Are We Going To See Another Recession?

by: Tim Iacono

The latest batch of economic reports from around the world have called into question what had been, in the late-summer up until about a week ago, a growing consensus that the U.S. and other important parts of the global economy are either about to enter another recession or, in the view of some, are already in a new recession.

While clearly affected by the latest moves by European officials to stem the sovereign debt crisis, last week's impressive bounce for stocks and commodities was also influenced by a fading sense of imminent calamity for economic growth following an increasing number of comparisons between 2011 and 2008 in recent months.

It's worth taking a closer look at the question of whether the world is now facing another recession - the likelihood and, more importantly, the severity - as it is of utmost importance for any investor. Was last Monday's low for stocks and commodities an enduring low or will another economic contraction produce even lower price levels in the period ahead?

One thing is clear - the U.S. economy today is much different than it was three years ago and, as shown below, the soaring unemployment rate is a key reason why.


It has been a grim three years for many Americans who have either been out of work or who now earn much less than they did in 2008 and, while this is certainly an important component of the U.S. economy, it does not completely dictate economic growth.

A job market that will be very weak for many years to come is now being accepted as conventional wisdom in the U.S. and, while it may cause a great gnashing of teeth (especially in the run-up to the 2012 election) it is but one of many factors that will influence whether we'll dip into another recession.

What has also changed over the last three years is the relationship between the ISM manufacturing data and consumer sentiment.

As shown to the right, the mood of the U.S. consumer is back to the levels seen at the depths of the 2008-2009 recession, however, the nation's manufacturing sector continues to expand, albeit at a modest rate. Surely this relationship will return to its pre-2008 norm at some point, the big question being whether the rest of the economy will match the current sentiment levels or if, for a variety of factors, the outlook of many people today is unnecessarily grim.

There is no doubt that conditions have deteriorated in recent months. Just last week, Goldman Sachs revised its economic forecasts downward, chief economist Jan Hatzius putting the odds of a recession at 40% and predicting that the unemployment rate will rise to 9.5% by the middle of next year. Hatzius commented, "the obvious risk with our (non-recession) forecast is that the slowdown in growth and the associated deterioration in the labor market is going to start feeding on itself and pushes the economy into recession via the stall-speed dynamic."

He also noted that, if another contraction were to occur, it will likely be relatively shallow, to be followed by another long, slow recovery. Importantly, the updated Goldman forecast is for a mild recession in both France and Germany early next year. Those nations are set to join other countries such as Greece and Spain that are already mired in an austerity-induced slowdown.

Another view on the prospects for the U.S. and global economy, one that is far more pessimistic than Goldman's, came from the widely respected ECRI (Economic Cycle Research Institute) which said the U.S. has either already entered or is about to tip into a recession and that nothing policymakers do at this point will cause that outcome to be averted. Its report released about a week ago provided the following details:

ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading Index, which was the first to turn down – before the Arab Spring and Japanese earthquake – to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact, the most reliable forward-looking indicators are now collectively behaving as they did on the cusp of full-blown recessions, not “soft landings.”

Last year, amid the double-dip hysteria, we definitively ruled out an imminent recession based on leading indexes that began to turn up before QE2 was announced. Today, the key is that cyclical weakness is spreading widely from economic indicator to indicator in a telltale recessionary fashion.

Why should ECRI’s recession call be heeded? Perhaps because, as The Economist has noted, we’ve correctly called three recessions without any false alarms in-between. In contrast, most of those who’ve accurately predicted a recession or two have also been guilty of crying wolf – in 2010, 2005, 2003, 1998, 1995, or 1987.

Perusing the entire report is recommended, as is having a look at this Bloomberg interview with ECRI co-founder Lakshman Achuthan who shares some additional thoughts about the nature of the current slowdown and its historical context, notably, that exiting the Great Moderation in 2007 (where recessions were far apart) signals a return to more typical shorter cycles.

Contagion - In The Economy And In Credit Markets

The ECRI report makes the point that what they see ahead is a "vicious cycle" where different parts of the economy feed on each other in a downward spiral. This development is referred to by Goldman Sachs as "stall speed dynamic," the analogy being an airplane that loses sufficient speed with the result being a loss of lift and a hasty return to earth.

There are a few critics of the ECRI's methodology and there are those who disagree with Lakshman's outlook such as FedEx (NYSE:FDX) chief Fred Smith who, last week, predicted slow growth, not contraction, and the perpetually optimistic Warren Buffett who sees long-lasting distress for housing, but clear signs of recovery, not recession, elsewhere in his many businesses.

And keep in mind that the ECRI is in the business of selling services which, as I understand, don't come cheap. Nonetheless, it is significant that they have made a recession call with essentially no "wiggle room" - either they'll be correct and their perfect record will remain intact, or they'll be wrong and have produced their first false positive. Last week, the latest reading of the ECRI Weekly Leading Index saw another decline, down from -7.2 to -8.1, its lowest level in more than a year, and, however this all works out in the months ahead, at this point, it would be hard to bet against Lakshman.

Importantly, despite the gloom and doom found at the end of the ECRI report (i.e., "if you think this is a bad economy, you haven’t seen anything yet"), during the Bloomberg interview Lakshman was careful to note that they are predicting a new recession, but not the severity of that recession. As a minimum, they see a mild recession. However, depending upon what happens in Europe and elsewhere, they see the potential for a far worse outcome.

Now, keep in mind that a mild recession is not much different than what we've seen so far this year. Based on the GDP numbers reported for the first and second quarter, the U.S. economy has grown at an annual rate of less than one percent which, when factoring in U.S. population growth of about one percent, is, effectively, a contraction. So, when viewed this way, predicting a new recession is not going too far out on a limb.

The key point here is that, despite the many characterizations of the spring slowdown being "transitory" (as Fed Chief Ben Bernanke said often earlier in the year), we have almost assuredly entered a period of either very slow growth or recession and a speedy return to growth rates of 3%-4%, which appears to be out of the question.

Of course, exogenous factors could produce a far worse outcome - what markets fear most after the 2008 experience.

It's worth noting that the prime candidate for this - the crisis in Europe - has produced little in the way of financial market stress here in the U.S., at least according to a new stress index produced by St. Louis Fed economists as shown below and detailed here (also available at the St. Louis Federal Reserve website here).



While some may argue that Fed economists are particularly incapable of creating a model that can predict calamity, others will argue that, as shown in the graphic, the S&P U.S. credit downgrade was much more of a shock than anything happening recently in Europe.

It is clear that parts of Europe either never exited the last recession or have already entered a new one and ongoing austerity measures are only likely to make things worse over the near term. Last week's decision by the Bank of England to initiate its version of "QE2" is providing more compelling evidence that policy makers see risks now skewed heavily to the downside.

China and the rest of Asia remain big wild cards and, dependent upon the decisions of policy makers there, these economies could have a big impact on the rest of the world. The bursting of the "China Bubble" has been anticipated for many years now and, despite their problems, as compared to the West, a unilateral approach to policy making has clear advantages.

As for the U.S., it seems likely to me that we'll enter a new recession sometime in the months ahead and, despite it being painful for those who will lose their jobs as unemployment moves higher, it will be nothing like 2008. Of course, this is dependent on what policy makers in the U.S. do as we near the official start of the 2012 election season but, in short, the economic "recovery" to date has been so weak that in many areas, there is far less room for decline than three years ago.

The collapsing housing sector was a big driver of the 2008 contraction and residential construction - pegged at record lows over the last two years - can't get much worse. Moreover, after a resurgence in consumer spending last fall in the wake of the Fed's QE2 money printing/wealth creation spree, consumption has already reverted to the anemic, post-2008 growth rates.

While anything is possible, it seems likely that we'll dip back into a mild recession that will be almost indistinguishable from our current slow growth track and, while we'll see unemployment rise, the move up from 9% unemployment will be nothing like the calamity of doubling the jobless rate from 5% to 10% in 2008 and 2009.

The Federal Reserve will likely feel compelled to take action and I think we'll see another round of Fed money printing early next year, well in advance of the November elections, but only after it becomes clear that inflationary pressures have receded and that the U.S. economy has entered a new recession.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.