Research & Advice


Walking the Recession Fence

February 11, 2008

  • The GDP growth rate for Q4 2007 was 0.6%.  The consensus was 1.2%, above 0%, the median of our Outlook 2008 predicted range.  We expect that rate to be revised down.
  • Stimulus from the federal government, the Federal Reserve, and Sovereign Wealth Funds will likely force GDP above its historical trend in the second half of the year.
  • We remain concerned for the first half of the year, primarily due to overstretched households that have little discretionary income.
  • The US will most likely avert a technical recession, but as described in our Outlook 2008, it will still fell very lousy.

The latest GDP report for Q4 2007 was reported at a growth rate of 0.6%.  Consensus estimates were for a rate of 1.2%, but a weak December put the rate in the range of our January 1, 2008 estimate of -1% to +1%.  I know, it’s a fairly wide range, but we thought that 1.2% was too optimistic and that there were significant downside risks.  As December data is becoming more available we now won’t be surprised if the final rate is revised down closer to only 0.3%. 

Similarly, we originally forecast a range of 0-1% for Q1 2008 on January 1st, but just three weeks later in our January 21st article we broadened that range negatively to +/- 1%.  I admit that I attach myself to data perhaps too much.  And in defining a recession we like to use the standard economic rule of thumb of two quarters of declining GDP to call any period a recession.  But like we said before, even if it isn’t a recession it is still going to be lousy, if not really lousy.  After all, the 2001 recession was incredibly mild by historical standards and that was a horrible period.  Granted, we were going through a bursting stock market bubble and endured the 9/11 attacks, but outside of those awful events (not that the two are comparable in any way) the economic data was wrenching.

In the Outlook 2008 report we explained how the year would be defined by two separate and two very unequal periods.  The first period (the first four to five months) would be very bad for the stock market and for the economy.  The second period (the last seven to eight months) would be very good for the stock market and for the economy.

And it seems that with a little help from the Fed as well as from election-year politics, this is exactly what is going to happen.  Certainly there is a clear and present danger of a recession in the first half of 2008.  However, there is the elevated chance of upside economic risks (or call it rewards, if you like) for the second half of 2008. 

Typically, in times of crisis, the federal government is notoriously late in trying to help.  The $150+ billion 2008 stimulus plan actually was put together in record time, and $100 billion of checks will likely start to be mailed out in May and June.  Additionally, Sovereign Wealth Funds have added some $70 billion of stimulus into the US economy (no matter what your opinion of SWFs, make no mistake, when a company receives a cash injection that is stimulus).  That is well over $200 billion of stimulus that will be hitting the economy by summer of 2008. 

And then there is the Fed.  They have dropped the federal funds rate from 5.25% to 3.0% in only five months starting from September.  This takes the real federal funds rate (“real” being an economic term for “inflation-adjusted”) down to about 1%.  That rate is well below the long-term real average of 2.4% that is considered neutral to growth.  Granted, it is not the -1% real rate we saw in 2004 when the federal funds rate was at a historically low one percent, but we did get to the stimulative zone incredibly fast.

(Also regarding interest rates, the average rate of 30-year fixed mortgages has dropped a full percentage point to 5.6%.  Combined with the federal government’s Hope Now program, this has allowed for a significant amount of home refinancing, thus mitigating the amount of foreclosures we might have otherwise seen this year, although there will still be a lot.  On a slightly separate note, housing is only 4.5% of GDP, and it has already blown up so badly that it won’t, by itself, push the economy into recession).

There is an unpredictable lag time in the efficacy of monetary policy, but a good rule of thumb is about twelve months.  However, this time around, only six months later we are already beginning to see benefits (most notably in reducing LIBOR, the interest rate to which many adjustable rate mortgages are tied).  By the autumn of 2008 we could very well likely begin to see GDP rates above their historical trend.

But for the first half of the year, before the stimulus has a chance to take hold, we have concerns.  Sure, some things are looking O.K.  We’ve recently had very good durable goods report, most inventory levels are very low, the 4-week moving average of unemployment claims (about 335,000) is well below the levels we typically see at the beginning of recessions (closer to 400,000), and job growth so far does not look recessionary.  In the first three months of the 1990-1991 and 2001 recessions, payrolls fell 335,000 and 374,000, respectively.  And while the payrolls numbers fell 17,000 in January (and grew in November and December), the less-reported-on household survey saw the number of employed jump by 634,000 – the third biggest increase in thirteen years.

However, as mentioned, we remain concerned about the first half of this year.  In particular, we are concerned about households’ inability to pay their debts.  At the end of 2007 we saw delinquency and default rates go up in first and second mortgages, auto loans, and credit cards.  This has not gotten too much attention in the financial press yet, but the dramatic and broad-based deterioration in households’ willingness and ability to stay current on their debts is a cautionary signal that the economy may not just stall for a bit, but actually contract. 

The credit bureau Equifax tracked the delinquency rate on household liabilities (30 to 120 days past due) and found it to be above 4%.  That compares to the early 2006 low of 2.5%, and the 3% level at the beginning of the 2001 recession and the 3.2% high at the height of the 2001 recession. 

The broad-based erosion in household credit conditions suggest that this problem extends far beyond subprime borrowing, and I don’t expect it to get better any time soon.  The rate of deterioration in housing is slowing, but still getting worse.  Also, unemployment has held up, but I don’t expect companies to pick up their hiring.  These things do not bode well for incomes, which is the needed cure for what ails the economy. 

Federal Reserve data tracks non-discretionary outlays at nearly 80% of wage income (food and energy = 30.3%; medical = 26.5%; debt service = 23.0%).  Said another way, the stuff that households have no choice but to spend money on each month consumes 80% of their wage income.  This is the highest level prior to the onset of any prior recession.  I know that this is some pretty obscure stuff, but I believe that it is important to look at things that others are not looking at.  In that category, in the last couple months both the transaction volume as well as loan amounts at pawn brokers have jumped.  This is where households go as a last resort.  Clearly there does not have to be much more of a rise in unemployment to break households.  While everyone else is concerned about housing, I believe that the biggest threat to the economy right now is income growth.  Income growth held up well in 2007, but clearly households are over indebted and overstressed. 

The 2001 recession was short and mild, but we still saw the unemployment rate creep up two percentage points.  From its recent 4.4% low the unemployment rate is now 4.9%.  I expect it to go higher.  One reason is because while employment numbers have so far held up, especially compared to the beginning of past recessions, employers are cutting hours worked to below the 35-hour-per-week threshold for full-time work due to slowing demand in both the manufacturing and service sectors.  Reducing hours allows companies that are hurt by slowdowns to hold back on the layoffs and thus retain their skilled workers.  We believe that this is an indication of a higher unemployment rate to come and one of the reasons that first-time unemployment claims have so far been held relatively low.

So while there is an upside risk (aka reward) in the second half of 2008, there is also significant downside risk for the first half of 2008.  We will walk the recession fence and most likely jump off on the side of very weak growth as opposed to contraction.  But with household balance sheets in such terrible shape, like we said before, we won’t need a recession to feel lousy.