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. We confirmed our recession call at the end of April despite better than expected macro data over January and February as this largely reflected an exceptionally warm winter. Despite the recent deterioration in data, consensus is hoping for a revival in growth over the second half of 2012. However, we continue to believe that the US is already in a recession which started in the second quarter (as we predicted) and that subsequent downward revisions to relevant economic data will prove this case.
The advance estimate of the Q2 2012 GDP report indicated growth of 1.5% which was even lower than the tepid 2.0% growth registered in Q1 2012 reflecting deceleration in personal consumption expenditure, slowdown in fixed investment and acceleration in imports that was partially offset by an uptick in inventories and exports. In our view, consumer spending and fixed investment will slow further over the second half of the year, and together with inventory destocking and a fall in exports will reinforce the recession.
Employment growth stalled in the second quarter averaging 73,000 per month compared to 226,000 in the first quarter largely reflecting payback from the extremely warm winter and lack of hiring resulting in anaemic income growth. In an environment of declining corporate profitability and considerable political uncertainty, corporates are highly unlikely to add to payrolls as they attempt to keep costs under control. Hence, we expect employment and income growth to remain extremely muted over the rest of the year. The price of gasoline in the US on a nationwide basis has risen by around 10% since the beginning of July. Further, the recent drought in the US has put upward pressure on the price of key staples like corn and soybeans which will lead to higher food prices. The increase in fuel and food prices will continue to weigh on consumer sentiment, which remains at depressed levels, adversely impacting consumer spending. Retail sales growth has been negative for the last three months which paints a very ominous picture for the US consumer.
The fiscal cliff (expiration of a number of expansionary polices at the start of 2013) continues to exert significant uncertainty on the household and corporate sector with economists estimating the drag on growth to be between 3% – 5%. It is quite likely that some of the expansionary policies are extended but it is reasonable to expect households and firms to increase their saving rate and liquidity levels respectively to cope with the increased level of uncertainty leading to lower aggregate demand.
Although consumer spending in the post crisis period has been weak compared to other recoveries, it has held up largely as a result of expansionary fiscal policies (lower taxes and increased transfers) which has resulted in the US government running a trillion dollar plus deficit annually since the financial crisis. Reversal of these expansionary polices will hurt consumer spending due to an increase in taxes and lower transfers resulting in lower disposable income. Peripheral countries in the Euro Area and the UK, which embraced fiscal austerity, are already in a recession and provide a useful template for what could be expected if households in the US are faced with a similar situation.
In our January and April articles, 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. Although spending on equipment and software continues to exhibit growth, it pales in comparison to growth registered in 2011. Core capital goods orders growth has been negative in four of the last six months which doesn’t bode well for spending on equipment and software. Further, decline in corporate profitability and low level of capacity utilization will result in firms cutting back on capital spending.
The US manufacturing sector has been a rare bright spot in the post crisis period with industrial production only around 3.3% below its pre-recession peak. However, the ISM manufacturing index has been below 50 (the level which separates expansion from contraction) for the past two months. More worryingly, the new orders sub index, which is a gauge of future production, has also been below 50 for the last two months (this index was above 60 as recently as May) implying a bleak outlook for industrial production and manufacturing payrolls.
The export sector has been a significant contributor to the post crisis recovery being a beneficiary of a weaker US Dollar and various stimulus programs in trade partner countries. In our view, the biggest shock to the US economy over the next couple of quarters will emanate from the external sector as deteriorating macro conditions in Europe and emerging markets negatively impact US exports.
The export orders subcomponent of the ISM index, which printed at 46.5 in July (it was at 59 in April), indicates the US economy is unlikely to receive much support from foreign trade. The last time the export order index was at a similar level was in May 2009 when the economy was emerging from the financial crisis. Back in mid-2009, coordinated fiscal and monetary stimulus had the desired impact of facilitating growth (albeit borrowed from the future) and easing financial conditions by reducing credit spreads. Today, further fiscal stimulus is a virtual impossibility for countries in the developed world due to high levels of government debt, and unconventional monetary policy has lost its novelty as it is seen to be largely ineffective in generating economic growth.
In January, we indicated that housing was a wildcard that could lead to a robust recovery in the US. The recent uptick in the housing market is seen by many as the path to growth; however, we remain sceptical of this optimistic view for a number of reasons. First, housing is coming off an extremely depressed base (residential investment only accounts for 2% of GDP compared to over 6% at its peak) which implies that even a large increase in percentage terms will only have a moderate impact on GDP growth. Second, job prospects for a number of first time home buyers who are vital for any housing recovery remain bleak, thus discouraging them from committing to a home purchase. Third, The Fed has committed to keeping rates low till 2014 which makes it likely that buyers will postpone residential real estate purchases. Fourth, credit conditions for non-prime borrowers remain tight which will reduce the beneficial impact of low mortgage rates. Lastly, excess supply remains significant which will continue to hinder any recovery especially in an environment of weak demand. In fact, given the demand and supply dynamics, it is not beyond the realms of possibility for house prices to decline further over the coming quarters.
It is important to remember that large parts of the developed world are in a deleveraging phase which will be characterized by lower trend growth, higher unemployment, increased defaults, rising protectionism and more frequent recessions. The Euro Area is heading towards a depression, the UK is in a recession and growth is slowing precipitously in emerging markets. Given this backdrop, it is highly unrealistic to expect the US to be the lone oasis of growth. Once markets realize that the US is already in a recession, risk assets will experience a severe correction and investors should be prepared for a roller-coaster ride.