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5 Reasons the U.S. Could See a Double Dip Recession

Fluctuation in gross domestic product (GDP) growth is an indicator used by the National
Bureau of Economic Research (NBER) to formally identify the beginning and end of a
recession. Specifically, the NBER defines a recession as “a significant decline in
economic activity spread across the economy, lasting more than a few months, normally
visible in real [inflation adjusted] GDP, real income, employment, industrial production,
and wholesale-retail sales.”2 But, for the purpose of investors focused on the economy’s
impact on financial markets, a recession can simply be defined as two consecutive
quarters of a decline in real GDP. Accordingly, those who fear a double dip recession
will be paying special attention to whether or not GDP growth turns negative relative to
the previous quarter. As such, it is imperative to keep in mind the components of GDP
and what could cause it to decline.

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.

The Ongoing Housing Correction

According to lagging data from April 2010, the 10 city Case-Schiller home price
composite was up 4.6% and the 20 city composite was up 3.8% versus April 2009. On
the surface, the release of these figures appears to represent very encouraging news for
homeowners and investors throughout the U.S. The concern, however, is that much of the
purchase activity in April was driven by the $8,000 homebuyer tax credit that has since
expired (in conjunction with a dwindling of stimulus spending throughout the economy).
Even with 30 year fixed mortgage rates hovering around 4.5%, mortgage application
volume has dropped precipitously since the tax credit expired.
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So, now that the government has pulled

forward housing demand and stimulated
short term buying, what are we left with? If
you believe housing guru Mark Hanson of
M. Hanson Advisers,3 we are left with a
gigantic shadow inventory of homes that are
in some stage of the foreclosure pipeline
which will eventually come on the market
and push housing prices back down. Let us
also not forget that 2011 represents the peak
in mortgage resets (see adjacent chart) and
even with historically low interest rates
available today, many people who took out
loans with teaser rates may not be able to
afford their new payments. When those two factors are combined, it seems likely that
housing prices will be under pressure during the next year or so and the impact on
consumers could lead to a decline in spending that hurts GDP growth. Of course, the
direction in housing prices could be positively affected by another round of government
tax cuts or stimulus aimed at preventing a further decline in prices. Additionally, banks
have the option of working with borrowers to offset the impact of rate resets and limit the
number of additional foreclosures.

Can the ECRI Leading Index Predict a Recession?

The aside chart was taken from John Hussman’s piece for the week of June 28th entitled
“Recession Warning.”4 It shows a recent plunge in the ISM Purchasing Mangers Index
(PMI) and the ECRI Weekly Leading Index (WLI). The PMI is an important indicator of
economic activity and any reading
above 50 suggests that
manufacturing is expanding. The
WLI, on the other hand, is a
composite index of 19 key weekly
economic indicators such as home
prices, stock market activity and
employment trends. Unfortunately,
this index has fallen for five
consecutive weeks, prompting
people who follow it closely to
wonder out loud about whether the
economic recovery is slowing or the
U.S. is heading towards recession.

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.

Herbert Hoover Revisited

With the benefit of perfect hindsight, many historians and economists blame the tax
increases imposed in 1932 as one of the main reasons the Great Depression lasted as long
as it did. Given that our current leaders are familiar with this argument, there is no way
they would try to enact anything as draconian as an increase of the income tax from 25%
to 63%, right? Surely members of Congress would not go out of their way to torpedo the
recovery? Unfortunately, in this case they may not even have to. If the last
administration’s tax cuts expire, the highest marginal tax rate will expand to 39.6% from
35% and the estate tax will reemerge in all of its glory. In a paper written in 20075,
Obama’s own adviser Christina Romer concluded that a dollar in tax cuts raises GDP by
about $3. However, what that analysis also implies is that a $1 tax increase could reduce
GDP by $3. Therefore, with the gridlock in Congress, the ongoing discussions about
reducing the budget deficit and the ever louder calls for fiscal austerity, there is a non-
trivial risk that tax rates will increase in 2011 and have a negative impact on GDP.

Where Has All the Credit Gone?

The Federal Reserve no
longer tracks the M3
measure of money supply,
but John Williams of
ShadowStats.com6
continues to provide his
own estimates of M3. This
measure, which includes
M1 (physical currency),
M2 (M1+ savings accounts,
money market accounts,
retail money market mutual
funds & small time
deposits) and all other CDs,
is still tracked by economists in Europe. Disturbingly, as the adjacent chart highlights,
M3 is declining at rapid pace. In fact, according to an article in The Telegraph7, the
money supply contracted at an annual rate of 9.6% in Q1 2010, falling to $13.9 trillion
from $14.2 trillion. What this means is that despite the Fed’s vigilant efforts to create
inflation by doubling its balance sheet, the money supply is still contracting.
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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.

A Persistent Dose of Unemployment

Data from the July 2nd employment summary8 put out by the U.S. Bureau of Labor
Statistics (BLS) indicated that in June there were approximately 14.6 million unemployed
Americans. The headline unemployment rate of 9.5% was down from 9.7% in May even
though nonfarm payrolls actually dropped by 125,000. How does that work exactly?
Well, in June the labor force dropped by 652,000 people. If not for that, the
unemployment rate would have been around 10%.

In addition, the employment to

population ratio fell to a four
month low of 58.5% and the
number of people who have
been unemployed for longer
than 27 weeks (with a mean of
35.2 weeks as seen in the aside
chart9) came in at 45.5% of the
total. Unfortunately, studies
regarding long term
unemployment indicate that
worker skills deteriorate over
time and the longer someone is
out of the workforce, the less
likely he or she is to become
re-employed at a similar caliber job.

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/