At the start of 2012, the consensus view was 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. In late January, we ascribed an 80% probability that the US is on the brink of a recession with a revival of the housing sector being the wildcard that could lead to a self-sustaining recovery. Better than expected data over January and February mainly due to an exceptionally warm winter led many to forecast a strong US recovery in 2012. However, based on recent economic data and our analysis of the global economy, the prospect of the US economy entering a recession in the current quarter appears even more likely.
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.
The plan was based on the assumption 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 which boosted investment spending on equipment and software.
As per the advance estimate of the Q1 2012 GDP report, personal consumption expenditure increased by 2.9% leading many to conclude that the resilience of the US consumer will result in a self-sustaining recovery. However, it is important to understand the factors that contributed to the increase in consumer spending. The warmest winter in recent memory (less job losses in sectors that are normally impacted by the weather like construction, lower utility bills, etc.), pent-up auto demand following the Japanese and Thai natural disasters, a 12% rally in the equity market and a decline in the personal saving rate from 4.5%to 3.9% were key drivers that contributed to the resilience of the US consumer during the first quarter.
However, lower real disposable income, falling net worth (the expected wave of foreclosures will put further downward pressure on house prices), a low saving rate and a leveraged balance sheet will provide a significant headwind for consumption across most income groups of the population. Firms will react to the recent fall in productivity by reducing headcount to prevent margin erosion which will adversely impact employment and household income. The recent uptick in initial jobless claims does not provide an inspiring outlook for the labour market.
The rise in the price of gasoline over the first quarter was to a large extent offset by lower utility expenses as a result of the unseasonably warm winter. However, the coming peak US driving season might exert further upward pressure on gasoline prices which will adversely impact consumer confidence and spending. The University of Michigan Consumer Confidence Index has essentially been flat at a low level for the past four months which doesn’t bode well for consumer spending.
In January, we mentioned that it was unlikely that business spending would be a major driver of growth in 2012 as a lot of demand had already been pulled forward due to the bonus tax depreciation program in 2011 which included all types of capital goods from cars and light passenger trucks to computers and associated hardware. The deceleration in equipment and software spending in the Q1 GDP report largely confirms this assertion. Further, the deterioration in durable goods orders (negative in two of the last three months) and the various manufacturing surveys point to continued weakness in this sector. Also, 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.
US exports to the Euro Area and the UK account for close to 18% of total US merchandise exports. The Euro Area periphery is in a depression, the UK is in a recession, emerging markets are slowing down and it appears the core Euro Area countries are heading towards a recession based on the latest Purchasing Manager Index surveys. Weakness in key trade partner economies will result in net trade being a drag on economic growth over the coming quarters.
A number of expansionary fiscal measures that were implemented in the past are set to expire at the end of 2012 which economists estimate could exert a drag on growth of between 3% – 4%. It is quite possible that some of these provisions are further extended but it is reasonable to expect households and firms to alter behaviour in anticipation of the tighter fiscal conditions that will adversely impact aggregate demand. We continue to expect cutbacks at both the Federal and State & Local government level which will negatively impact employment and economic growth.
In our previous article we indicated that the revival of the housing sector was the wildcard that could lead to a self-sustaining recovery. Despite the most supportive weather for housing in recent memory, most housing data continue to disappoint versus expectation and remain at anaemic levels. House prices are still declining and the expected wave of foreclosure post the settlement of the ‘robo-signing’ scandal by banks will exert further downward pressure on residential real estate prices which will adversely impact net worth, confidence and spending.
It is quite possible that housing, largely due to the multifamily sector, continues to contribute to economic growth over the coming quarters as it did in Q4 2011 and Q1 2012. However, in our view, it is unlikely to lead to a sustainable recovery as the favourable weather impact (residential investment rose by 19.1% in Q1 2012 on a seasonally adjusted annualized basis) fades and the foreclosure supply floods the market with inventory.
Our recession call and this reiteration are based on an analysis of the US economy and the transmission effects of the external shocks from the situation in Europe and the slowdown in China. While everyone is focused on Europe, we think the real stress to the global economy will come from the emerging markets, especially China. In Europe, we expect a sharp slowdown in the German economy, contrary to the popular belief that Germany will continue to be the bright star. We assign a very high probability that the US recession starts in the current quarter with economic data continuing to deteriorate in May and June and significant downward revisions to prior data to follow over the coming months.