As we begin 2012, the consensus view is for a mild recession in the Euro Area, deceleration of growth in emerging markets (with a soft landing in China) and below trend growth in the US. However, we assign an 80% probability that the US is on the brink of or is already entering a recession.
To understand the rationale behind our recession call, it is important to first analyse the drivers of the post crisis economic recovery. Governments across the world along with their central banks panicked at the collapse in economic activity and unleashed what is probably the biggest fiscal and monetary easing in human history. Accounting rules were relaxed, losses were covered up and moral hazard was ignored in a bid to stave off the collapse of the global economy. Trillions of dollars were thrown at the problem, including a huge expansion of credit in China and other emerging economies and massive government borrowing and spending to boost demand in the developed world. At the same time major central banks led by the US Federal Reserve slashed interest rates and flooded the system with liquidity through quantitative easing (QE) which reduced borrowing costs and boosted asset prices.
As a result of various fiscal programs, transfers from government as a share of personal disposable income in the US is currently over 20%. In addition, the ability to default on debt without personal liability and a slowdown in the pace of foreclosures has enabled many consumers to either walk away from their underwater mortgages or live rent-free in their homes while defaulting on their debts. This added to the disposable income of households and helped sustain consumer spending. The central bank monetary measures reduced borrowing costs across the board and also resulted in a bear market rally in risk assets as a consequence of the rise in inflation expectations and a weakening US dollar.
The plan was that the combined fiscal and monetary stimulus would boost demand and result in a sustainable cycle of corporate investment and job creation thereby pulling the global economy out of the slump and set it on a path of organic growth. Once the cycle started and growth picked up, government debt would fall and central banks would also be able to contract their balance sheets and raise interest rates.
Unfortunately, none of the above has happened. The fiscal and monetary stimulus did boost growth temporarily but not to the extent anticipated. Consumers took the stimulus money and used some of it to pay down debt and spent the rest of it. As a result of the stimulus spending, corporate revenues picked up but companies did not hire more people as expected, instead focusing on enhancing productivity. This is why investment spending by corporates on equipment and software has been a bright spot that contributed to the recovery with this segment accounting for around 39% of GDP growth from the recession low.
Exports have been a significant contributor to growth during the recovery with real exports growing at an annual rate of around 10% from the recession low. Another prominent feature of this jobless recovery has been the strong growth in corporate profitability as profit before tax more than doubled since end 2008 equating to approximately 13% of GDP, the highest level in 60 years. Corporations benefited from the various stimulus packages, a lower US Dollar, decreased funding costs and lower staff costs with wages and salaries as a share of GDP at an all-time low of around 44% as a result of the slack in the labour market.
Markets are now relieved that the double dip fears over the summer of 2011 were alleviated by economic data that surprised on the upside over the last quarter of the year. However, most of the improvement was due to transitory factors like a decline in the personal saving rate, lower gasoline prices and a rebound in auto production post the Japanese earthquake.
As mentioned above, household income has been boosted by government support such as transfer payments and tax cuts that are unlikely to last going forward. The level of unemployment and under employment along with the lack of job security should make households reluctant to add further debt to an already stretched balance sheet. Owners’ equity as a share of household real estate value is close to an all-time low of below 40% providing little scope for home equity extraction to fund consumption expenditure. The personal saving rate has declined from 5% in the summer of 2011 to 3.5% by December 2011 providing a boost to consumer spending. However, the saving rate will rise in 2012 providing a headwind for consumption, especially as income growth remains muted.
Lower real disposable income, falling net worth and a leveraged balance sheet will provide a significant headwind for consumption across most income groups of the population. Although there has been a recent uptick in hiring, a large portion of new jobs that have been created are in low paying sectors such as retail and transportation. A secular decline in higher paying jobs in the real estate, financial and government sectors and considerable slack in the labour market (the share of people who have been unemployed for over six months is over 40%) will continue to inhibit wage growth.
It is unlikely that business spending will be a major driver of growth in 2012 as a lot of demand has already been pulled forward as a result of the recently expired bonus tax depreciation program which included all types of capital goods from cars and light passenger trucks to computers and associated hardware. Further, the expected fall in corporate profitability due to declining revenues combined with a low level of capacity utilization will also restrain firms from adding to capital expenditure.
The economic downturn in Europe, with US exports to Euro Area and the UK accounting for close to 18% of total US merchandise exports, a slowdown in emerging markets and a stronger US Dollar will curb export growth in 2012 and adversely impact employment in manufacturing that has been a significant beneficiary of the export renaissance. With corporate profit margins at an all-time high, any shortfall in revenue due to lacklustre demand will adversely impact profitability and equity prices which will hurt consumer confidence and eventually provide another headwind for consumption. The recent raft of earnings downgrades and downbeat outlook by companies provides an ominous sign for profitability.
The government sector, both at the federal and the state and local level will also be a drag on growth as budgets get trimmed to ensure the fiscal deficit remains in check. We expect further layoffs in this sector which accounts for a non-trivial 20% of GDP and 17% of employment. The state of US politics in an election year will also reduce the likelihood of a large scale fiscal stimulus program aimed at promoting growth.
The housing sector remains the wildcard in 2012. Record low interest rates, enhanced affordability and possible government intervention along with people migrating to the US from countries like China could provide positive impetus to this sector. However, the massive oversupply remains an issue that will take time to work through before construction of new homes can add to economic growth. Tighter lending conditions by financial institutions compared to the pre-crisis years will limit housing’s contribution to growth.
We acknowledge that US households, through a combination of repayment and default, have made some progress on deleveraging with household debt to gross disposable income at around the same level as it was in 2004. However, we believe households are still in the early stages of the deleveraging cycle, and hence not in a position to drive the economic recovery with debt to gross disposable income at 111% compared to a 40 year average of around 80%.
In response to the slowdown in growth, the Federal Reserve will potentially engage in another round of quantitative easing that will prove even more futile than the previous iterations in delivering economic growth. A major beneficiary of the last two rounds of quantitative easing was the export sector largely due to depreciation of the US Dollar. However, with most major central banks resorting to unconventional monetary policy and emerging markets lowering interest rates, the US Dollar is unlikely to depreciate in a significant manner. Risk asset prices could potentially rally but arguably the recent rise has already priced in easing by the Federal Reserve.
In summary, lower household consumption due to lower income and wealth and high level of debt, declining capital expenditure due to demand having been pulled forward, drag from both the federal and state/local governments as they aim to reduce deficits and falling exports due to recession in Europe and slowdown in growth in emerging markets will lead to a recession in the US. It is a fallacy that the US can decouple from the rest of the world and escape this perfect storm of negative factors.