As we have long expected, the economy is tracing out a trajectory typical of the weak recoveries that follow balance-sheet induced recessions and credit crises caused by highly excessive debt. This is significantly different from the garden-variety recessions after World War II that were primarily caused by Fed tightening of monetary policy in response to rising inflation and full resource utilization. In those instances, once the Fed achieved its desired response it eased monetary policy once again, and the economy resumed its normal growth path.
In a balance sheet recession, as is happening now, the dire effects of debt deleveraging overwhelm the efforts of the government to stimulate the economy. Periods of credit crises are almost always followed by many years of below average growth, high unemployment, anemic expansions and frequent recessions. Recent examples include Japan’s two-decade period of sluggish growth and the current tepid recovery in the U.S. In our view, working our way out of the mountain of debt, both private and public, that was incurred during the boom will take many years and will keep a solid lid on overall gains in the stock market.
The current economic recovery remains in sharp contrast to any other expansion of the post-war period, and is now showing definitive signs of petering out once more. The recently reported first quarter GDP is a mere 1.3% above the amount reached at the peak of the last cycle in the fourth quarter of 2007. In eight previous post-war expansions, GDP had increased by an average of 13.3% in the 17th quarter following a peak, with the lowest being 10.5%.
Now, even this tepid recovery is slowing down once more. In the last two months the overwhelming weight of the evidence supports this view, as the following indicators have either come in below expectations or suffered an actual downturn: core durable goods orders, the Chicago Fed National Activities Index, new home sales, existing home sales, payroll employment, the NFIB Small Business Index, construction spending, the ISM Non-Manufacturing Index, the Kansas City Fed Index, the Philadelphia Fed Survey, industrial production, the Empire State Manufacturing Index, the NAHB Housing Index, the ADP payrolls, auto sales, real disposable income and the GDP.
At best, we think the economy will be disappointing in the period ahead. Consumers, who account for about 70% of GDP, are hamstrung by debt. In addition they have kept up their spending only by running their savings rate back down to 3.8% of disposable income, only the fifth month below 4% since 2007. Other limiting factors are low wage growth, high unemployment, the large numbers of workers who have dropped out of the labour force, declining home prices, higher tax payments and a flattening out of transfer payments. Therefore it no wonder that consumer confidence still remains at recessionary levels.
Still ahead is the so-called “fiscal cliff”, another conflict as we approach the debt ceiling again, a contentious election, and the continued inability of a dysfunctional congress to get anything done. All in all this is not a political outlook that is likely to give investors any confidence in the period ahead.
Adding to the headwinds is the worrying state of the global economy. Europe is plunging into recession with the fragile consensus unravelling with the fall of the Dutch government, the election of a left-of-centre government in France and the indecisive results pending the new election in Greece. For more than two years the goal of European leaders has been to prevent the Greek crisis from spreading to other southern-tier nations. After innumerable meetings, agreements and bailouts, that attempt has seemingly failed with the increased vulnerability of the Spanish financial system. Most of Europe has now plunged into recession, an event with global implications, as Europe is the largest source of Chinese exports.
China is dealing with a speculative housing boom and a major political scandal prior to a change in leadership to a new generation. Even the suspect official economic statistics have been indicating a slowdown in the economy, while other evidence indicates that the situation may be worse than the official numbers show. China’s economy is heavily based on exports and is extremely vulnerable to slowdowns or recessions in other major economies. India is experiencing a similar deceleration of growth. In the last few years China and India have accounted for the lion’s share of global growth, and any slowdown has major implications for the overall global economy.
We believe that the numerous headwinds to economic growth are creating substantial downside risks to the economy and corporate earnings that, until recently, were not being appropriately discounted by an increasingly euphoric stock market. We believe that the correction is only the beginning of a major downturn. At current levels the downside risks are still far greater than the potential upside rewards.
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