Bonds (NYSEARCA:BAB). Gold (NYSEARCA:GLD) also provides portfolio protection as a store of value to protect against economic crisis. And even selected high quality stocks can perform well even in recessionary environments including McDonald's (NYSE:MCD), HJ Heinz (HNZ), Tootsie Roll (NYSE:TR) and WGL Holdings (NYSE:WGL).

Of course, the one key variable in predicting a U.S. recession is monetary policy. For as long as the U.S. Federal Reserve decides to remains aggressively easy and provide further stimulus, the economy and the stock market have the ability to float. Thus, this will be a critical point to monitor going forward. But at this stage, the marginal impact of Fed stimulus efforts is becoming increasingly diminished. And depending on how events play out in the coming months, the potential exists that any additional rounds of stimulus may be overwhelmed. For these reasons, it is worthwhile to begin preparing for what might be a turbulent summer in the months ahead.

Disclosure: I am long GLD, MCD, HNZ, TR, TLT, WGL, MBB.

Disclaimer: This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.