Thread: Don't count on a 'normal' recession

Don't count on a 'normal' recession

Wall Street expects financial innovations and global growth to keep any US slowdown in 2008 short and shallow. But the stock market is likely to be seriously disappointed.
By Jim Jubak

The stock market doesn't much care whether a 2008 slowdown in the economy is an official recession or not. As far as Wall Street is concerned, there's just not much difference between economic growth falling to 1% or to minus-0.5%.

As long as the slowdown, recession, whatever, is short. No more than two quarters. Over and done with by mid-2008. Then the economy and the stock market, Wall Street believes, can look forward to another long boom.

Recent history supports that view. Over the past two decades, recessions have been remarkably short and remarkably mild. If any 2008 recession is a "normal" one, investors are absolutely right to look past it to an economic recovery in the second half of 2008. And that would explain why the sea of troubles that has washed over the economy in the last few months of 2007 has had relatively little effect on stock prices. The Dow Jones Industrial Average ($INDU), for example, as of Dec. 20, was down just 7% from its Oct. 9 all-time high.

Disappointing odds
But what if a 2008 slowdown or recession isn't normal? What if it drags on for 12 months and not just six or eight? Then the stock market has set itself up for serious disappointment, with multiple dips in the major averages as investors gradually realize that 2008's economic slowdown will be lengthier than expected.

The odds of that kind of disappointment in 2008 are, unfortunately, high. This sure doesn't look like the "normal" recession. Because so many consumers got used to drawing against their rising home equities to fund their spending, the bursting of the housing bubble and the crisis in the subprime-mortgage market have resulted in far more damage than usual to consumer cash flows. The drop in consumer demand is well beyond what you'd expect in an economy that's still producing jobs at a decent rate.

Even with personal income rising at a 6% annual nominal rate -- that's before subtracting inflation -- consumer spending has started to slow. If employment growth drops, as the Federal Reserve projects in 2008, then the drop in consumer spending could well accelerate. And at the current rate of progress in the housing market, it's going to take way more than a couple of quarters to repair consumer balance sheets damaged when the bubble burst in 2007.

The bad old days
A 2008 economic slowdown or recession wouldn't need to be one for the record books in order to disappoint Wall Street. It could simply mark a return to the bad old days, from 1959 through 1983, when recessions lasted 50% longer, were nearly twice as severe and took place about twice as often.

A September 2007 report from the Federal Reserve Bank of Dallas summarizes the difference between a recession in the bad old days and now:

"On average, the five recessions from 1959 to 1983 were 47 months apart, lingered 12 months and were associated with a 2.17 percent peak-to-trough decline in real gross domestic product. By contrast, the 1990 downturn came after 92 months of expansion, lasted eight months and involved a 1.26 percent decline in GDP. The 2001 slump ended a record 120 months of uninterrupted growth, lasted eight months and entailed a GDP decline of only 0.35 percent."

Economists first picked up this shift to shorter, less severe and less frequent recessions in the late 1990s. Since then, they've been working hard to explain why the economy is behaving this way. Explanations for what has been dubbed the Great Moderation include:

Structural changes in the economy, such as "just in time" production systems that prevent a big buildup of investories that can result in a slump in new orders as companies work off old stock.

Financial innovations, such as home-equity loans that smooth the swings in consumer buying that can result from dips in personal income and employment.

The creation of global markets for raw materials, including labor, goods and services, that smooth out shifts in the growth rate of any individual economy.

It's the second and third of those three possible causes for the Great Moderation that form the crux of Wall Street's hopes for a quick and shallow downturn. Yes, it's absolutely true that the surge in mortgage refinancing and home-equity lending fueled the boom in U.S. consumer spending that drove not only the U.S. economy but also the world economy.

The cash coming out of U.S. home equity turned into massive purchases of goods and services from China, India, Japan, the oil economies of the Middle East and Russia, and the European Union. And that purchasing produced double-digit growth or near-double-digit growth in those economies.

Those economies pumped a good percentage of their cash back into the U.S. through purchases of Treasury bills and mortgage-backed securities. Those purchases lowered U.S. interest rates and made it possible for another round of home-equity refinancing at lower interest rates and another round of home-equity cash-outs.

Global insurance policy
It was great while it lasted, but now it's time to pay the piper. The fountain of U.S. home-equity cash has dried up. U.S. consumer spending is slowing, and so is the nation's economy. A weak dollar is enabling U.S. companies to increase exports, which cuts into sales by overseas companies. At some point, all this adds up to recession or near recession in the U.S. and a slowdown in global economic growth.

Not so fast, Wall Street says. In your emphasis on cause No. 2, financial innovation, you've forgotten about cause No. 3.

In a global market, consumers in the fast-growing economies of China, India and Russia have become rich enough that they increasingly demand goods and services. These emerging-economy consumers can take the baton from U.S. consumers and keep the race going. Not only will that be enough to keep the global economy as a whole from slumping, but growth in these countries will moderate the depth and duration of any decline in the U.S.

Think of this increase in demand as a kind of insurance policy for U.S. and global economic growth. If an economic storm strikes the U.S., this policy will work to minimize the damage.

But any insurance policy has its limitations. For example, a storm can be so intense that it inflicts damage beyond the coverage of the policy.

And that's the danger we face in 2008. As long as the downturn in the U.S. economy is modest, then, yes, demand from overseas consumers with newly increased incomes can pick up the slack. But if the downturn in the nation's economy is serious, there simply aren't enough consumers in China and India and elsewhere to pick up the slack.

According to the U.S. Bureau of Labor Standards, consumer spending accounts for about 60% of the country's $13.2 trillion economy. That's about $8 trillion. A 1% drop in U.S. consumer spending equals $80 billion.

The Chinese, Russian and Indian economies are significantly smaller than the U.S. economy, ending 2006 at $2.7 trillion, $1 trillion and $900 billion, respectively (at the exchange rates then). And consumer spending makes up a significantly smaller percentage of overall economic activity in these countries. Consumer spending in China, for example, makes up less than 30% of the total economy.

White-swan pricing
Using that 30% figure as an average to get a ballpark number, each 1% drop in U.S. consumer spending would require a 7% increase in consumer spending from China, Russia and India. That seems doable for these economies. At that level of decline in the U.S. economy, the global insurance policy could work, I'd say.

But increase the severity of the U.S. decline to 2%, and China, Russia and India would have to grow consumer spending by 14%. That would be tough. China is going full-tilt, with inflation racing ahead, and its GDP is growing at just 11% a year.

So investors are facing another version of the problem that sank the mortgage-backed debt market. Within some definition of "normal," the insurance policy works. In the mortgage-backed debt markets, AAA-rated securities are indeed safe. And in the economic realm, the U.S. economic slowdown is short and shallow.

But if we get an abnormal event -- what's called a black swan -- then "safe" mortgage-backed securities fail, and the U.S. economy experiences a downturn that lasts longer than Wall Street expects.

Right now, the stock market is priced only for white swans. Given Wall Street's recent record on valuing debt securities while underestimating the ramifications of a black-swan event, that makes me nervous.

A game of wait-and-see
So put me in the "show me" camp. I'll believe the downturn in 2008 will be "normal" when I see housing prices stabilize, when I hear Wall Street CEOs saying they know the size of their eventual write-offs and when I see banks willing to lend to each other again.

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Don't you realize that we need to BOMB and KILL and PUT sanctions on nations. Don't you realize we have to keep the borders open.

I mean, c'mon.. recession re-smedging.. who cares.

All we need is to kill islofascistnaziislamo kooks and we are all set!

Who cares about borders and about recession and about our soveriengty.. AND about the plummeting dollar.

We have ISLAMOFASCIST and that is the cure for what ails america!

I say, lets kill em' all and let the neocons/neolibs sort it out.