Recession or Depression

by Phil Williams | October 27, 2008

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I had the great fortune early in my career to work in Shell Oil’s planning department where we worked with scenario planning. Scenario planning is a strategic planning tool that looks at various possible scenarios and allows managers to determine how they might react if one or another scenario eventuates. Given that we can’t accurately foretell the future we need to position our investment portfolio based on our best reading of how things might unwind going forward. It is within this context that I position the following article.

There is much debate at the moment as to whether the current downturn will turn out to be a V or L-shaped recession or whether the economy morphs into something far worse, namely a greater depression. Whilst there doesn’t appear to be a common definition as to what constitutes a depression, it is generally perceived as a period of sustained economic downturn, featuring high unemployment (probably above 10%) and a reduction of 10% or more in GDP.

Base Case – long and protracted recession lasting “another” 12-18 months

The first scenario looks at the argument for a recession. There is little doubt that the US is currently in recession. However I believe that the downturn will turn out to be far more protracted than most people currently think. The key reasons supporting this view are:

• Sustained reduction in consumption – at its peak consumption made up over 70% of US GDP. In fact the mantra of many cheer-leaders for the American dream was “Spend, Spend, Spend”. There are however a large number of factors that will weigh heavily on consumption going forward. These include:

• A large reduction in mortgage equity withdrawals (MEWs), which at their peak totaled over $800 billion, or 6% of GDP. MEWs are declining quickly in line with the sharp drop in house prices and are unlikely to rear their ugly head any time soon;
• Consumers are clearly maxed out with their credit. They used their houses as ATMs, went on a spending spree with no payment down, interest free holidays on a whole range goods including autos, and then used plastic like there was no tomorrow. So not only are banks tightening up on consumer credit but those consumers that can afford it will have to start running down their debt to more reasonable levels;
• Tightening credit - Banks are tightening up on all areas of credit. In some instances this is being imposed on them through their own funding problems. However prudent management would dictate that banks reduce credit in times of a downturn as credit quality deteriorates and customers’ ability to repay comes into question;
• Demographics - As in many other western societies America’s population is ageing quite rapidly. The bursting of the housing and stock market bubbles will have a major impact on many people’s retirement plans. This will force people to stay in the workforce longer (where they can). However instead of using rampant asset price inflation as the key strategy in funding their retirement, people are now going to have to save for retirement the old-fashioned way i.e. through saving out of their income.

In the early 60s and 70s the savings rate moved in a range of between 8 and 12%, reaching a peak of 14% in the 70s. The savings rate dropped steadily from that time and at its low ebb a year or so ago America’s savings rate dropped to negative 2% of GDP. Clearly such a low rate is unsustainable in the long-run and so with asset inflation no longer an option Americans are going to have to substantially increase their savings rate and this will have a major impact on consumption. Even a move towards a low rate of 4% would weigh heavily on consumption. However I believe that people’s retirement plans have been thrown into such disarray that savings could easily move back to the 6-8% range which would have a massive impact on consumption and thus GDP;

• Changing consumption patterns - Over the past 4-5 years Americans have spent up big on houses, furniture and fittings, electronic gadgets and autos. Typically these items have a long shelf life so there will be little need to rush out and buy such items in the near future, particularly when consumers have limited access to credit and they are increasing their savings;
• Increasing unemployment – much of the increase in employment over the past 5 years was related to the housing and financial boom. Large numbers of jobs were created in real estate, construction, retail and finance and these jobs will obviously disappear. However the US is also particularly vulnerable to increasing unemployment due to the changing composition of the US economy. For instance over the past decade US companies have sent many of their manufacturing jobs overseas. It seems reasonable to assume that many of the service jobs created in their place e.g. retail, home services etc relate to discretionary-based expenditure which will be significantly impacted by the downturn;
• Declining returns on investments will significantly impact retirees ability to consume;
• The wealth effect clearly works in reverse as well. With trillions of dollars being wiped off the value of asset prices this is going to have a major reduction in expenditure going forward;
• Changing psychology – US citizens could not possibly go through the fall-out of the housing and stock market declines, as well as the looming increase in unemployment without it having a major impact on their psychology. Just as the Great Depression had a lasting impact on that generation’s psyche, a long drawn out downturn will also severely sap the confidence of consumers for some time to come.

• Asset deflation – it is clear that the US and other world economies are de-leveraging at a rapid rate. It would seem that this de-leveraging will continue for quite some time to come as asset deflation feeds on itself. For example regulators allowed leverage at Freddie and Fannie to reach 50 to 1. De-leveraging back to more normal levels of say 10 to 1 could take $4 trillion out of purchasing power. Now whilst this will impact mainly asset prices it will also have a flow on to consumption as well. De-leveraging of hedge funds (where leverage was typically 30 to 1) and other financial institutions due to asset write-downs will also have a major impact on asset prices and consumption.

Additionally it does not appear that the decline in housing prices is going to end any time soon. By most measures house prices still appear to have another 10-15% to go. A significant amount of the demand was fuelled by people buying second homes. This will clearly dry up as people struggle to keep their main residence. The return to more stringent loan conditions like a 20% down payment will also impact the housing recovery by suppressing demand.

• Problems in the government sector – the recession will clearly have a major impact on the budget position of State and local governments. This will lead to reductions in expenditure as well as increasing lay-offs as these entities strive to keep their deficits under control. Their budgets will also be impacted through an increasing need to support social programs for the poor.

•  Company failures – the turmoil to date seems to have focused primarily on the financial sector. However as the route continues the downturn will have a more significant impact on the real economy, which will in turn be affected by an increasing number of company failures. Factors contributing to these failures will include:

• A reduction in credit as banks tighten up on their lending criteria;
• Junk bond defaults;
• Chronic under-funding in pension schemes. Many companies would have determined their contributions to pension schemes based on returns of 10% per annum. With asset prices collapsing many companies will be forced to make up significant shortfalls in their contributions and in many instances they won’t have the ability to do so;
• The reduction in consumption mentioned above will obviously also impact the viability of many organisations.

• Reduced exports – the stronger dollar and the fact that many of its trading partners are also moving into recession will constrain export growth and could in fact lead to a reduction in exports.

There are of course a number of counter-veiling forces that will work against these contractionary forces. These include the US Federal deficit, which is likely to move from 3% to over 7% of GDP by the time this downturn is finished as well as a decline in commodity prices which restores purchasing power. However these factors will take time to work and I do not believe they will be sufficient to offset the forces highlighted above.

Interestingly some debate has focused on whether the USA government bailouts and the massive expansion in the Fed’s balance sheet will prove inflationary. At this time I am undecided on this matter. However I am inclined to think that deflation is more likely than inflation. In particular the increase in the Fed’s balance sheet will only prove inflationary if this translates into increasing credit growth. In the current circumstances this would seem most unlikely. It seems to me that the Fed’s lending is going into the banks to shore up their liquidity but is not being pushed through to the lending side; akin to pushing on a string. I can see few circumstances where banks are likely to increase their lending any time soon or where consumers will be able to take on additional debt (and be able to pay it back).

Scenario 2 – The recession morphs into a depression

The second scenario occurs when the deep and protracted recession morphs into a depression, either now or in the next couple of years. Interestingly there seem to be a number of factors that could potentially trigger a US depression. Some of the more likely candidates include:

• A catastrophic failure in the financial markets, potentially triggered by say a problem in derivatives. The notional value of credit default swaps for example has grown from next to nothing in 2000 to topping $60 trillion in 2007. Other financial factors could include major defaults in the credit card, auto finance and commercial property sectors which work together to weaken the capital base of US financial institutions.
• The ongoing collapse of the stock market. The recent panic in the stock markets around the world has been a sight to behold. I think that up until recently many on Wall Street had been in denial, using the tried and tested “Buy on the dips” mentality that had worked so well for the past 25 years. However it seems to me that the recent market action is suggesting a change in psychology as people come to grips with the fact that things might be changing. However I believe that we are still a long way off the market capitulation that would warrant a market bottom. Moreover I think as people continue to see their future evaporate before their eyes then real fear could arise, which could lead to an increasing move out of managed funds, thus leading to more forced selling.

It is of course interesting to note that a number of previously cautious investors (e.g. Warren Buffet, John Hussman and Jeremy Grantham) are suggesting that the market might be moving towards providing some reasonable value. Whilst clearly these people have marvelous track records, in my opinion value will only appear if earnings remain at reasonable levels. Interestingly S&P analysts have recently downgraded their earnings forecasts for the S&P 500 to $48.50 for 2009. This is well below the March 28 estimate of $81.50 for the same period. The most recent estimate still puts the S&P 500 P/E ratio at a historically expensive level of 18. A reversion back to recessionary levels of say 8 would suggest that the S&P 500 could drop to as low as 388 or lower. Interestingly the S&P 500 put in a huge double top at the 1500 level over the period 2000 and 2007 with a bottom at the 800 mark in 2003. Based on traditional technical analysis measures this would suggest a possible low-point of 50 for the S&P 500. Impossible you say. Well this is not far off the equivalent 400 level for the Dow that Robert Prechter has been suggesting for some years now.

• US Dollar collapse – the buck seems to be the best of a lousy bunch at the moment. However a rogue event could trigger a run on the dollar that could lead to a collapse in the bond markets and an increase in interest rates.

Ordinarily I would also prepare a scenario based on a speedy or muddle through recovery. However at this time I cannot see any forces that are likely drive a turnaround, particularly with the consumer in retreat.

Accordingly all I can suggest is that one continues to baton down the hatch for the next little while and enjoy the ride. This is a once in a life time experience.

Finally just as an aside I note that European and Asian leaders met over the weekend and called for a radical change in the financial regulatory landscape. By comparison George W called for a continuation of the free market system. Whilst the two positions are not mutually exclusive it seems to me that the US’s reputation has taken a severe battering as a result of this financial crisis and the rest of the world is in no mood to put up with American rhetoric. The US has lost any moral high-ground and the world will impose its wishes on the US. This is supported by several other instances of late including Russia snubbing its nose at Condolezza Rice over the war in Georgia and the increasingly cozy relationship between Venezuela and Russia.

We do indeed live in very interesting times.

 

Copyright © 2008 Phil Williams
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BIO
Originally trained and worked as an Economist before working for a major international oil company for many years. Currently working as a management consultant with one of the worlds top IT companies. 

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