Growth! It’s being a long time between drinks for the US economy, but over the September quarter it expanded at a 2.8%pa annualised rate. The world’s major economies all look set to expand over the fourth quarter, ending the recession. The first wave of euphoria from this news is already reflected in the 63% market rally since the low in March.
But the economic question now is what kind of recovery is coming. How long will it take to return to normal, will that transition be uninterrupted, and what will normal growth look like in the post-crisis world?
While there are many answers to these questions being offered at the moment, they can be mostly sorted via a simply taxonomy that is now worn to the point of cliché . Recoveries are either "V", "U" (or "L") or "W" – named for the shape that GDP (level) traces out over time.
Is it a "V"?
The recovery everyone is rooting for is V-shaped – stronger than normal growth, quickly restoring output to trend, and reducing unemployment back to the natural rate of 5% or so. This outlook is not simply wishful thinking: economies tend to exhibit V-shaped recoveries (in that there is a relationship between the size of sharp recessions and sharpness of the bounce-back).
A V-shaped recovery would justify the rally in share prices; in fact, it would suggest that stocks are still cheap. Remember that prior 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. So when the fall in earnings set in and share prices were driven lower, the extent of the share price correction wasn’t as large as it could have been if we’d started with a rip-roaring bull market and bloated PE ratios.
As economies recover and GDP returns to trend, corporate earnings should fully recover, so an S&P of 1,500 could again be on the cards. In fact – and let’s not get too far ahead of ourselves here – we might expect 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 the June and September quarters have given strong testimony to that. On the other hand, do we really think that previous earnings are attainable in a new world that 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 no growth before the recovery begins. If the stock market is the cheerleader for the V-shaped recovery, the bond market is the pallbearer for the U-shaped recovery. Long-term interest rates remain low, suggesting anaemic growth, no inflation, and low cash rates for years to come.
There is historical evidence for the idea that financial crises can have a lingering impact on growth. One example would be the damage to the government’s accounts wrought by bank bailouts, as these could require years of high taxes and government frugality to fix.
Another example might be where different sectors really struggle to recover – such as the collapse of the housing sector ruling out any major construction rebound as the stock of houses already built and now empty has to be exhausted first. Likewise, the automotive industry will be reeling for years, as the destruction of personal wealth has led to higher savings and less splurging on major durable goods like cars. It will take quite a time for workers from these sectors to retrain and relocate to find work in other sectors that are expanding.
A third "U" scenario is a repeat of the dynamic from before the credit crisis: strong growth in developing economies pushing up commodity prices for raw materials, and those price effects acting as a brake on developed economy growth. Against these outcomes, however, we must weigh the impact of an extraordinarily large and timely application of monetary and fiscal stimulus which points toward an upturn rather than not.
Give us a "W"!
The worst-case scenario is the W – in which current growth will shortly give away to further recession. In the W scenario, current evidence of a recovery is simply a dead-cat bounce, as firms restock their vastly depleted inventories, and government stimulus provides a one-off boost to house and car sales. But then nothing happens – the consumer remains comatose. Or, the consumer’s recovery is genuine, but before long either inflation fears force the Fed to raise interest rates, or a rising debt bill forces the government to balance the budget with higher taxes. A misjudgement on the part of the Fed or the US government could send the economy back into recession. The last possibility for cementing in the W scenario is that the absence 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 and 2011. A simple extrapolation from the US leading indicators, a composite collection of data that has historically signalled future growth, would lead us to expect GDP growth of 3.3%pa to be sustained over the next few quarters. We could call this recovery a moderate V-shaped one.
The current data makes us broadly optimistic about the strength of the recovery, but there are two stumbling blocks that lead us to consider the possibility that we are wrong with this baseline projection. The first is the disastrous state of the US labour market – unemployment in the US is over 10%. It is hard to see unemployment falling quickly, and without this reversal, it will be a long slow recovery for consumer demand. The worrying precedent is the mild 2001 recession, which was also followed by a jobless recovery – until the housing boom/bubble soaked up displaced labour from the aftermath of the tech bubble. It is hard to see where the former auto-workers and home-builders are going to go now.
The second problem is that US households are likely to respond to this crisis by trying to permanently raise their saving rate. If so, the most likely outcome is that the demand for China’s goods will be impaired for a long time. Can the rest of the world make up for the US? We doubt it. And by the way, such an outcome is likely to see ongoing weakness in the US dollar.
We believe that many of the current "W" type prognostications will fade away if we get another six months of solid US growth, 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 over the last quarter have exceeded expectations. Around 84% have exceeded consensus estimates (although those earnings are still down year on year) and over 50% have managed to do this by a margin of 5% or more. Looking solely at the bottom-line, that is a very strong result.
However, scratch below the surface and things become a little less encouraging. Sales have been below what everyone was expecting and this implies that cost cutting, hence an improvement in profit margins, has been the source of all this joy. Cost cuts have been the order of the day for the last three quarterly profit rounds now, but cost cutting cannot continue indefinitely and ultimately a more sustainable rise in earnings requires growth in sales. Meanwhile analysts continue to forecast a continual improvement in profit margins to the extent that those margins are predicted to move back to previous 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 is responding, but it is still early days. Earnings expectations seem to be solely fixated on the V-shaped recovery.
To be sure there are plenty of positives in this environment. Huge monetary stimulus remains in place globally and will likely stay that way given sluggish GDP growth and the fact that banks continue to hold tight to their purse strings. And it seems to us that short term interest rates will stay low for some time (with some exceptions – Australia and Norway). The emerging market economies are also continuing to recover strongly, and for some the credit crisis seems to have been genuinely a bad dream. But the recovery must gain genuine economic traction through developed economies as well – it must manifest itself in rising final demand from businesses and households if it is to be sustainable without the benefits of inventory restocking and when stimulus is withdrawn.