Comstock Partners, Inc.August 13, 2009
Normal Economic Recovery Highly Unlikely
Although GDP in the current quarter will probably be up, the chances for a typical V-shaped recovery are exceedingly slim. First, positive GDP quarters during recessions are not unusual, and have occurred in six of the ten post-war recessions prior to this one. Second, even if the current quarter proves to be the statistical end of the recession the ensuing recovery is likely to be so weak that it will hardly be visible to the naked eye. Third, the uptick in the current quarter will be a result of a temporary catch-up of inventories to meet a still tepid level of demand, and the 'cash for clunkers' program that is merely shifting auto sales forward and drawing demand away from alternative spending. Incomes are receiving a boost from temporary tax cuts, a one-time social security payment and extended job benefits. Looking ahead, we see no drivers for a sustainable recovery for the following reasons.
1) Consumer spending accounts for more than two-thirds of GDP, and, for a variety of reasons, consumers will be under pressure for some time to come.
2) Consumer spending over the past decade has been supported by easy credit and by successive bubbles in the dot-coms and housing. The dot-com and housing bubbles are gone, and while interest rates are low, credit requirements are much more stringent.
3) Household savings rates in the decades prior to 1992 ranged mostly between 7% and 11%. The rate steadily dropped to zero by 2008 and rose to 5.2% in the 2nd quarter. Without the comfort of high and rising net worth, the savings rate is likely to rise to 9% or higher, resulting in reduced spending for discretionary items.
4) Consumer spending typically accounted for 61% to 64% of GDP from 1955 to 1985, but is now 70.5%. A drop back to 65% would reduce spending by 7.8%, although it wouldn't happen all at once.
5) Household debt for the last 55 years averaged 55% of GDP and was 64% as late as 1995. It is now about 100% and is a huge burden on a large number of households. Any reduction of debt is another restraint on future spending.
6) The ongoing housing situation is yet another burden on consumers. A recent Deutsche Bank study showed that on March 31st, 26% of US homeowners with mortgages owed more on their properties than they are worth, and that this will rise to an estimated 48% by the 1st quarter of 2011 as home prices drop another 14%. This will result in a continued rise of foreclosures, adding to housing inventories and further reducing consumers' ability and willingness to spend. July foreclosures were up 7% month-to-month and 32% year-over-year.
7) Employment is still declining, albeit at a lower rate, and wages are 4.7% below a year earlier, the largest decline since the records began in 1960. We see continued news stories about further wage reductions, reduced hours and forced unpaid vacations, indicating that household income will remain under pressure for some time.
8) Despite the recent rise in their stocks, the banking industry is still highly fragile. On the "Morning Joe" show, Elizabeth Warren, the Harvard professor who heads the Congressional Oversight Panel, stated that almost all of the toxic assets that were on the banks' books last autumn are still there as the original Paulson plan to buy them back was subsequently changed. Furthermore since the accounting rules were changed so that the banks no longer have to mark to market, they are unwilling to sell at the far lower market price since they would then have to take a big writeoff. She also added that "We have a real problem coming" in commercial loans where the medium and small banks have particularly large holdings. A large part of these loans come due from 2010 to 2012, and there has already been a high default rate on those that have already matured.
9) A recent study of past credit crises by Professors Kenneth Rogoff and Carmen Reinhart indicate that recessions caused by credit crises lasted far longer and were more severe than average, and that the ensuing recoveries were sub-par. Furthermore, with the exception of the 1929-to1932 depression, all of the recessions were restricted to one country or region and were not global in nature. Therefore, in most instances, the affected nation was eventually able to export their way out, an option that is not available this time.
All in all, there are now no drivers for a durable and sustainable recovery. Lower incomes and spending cannot possibly support anything but the weakest type of recovery, and a lapse into another recession is a distinct possibility. Stocks have been in a secular bear market since early 2000, and in the climate we see ahead, earnings are likely to remain subdued with P/Es declining well below their present level.