A Double Dip Recession and why Quantitative Easing won’t work

In our Economic & Market Outlook dated 5 July 2010, we noted that leading indicators had begun to deteriorate sharply in the United States, the implication being that the US economy may well be heading back into recession. As the US is still the world’s largest economy, it remains of global importance. Economic data released since the end of June has only added to our concerns and we would have to say, failing any further stimulus, that the odds of a US recession have increased significantly.

ECRI LEADING INDICATOR
The ECRI WLI growth metric has had an impressive (but not perfect) record for forecasting the onset of a US recession. The ECRI WLI charts the weekly changes in a proprietary index of Leading Economic Indicators. The ECRI was founded by the late Prof. Geoffrey H. Moore, who in 1950developed a list of leading indicators for recessions and recoveries.



According to dshort.com:
“A significant decline in the ECRI WLI Index has been a leading indicator for six of the seven recessions since the 1960s. It lagged one recession (1981-1982) by nine weeks. The WLI did turned negative 17 times when no recession followed, but 14 of those declines were only slightly negative (-0.1 to -2.4) and most of them reversed after relatively brief periods…The deepest decline without a near-term recession was in the Crash of 1987, when the index slipped to -6.8.”

As at 20 August, the index stood at -9.9. Although it has improved marginally from its low of -11 on 23 July, the index continues to imply that the likelihood of a recession is high. Of course any leading indicator is not foolproof however it would be imprudent to ignore it altogether given its track record.



WHY WE BELIEVE A US RECESSION IS INCREASINGLY LIKELY

After a strong start to the year recent data releases in the United States have added doubt to the strength of the recovery. June quarter Gross Domestic Product (GDP) was recently revised down from the original estimate of 2.4% to a weak 1.6%. It is now clear that the strong March quarter growth, was simply a case of inventory re-stocking after the plunge in production that occurred during the Global Financial Crisis (GFC) rather than any particular strength in final demand. In other words, during the GFC consumers deferred their consumption of certain items (mainly discretionary items and durables) and at the same time, companies ran down inventories and reduced production. So as demand improved after the GFC, production resumed and inventories restocked to the point where supply has now caught up with demand. Importantly, at this point further growth in US output (production) requires an improvement in final demand.
This is where we have concerns for thefollowing reasons:

• US retail sales rose by 0.4% in July. Excluding car dealers and service stations, demand dropped by 0.1%. This is the third decline in core retail sales in the last 4 months. Personal consumption accounts for about 70% of GDP.
• The fall in the value of the Euro reduced the competitiveness of US industry, resulting in a 3.37% fall in net exports in the June quarter, the worst in 6 decades. While we expect this imbalance to narrow it may continue to act as a negative contribution to growth in coming quarters, all other things being equal.
• The expiration of the US first home buyers tax credit has led to a sharp fall in home sales and buildings approvals once more. A downturn in the building sector has wider ramifications due to the flow on impact to bulky good retailers such as furniture stores, white good retailers on so forth.
• The fall in US home sales is perhaps a prelude to a further fall in home prices which naturally curtails consumption (prior to the GFC a moderate proportion of consumption was financed by home equity drawdowns against rising asset values).
• Unemployment remains stubbornly high. A reduction in unemployment is a prerequisite for a sustained improvement in aggregate demand. Such a reduction appears unlikely given the weak growth outlook.

So it is abundantly clear that private sector demand is unlikely to grow in a robust fashion. Indeed, given that many of the US stimulus measures have expired (first home buyers tax credit, investment tax credit, cash for clunkers and cash for green appliances), it is certainly plausible that growth may actually fall in coming quarters. And so, with that rather sombre assessment, attention then turns to the public sector. Remember, GDP is a combination of government aggregate demand and private sector aggregate demand. If private sector demand is forecast to be weak then the Government can always step in to stimulate demand. As you are no doubt aware, stimulus can be by way of monetary policy (via the US central bank, the Federal Reserve) and fiscal policy (government spending). But with the US Government mired in debt, the political will to provide further fiscal stimulus is waning. Any new measure will prove difficult to get through parliament. This leaves only monetary policy. With the Federal Funds Rate (the equivalent to our official cash rate) already at 0.25%, reducing the cash rate to zero is unlikely to have any beneficial impact. The Bank of Japan kept its policy rate at 0% for more than a decade with little or no effect. This leaves Quantitative Easing as the only available policy tool left.

WHAT IS QUANTITATIVE EASING?

Quantitative Easing is a Government monetary policy tool used to increase the money supply by buying government securities (or other securities) from the market. Quantitative Easing increases the money supply by providing financial institutions with capital in an effort to promote increased lending and liquidity. By creating a greater supply of money there is the risk that Quantitative Easing may eventually lead to higher prices (more funds chasing a fixed amount of goods for sale) or inflation.

WHY QUANTITATIVE EASING WON’T WORK

The basic premise of Quantitative Easing is that the extra liquidity created (effectively by printing money) will encourage banks to lend and consumers and businesses to borrow. The business or consumer will then use the borrowed funds for consumption or investment purposes, which will add to aggregate demand and so be beneficial for growth. All of this sounds fine in theory. Yet Quantitative Easing undertaken to date has ALREADY increased the monetary base by over US$1 trillion without any commensurate increase in demand for money. This is because banks, while perhaps willing to lend, are only willing to do so under reasonable commercial terms. These ‘reasonable commercial terms’ typically involve ‘reasonable security’. Given the sharp fall in property
prices, the amount banks are willing to lend against property assets has understandably fallen (lower loan to valuation ratios). Banks are still in the business of making money not losing money. Similarly, most banks are being more cautious when lending to business given the uncertain economic outlook. So, despite the massive supply of money injected into the system, to date it has had little effect. Further with household debt still high and house prices still under pressure, it is likely that the consumer will continue to undergo a multi year period of deleveraging. There may be plenty of supply - but there is no demand for money at the present time. To conclude, the reason why we believe the US economy cannot be resurrected by Quantitative Easing is because the problem is not one of liquidity - it is one of solvency. US households, parts of the corporate sector and the US Government itself need to go through a prolonged period of debt reduction to repair balance sheets before a sustainable platform for growth can arise. Trying to encourage more borrowing is NOT the answer.

DOES THIS MEAN A RECESSION IS INEVITABLE

The probability of a recession in the United States has increased considerably in recent months but this does not mean it is inevitable. Failing any further fiscal stimulus, we do believe that growth is likely to remain well below trend (at best). While it is possible that growth could (and hopefully will) surprise on the upside, risks are clearly tilted to the downside. Such a scenario is unlikely to be positive for US sharemarkets or, given the positive correlation, global sharemarkets in the near term.

For more information please do not hesitate to contact one of the following members of our Wealth Management team:
Charlie Viola +61 2 8236 7798
Director
Martin Fowler +61 2 8236 7776
Director
Haris Argeetes +61 2 8236 7851
Manager


Contact

Martin Fowler
T  +61 2 8236 7776
mjfowler@moorestephens.com.au

www.moorestephens.com.au