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Recession risk at 40% as stocks dip 4.3%

Posted: 09 Aug 2011 ?? ?Print Version ?Bookmark and Share

Keywords:stock market? recession?

The economic weakening in Eurozone financial markets and lousy economic data from the U.S. has prompted global stock markets to sink, further exacerbating fears over an impending economic crisis. The Dow fell more than 500 points or 4.3 percent, 10-year Treasury yield down to 2.41 percent and WTI oil futures dropped more than five dollars per barrel to below $87/barrel.

Is today's huge market decline just another example of extreme market volatility divorced from fundamentals? Unfortunately, on this occasion, there are very good reasons to be worried. A recent study by a Federal Reserve researcher has concluded that when real GDP growth drops below two percent YoY, a recession follows within a year roughly 70 percent of the time. The latest set of GDP data shows YoY growth dipping to just 1.6 percent in 2Q11.

Another cause for worry is that since World War II, whenever the three-month-moving average of the unemployment rate has risen by more than 0.3 percentage point, a recession has always followed. The three-month moving average hit a trough at 8.9 percent in March and April, and as of June had crept up to 9.1 percent. If the unemployment rate just creeps slightly higher to 9.3 percent (June was 9.2 percent) and stays there for a couple of months, the three-month moving average rate will hit 9.3 percent and the recession signal will be triggered.

The ISM non-manufacturing index has only a brief history (back to the mid-1990s), but on two occasions when it dropped below the 50 mark after a prolonged expansion!April 2001 and January 2008!these moves coincided exactly with the first month of recession. This signal is not conclusive because it gave a false recession signal when it dipped below 50 in March 2003. Nor has it yet triggered the recession signal!but just getting closer!slipping to 52.7 in July, still in growth territory for now.

Forecasting simply based on rules of thumb is dangerous. The normal rules may not apply in this particular episode where we have a very unusual recovery. We may still be in a sustained, but modest recovery with periodic ups and downs, where the downs will bring the pace of growth so close to zero that it will look like the economy is heading into recession. It is also worth noting that housing activity has usually been a key driver of recession, but that housing activity has not recovered at all from its collapse in the last recession, so its downside at this point is limited. However, the signals are disturbing and at a minimum, they show an economy with very weak growth prospects. It is also troubling that policymakers do not seem to have the weapons to match the risks we are facing.

The Fed may be more reluctant to do a QE III than it was last year, since the inflation rate is now higher, but if the Fed is confident that economic weakness will bring inflation lower, it will probably try it, though it is hard to see any of these options as game changers. They would provide some help at the margin, although the Fed would be doing them not because it could be sure they would make a huge difference, but because it would feel the need to do something.

In Europe, of course, the inflation-phobic European Central Bank has been moving in the opposite direction by raising interest rates (as it did in 2008 when it raised rates during the recession). It has some leeway to reduce rates, but it would be very reluctant to use it.

On the fiscal policy side, the political debate in the U.S. has concluded that stimulus has failed. The direction of fiscal policy is now towards tightening, as embodied in the debt-ceiling agreement. The argument that budget deficits have been holding back the economy is a weak one, since the normal mechanism through which that would occur is crowding-out via high interest rates. Nevertheless, interest rates are low, not high. The most effective fiscal policy action to generate activity and jobs would be a major program of public works to re-employ unemployed construction workers, but we can safely assume that is not on the agenda.

The best that U.S. fiscal policy can do now is to avoid adding further harm, by extending the payroll tax cut and extending emergency unemployment insurance benefits into 2012. If action is not taken, these policies will expire, adding a fiscal tightening of around $150 billion (one percent of GDP) to the drag imposed on the economy by declining government spending.

In Europe, governments on the periphery will be pressured to introduce still more austerity that will further weaken economic growth.

The U.S. growth rate estimate for 2011 is reduced to 1.7 percent (from 2.5 percent) and for 2012 to two percent (from 2.6 percent). These should be regarded as the lower bounds for the reductions!the growth cuts will be at least that big and may be bigger. This outlook would not imply a recession, but would imply an increased recession risk that is now placed at 40 percent.

Friday's employment report will be the next important data signpost. A bad report will reinforce recession fears. A better-than-expected report will provide some relief, but we would need a series of better-then-expected data reports to conclude that we are free from recession.

- Nigel Gault
??IHS Global Insight





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