Whether the US can avoid slipping into another serious recession is a subject of considerable debate among market participants. Along with Europe’s sovereign debt problems, the risk of a serious renewed recession in the US is one of the major clouds hanging over global equity markets.
Gross domestic product (GDP) growth in the first half of this year has already been subdued, running below one per cent. Though the hard data over the past month have been stable, with retail sales increasing by 0.5 per cent in July, personal consumption expenditure increasing by 0.8 per cent and industrial production rising by 0.9 per cent, all these data points are backward-looking.
The more forward-looking survey data show significant deterioration. The Philadelphia Fed Index has dropped to -30.7, a level only observed previously during or on the cusp of a recession. The National Federation of Independent Business survey for small businesses has also weakened, with an increasing number of firms now expecting a decline in sales over the coming quarter. The biggest shocker has been the collapse in the University of Michigan Consumer Sentiment Index. It hit a 30-year low in August, even lower than levels in November 2008.
Bond markets are clearly signalling economic weakness, with US 10-year rates slipping below two per cent.
Though the US economy may possibly slip into a shallow technical recession, two quarters of slightly negative growth, it is important to ensure that this does not turn into a deep downturn. The fears about a sharp downturn arise from the lack of ammunition with the authorities to tackle such an event (limited room on both fiscal and monetary front), and the savage effect it will have on corporate earnings in the US, the stock market and household wealth.
Though the lack of room for policy action is well known, few people realise just how elevated corporate earnings are in the US.
The profit share of GDP in the US is at an all-time high (nearly double its long-term average). This is driven by several factors: the effective tax rate has fallen to 25 per cent from 40 per cent in the year 2000; interest costs have dropped to less than 1.5 per cent of sales from four per cent in 2000; and real unit labour costs are at 60-year lows, with wage share of GDP at a 50-year low. The final factor in the elevated profitability of corporate America is the weak dollar, and the translation effect of converting overseas earnings streams into the dollar.
A deep recession will lead to at least a 20 per cent drop in earnings in the US, which is easily possible, given high earnings today. Thus, the market will no longer look as cheap as the bulls would have you believe.
This is the big risk that investors are worried about. The US economy double dips, the authorities cannot do much to address another sharp downturn, earnings decline 20 per cent-plus, and the markets have one more leg down, dragging everybody down once again.
But to come to the main point, will the US have another steep decline? To answer this question, one must understand why growth in the US slowed sharply to just 0.7 per cent in the first half of 2011. Growth in real final sales (GDP growth minus the inventory contribution) declined from 2.9 per cent in the second half of 2010 to just 0.7 per cent in the first half of 2011. The slowdown in personal consumption expenditure accounted for 1.3 percentage points (57 per cent) of this growth downshift and a slowdown in government spending accounted for 0.5 percentage points (23 per cent). Looking at the data in more detail, it becomes clear that about half the decline in consumption was owing to a drop in auto sales and another 10 per cent owing to a reduction in gasoline purchases. It is clear that the earthquake and tsunami in Japan, which had a significant impact on the global auto supply chain, and the surge in fuel prices led to a reduction in auto and fuel sales in the US in the first half of 2011. Looking ahead, prices for most agricultural and industrial commodities, along with fuel costs, are likely to be lower in the second half of 2011. Also, the supply disturbances out of Japan are now mostly over. Motor vehicle production increased by 5.2 per cent in July, while both orders and shipments increased by 12 per cent. A reversal in commodity inflation and auto supply disruptions should provide some stability and support to consumption in the second half of 2011, and enable the US to avoid a sharp slowdown.
If we assume that consumption in the US will stabilise, then the bigger risk to growth is fiscal restraint. The question is: how much of a headwind on growth will it end up being? Fiscal tightening probably cut growth in the first half of 2011 by 0.75 to one per cent, and if current policy settings remain, this drag on growth will increase to between 1.5 and two per cent in 2012. The political environment in the US today is such that fiscal policy has become a major election issue along with jobs. The tea party movement, and its influence on the Republicans, has severely constrained the room for policy flexibility in this area. The Republicans were seemingly willing to even risk default to ensure spending cuts. The increase in fiscal drag in 2012 is largely owing to the scheduled expiry of the payroll tax cut at the end of 2011. If this is not extended, it will raise the tax burden on US households by $110 billion annually (0.7 per cent of GDP). If US President Barack Obama is able to convince the Republicans to extend this payroll tax relief and, hopefully, introduce some other job creation-related fiscal sops, than the fiscal drag on growth in 2012 will be no worse than in the first half of 2011. It will be critical for investors to track progress on this front over the coming months.
The single biggest risk that could push the US into another deep downturn is that of significant fiscal tightening, hitting an already weak economy. With Federal Reserve Chairman Ben Bernanke having fully understood the risks of premature fiscal tightening, US policy makers will hopefully pay heed to his advice and avoid rigid ideology-based policy positions. As for Europe pushing the US over the edge, direct US exposure is limited, since exports to the European Union (EU) only account for about two per cent of US GDP and cross-border exposure of most US banks is quite limited. However, a blow-up of any large EU financial institution will have unexpected consequences in the US.
As for other issues that could push the US into a deep downturn, there seems to be a reasonable amount of pent up demand in the US economy. The stock of capital goods has declined sharply as a share of GDP. On a flow basis, spending on these cyclical sectors is about 19 per cent of GDP, more than five percentage points below the post-1970 average. It would be a break from history for the US to go into another deep downturn, with cyclical spending already depressed.
Hopefully, the US can avoid another sharp leg down in its economy. Consumption seems stable, fiscal restraints can be eased, and most cyclically sensitive sectors are already depressed. A technical and shallow recession may still hit, but in the absence of a sharp renewed downturn, earnings should hold up, and markets don’t look that expensive.
The author is fund manager and CEO of Amansa Capital
