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GDP equals consumption plus government spending plus investment plus net exports
(GDP=C+G+I+NX). In the aftermath of the financial crisis, consumption decreased as
asset values declined and unemployment rates spiked. As a result of the subsequent
reduction in consumer spending, the government increased its spending in order to make
up for the reduction in consumption. In the short run this strategy has worked as the
stimulus has contributed meaningfully to the recent growth in GDP. But going forward,
what happens if the government cuts back on spending? What happens if asset values
fall, unemployment levels remain elevated and consumers retrench even further? What
happens if banks continue to curtail their lending and no capital is available for
investment? The answer is that U.S. GDP could once again contract.
In this context, below are five reasons to be concerned about a rare double dip recession.
The reason investors should pay attention is that such an outcome could have a marked
impact on corporate profits and thus the stock market, at least in the short run. Fears of a
double dip have already helped fuel a 12% decline in the S&P 500 since May, but the
ultimate outcome remains to be seen.
Grey bars in the chart represent recessions and just a quick glance at the picture leads to
the unmistakable conclusion that there is some correlation between a large drop in these
indices and recessions. Unfortunately, after a 6.9% drop recorded for the week of June
25th, the next week produced an even worse 7.6% decline. For the week of July 23rd, the
index plunged 10.5% further (excluding revisions to previous figures). But what is the
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historical relationship between these figures and recessions? From Hussman’s piece:
“Taking the growth rate of the WLI as a single indicator, the only instance when a level
of -6.9% was not associated with an actual recession was a single observation in 1988.”
Recent declines in both of these indices certainly do not guarantee a return to recession.
However, investors globally should be aware that risks of a double dip are elevated and
should consider whether or not the U.S. equity market has properly accounted for that
possibility.
Falling money supply is concerning because it signals the potential for outright deflation,
a decrease in the general price level of goods and services. Ben Bernanke would be the
first person to acknowledge that GDP growth is hard to come by when credit and the
money supply are contracting. In a deflationary environment, businesses have little
access to growth capital because banks reduce their lending activities as a result of
increased risk aversion or regulatory requirements. Further, deflation causes the debt
burden on consumers to become even more crippling as wages fall and the real cost of
debt payments rises. This is why Bernanke vowed to throw money out of a helicopter, if
necessary, in order to prevent deflation. But, the Fed Chairman’s dilemma is that banks
are not lending and, even worse, credit lines are being reduced for businesses and
consumers. Accordingly, Bernanke may have to go door to door with a sack of money in
order to produce inflation and growth in spending.
But aren’t things getting better? In reality, the evidence is mixed. The headline
unemployment rate has been steadily dropping due to people falling out of the labor
force. When those people begin to look for jobs again, the unemployment rate will
increase even if employment stays flat. In addition, many of the jobs created so far in
2010 were due to temporary hiring for the U.S. Census, and that hiring has already run its
course. Also, just to keep pace with employment-age population growth, the U.S. needs
to create 125,000 jobs each month. Therefore, at a job growth rate of 225,000 per month,
it would take almost 3 years to re-employ the 8 million workers who have lost their jobs
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in the past few years. Of course, this is on top of the 125,000 jobs needed to facilitate the
entry of new workers. In summary, it appears that at least for now, the U.S. economy has
stopped losing jobs at a rapid pace, but the overall unemployment situation is not
improving very much.
The ultimate risk is that once unemployment benefit payments run out, people will have
to cut back even further on consumption and potentially stop paying their mortgages and
credit card bills. At that point, the vicious cycle of lower spending impacting businesses
and defaults hampering financial institutions starts again, leading to a contraction in both
consumption and investment which limits GDP growth.
References
1. http://www.nber.org/cycles.html
2. http://mhanson.com/
3. http://www.hussmanfunds.com/wmc/wmc100628.htm
4. http://www.econ.berkeley.edu/~cromer/RomerDraft307.pdf
5. http://www.shadowstats.com/
6. http://www.telegraph.co.uk/finance/economics/7769126/US-money-supply-plunges-at-1930s-
pace-as-Obama-eyes-fresh-stimulus.html
7. http://www.bls.gov/news.release/empsit.nr0.htm
8. http://economix.blogs.nytimes.com/2010/07/02/bleak-outlook-for-long-term-unemployed/