Growth! It’s being a long time between drinks for the USeconomy, but over the September quarter it expanded at a 2.8%pa annualisedrate. The world’s major economies all look set to expand over the fourthquarter, ending the recession. The first wave of euphoria from this news isalready reflected in the 63% market rally since the low in March.
But the economic question now is what kind of recovery iscoming. How long will it take to return to normal, will that transition beuninterrupted, and what will normal growth look like in the post-crisis world?
While there are many answers to these questions beingoffered at the moment, they can be mostly sorted via a simply taxonomy that isnow worn to the point of clichÃ©. Recoveries are either "V", "U" (or "L") or"W" â€“ named for the shape that GDP (level) traces out over time.
Is it a "V"?
The recovery everyone is rooting for is V-shaped â€“stronger than normal growth, quickly restoring output to trend, and reducingunemployment back to the natural rate of 5% or so. This outlook is not simplywishful thinking: economies tend to exhibit V-shaped recoveries (in that thereis a relationship between the size of sharp recessions and sharpness of thebounce-back).
A V-shaped recovery would justify the rally in shareprices; in fact, it would suggest that stocks are still cheap. Remember thatprior to the credit crisis, the S&P 500 was at 1,500 (1,050 today), but thankfully stocks were not particularly expensive relative to earnings. Sowhen the fall in earnings set in and share prices were driven lower, the extentof the share price correction wasn’t as large as it could have been if we’dstarted with a rip-roaring bull market and bloated PE ratios.
As economies recover and GDP returns to trend, corporateearnings should fully recover, so an S&P of 1,500 could again be on thecards. In fact â€“ and let’s not get too far ahead of ourselves here â€“ we mightexpect earnings to be even higher for a given level of output. After all,firms have used the recession to wring out costs, and earnings results for theJune and September quarters have given strong testimony to that. On the otherhand, do we really think that previous earnings are attainable in a new worldthat frowns upon excessive leverage? This question tempers our enthusiasm.
Is it a "U"?
A less pleasant outcome is the U-shaped (or, even worse,L) recession, where the economy lingers for a while in a period of low or nogrowth before the recovery begins. If the stock market is the cheerleader forthe V-shaped recovery, the bond market is the pallbearer for the U-shapedrecovery. Long-term interest rates remain low, suggesting anaemic growth, noinflation, and low cash rates for years to come.
There is historical evidence for the idea that financialcrises can have a lingering impact on growth. One example would be the damageto the government’s accounts wrought by bank bailouts, as these could requireyears of high taxes and government frugality to fix.
Another example might be where different sectors reallystruggle to recover â€“ such as the collapse of the housing sector ruling outany major construction rebound as the stock of houses already built and nowempty has to be exhausted first. Likewise, the automotive industry will be reelingfor years, as the destruction of personal wealth has led to higher savings andless splurging on major durable goods like cars. It will take quite a time forworkers from these sectors to retrain and relocate to find work in othersectors that are expanding.
A third "U" scenario is a repeat of the dynamic frombefore the credit crisis: strong growth in developing economies pushing upcommodity prices for raw materials, and those price effects acting as a brakeon developed economy growth. Against these outcomes, however, we must weighthe impact of an extraordinarily large and timely application of monetary andfiscal stimulus which points toward an upturn rather than not.
Give us a "W"!
The worst-case scenario is the W â€“ in which current growthwill shortly give away to further recession. In the W scenario, currentevidence of a recovery is simply a dead-cat bounce, as firms restock theirvastly depleted inventories, and government stimulus provides a one-off boostto house and car sales. But then nothing happens â€“ the consumer remainscomatose. Or, the consumer’s recovery is genuine, but before long eitherinflation fears force the Fed to raise interest rates, or a rising debt billforces the government to balance the budget with higher taxes. A misjudgmenton the part of the Fed or the US government could send the economy back intorecession. The last possibility for cementing in the W scenario is that theabsence of new regulation fosters another financial crisis.
What the hell is it?
The consensus of economists is that the current pick-up ingrowth will be sustained, with GDP expected to expand by 2.5-3%pa over 2010 and2011. A simple extrapolation from the US leading indicators, a compositecollection of data that has historically signalled future growth, would lead usto expect GDP growth of 3.3%pa to be sustained over the next few quarters. Wecould call this recovery a moderate V-shaped one.
The current data makes us broadly optimistic about thestrength of the recovery, but there are two stumbling blocks that lead us toconsider the possibility that we are wrong with this baseline projection. Thefirst is the disastrous state of the US labour market â€“ unemployment in the USis over 10%. It is hard to see unemployment falling quickly, and without thisreversal, it will be a long slow recovery for consumer demand. The worryingprecedent is the mild 2001 recession, which was also followed by a joblessrecovery â€“ until the housing boom/bubble soaked up displaced labour from theaftermath of the tech bubble. It is hard to see where the former auto-workersand home-builders are going to go now.
The second problem is that US households are likely torespond to this crisis by trying to permanently raise their saving rate. Ifso, the most likely outcome is that the demand for China’s goods will beimpaired for a long time. Can the rest of the world make up for the US? Wedoubt it. And by the way, such an outcome is likely to see ongoing weakness inthe US dollar.
We believe that many of the current "W" typeprognostications will fade away if we get another six months of solid USgrowth, at which point the labour market should be improving (albeit slowly).
A word on the American corporate performance
The vast majority of S&P company earnings reports overthe last quarter have exceeded expectations. Around 84% have exceededconsensus estimates (although those earnings are still down year on year) andover 50% have managed to do this by a margin of 5% or more. Looking solely atthe bottom-line, that is a very strong result.
However, scratch below the surface and things become alittle less encouraging. Sales have been below what everyone was expecting andthis implies that cost cutting, hence an improvement in profit margins, hasbeen the source of all this joy. Cost cuts have been the order of the day forthe last three quarterly profit rounds now, but cost cutting cannot continueindefinitely and ultimately a more sustainable rise in earnings requires growthin sales. Meanwhile analysts continue to forecast a continual improvement inprofit margins to the extent that those margins are predicted to move back toprevious peaks by the end of 2010. How likely that is, is open to debate. There is very patchy and tentative data on how the US real economy isresponding, but it is still early days. Earnings expectations seem to besolely fixated on the V-shaped recovery.
To be sure there are plenty of positives in thisenvironment. Huge monetary stimulus remains in place globally and will likelystay that way given sluggish GDP growth and the fact that banks continue tohold tight to their purse strings. And it seems to us that short term interestrates will stay low for some time (with some exceptions â€“ Australia andNorway). The emerging market economies are also continuing to recoverstrongly, and for some the credit crisis seems to have been genuinely a baddream. But the recovery must gain genuine economic traction through developedeconomies as well â€“ it must manifest itself in rising final demand frombusinesses and households if it is to be sustainable without the benefits ofinventory restocking and when stimulus is withdrawn.
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