It's Official - Recession Began Last March:
The Fed Wasn't Able to Repeal the Business Cycle
Headlines in financial publications throughout the 1990’s asked investors to ponder the momentous question: can timely action by the Fed effectively repeal the business cycle? That is, asked market pundits and economic experts, is it possible for the enlightened raising and lowering of interest rates to sufficiently dampen the amplitude of economic activity such that recessions could be altogether avoided? The year 2001 was the year during which the resounding answer to that question became: no, as the domestic economy slipped into recession.
The National Bureau of Economic Research notes that the U.S. economy peaked in March 2001, summarily ending the longest economic expansion in the history of the United States. Despite the lengthy upturn of the 1990’s, the economy eventually fell victim to the bursting technology bubble, previous monetary tightening, a shock in energy prices and, ultimately, terrorism. However, Gross Domestic Product (“GDP”) remained flat during 2001’s second quarter and did not decline until the third quarter when it fell at a 1.3% rate. We expect GDP to be negative in the fourth quarter of 2001, thereby also qualifying under another technical definition of a recession, that is, two successive quarters of negative real growth in output.
Furthermore, we expect that the recession will persist into the first quarter of 2002, with GDP to be negative at least through that quarter. However, because of the magnitude of stimulus, the overall recession should be of only average length (approximately 1 year) and should turn out to be comparatively mild, in terms of expected peak to trough decline in GDP.
If overall GDP declines will be mild, business capital spending will enjoy no such blandness. Declines in capital spending have just been awful. Domestic spending on industrial equipment dropped at a 21% rate in the second quarter of 2001 and at a 24% rate in the third quarter. Non-defense capital goods orders are down 20% from levels that prevailed a year ago.
Corporate earnings have been woeful too. Once 2001 is fully reported, we anticipate that S&P 500 earnings will have declined 22% year over year, the worst performance since Word War II. Profit margins have absolutely plummeted which is why a relatively mild recession caused such a huge earnings drop. Margins in the third quarter of last year were equivalent to World War II lows and will set a record low once the fourth quarter is reported. Technology companies are outright losing money while telecommunications earnings, such as those for fiber optics, switching and networking companies, will be down 75% in 2001. Earnings on discretionary consumer goods companies, such as retailers, will be down in excess of 40%, capital goods and basic materials, such as machinery and paper companies, will decline about 20% and financials earnings will be down 15% for 2001.
It is the very leveraged, very resilient U.S. consumer, with wallet swelled by his latest mortgage refinancing and appetite fueled by deflation in consumer technology goods and autos, who has consistently propped up the economy. Consumer spending slowed sharply in 2001 but remained stronger than in most post-War recessions and is still growing at around a 2% rate.
The chief cause of this round of mortgage refinancing has been eleven Fed rate cuts in 2001, the most aggressive Fed action ever. In an effort to prop up an economy reeling under the weight of the tech crash (and to reverse tightening efforts undertaken in 2000) the Fed lowered the Fed funds rate from 6.50% to 1.75% in those eleven moves, bringing that bellwether rate to a 40 year low. However, the real Fed funds rate (that is, adjusted for core inflation) is only slightly positive, at 0.25%. Since the Fed has taken the real Fed funds rate to zero in previous cycles, it seems reasonable that the Fed would ease one more time. The most likely timing of that move would be at the January 29 - 30 meeting of the Federal Open Market Committee.
Evidence of a recession is everywhere. Capacity utilization in the technology sector is below 60% and still dropping. The purchasing managers’ index attained a low of 39.8 in October - only a number above 50 indicates industrial sector expansion. Factory output incurred its steepest decline since 1982, down over 6%. It too is still declining. Finally, inventory liquidation accelerated in the fourth quarter of 2001 with around $100 billion of shrinkage worked off. The net result is that continued inventory runoff will reduce GDP growth by a full percentage point for the fourth quarter of 2001.
The employment side is equally dismal. Since employment levels peaked in March 2001, over 1.2 million jobs have been lost, compared with 1.8 million jobs lost in the 1990 - 1991 recession and 2.8 million jobs lost in the 1981 - 1982 recession. Further, the recession is by no means concluded; that is, total job loss may ultimately reach or exceed the levels attained eleven years ago. The unemployment rate climbed to 5.7% in November and will probably continue to rise for several months. Unemployment tends to peak just after recessions end. It peaked at 7.8% in 1992, after the end of the 1990 - 1991 recession and peaked at 10.7% in 1982, toward the end of the 1981 - 1982 recession.
Almost as if it were orchestrated, the majority of European countries, along with Japan and most emerging markets, joined the U.S. in recession in 2001. Furthermore, outside the United States, the recession will be quite severe with global growth dipping below zero for the first time in twenty years. Higher energy prices, the collapse of worldwide technology investment and the terrorist attacks in the U.S. have all contributed to a dismal economic picture globally.
In the U.S. the stimulus created by aggressive Fed easing as well as increased fiscal spending has created the perception that the recession will not only be mild and shallow but also that a “snap-back” effect, or “V” shaped recovery, is imminent. This conviction is part of the reason for the stronger stock market in recent weeks. While inventory rebuilding in the United States may result in a quarter or two of good growth contribution, the ongoing dismal corporate profitability picture will depress employment, keeping a lid on all-important consumer spending. Simultaneously, Japan is experiencing its fourth recession in ten years and its recovery is very dependent on trade, despite recently enacted reforms. The recovery in Europe will be muted and there are pockets of crisis elsewhere, as in Argentina. Only Asia (excluding Japan) is expected to experience a 6% or so rebound by 2003. Elsewhere, the recovery will be extremely modest.
We expect that GDP growth will be up less than 2% in 2002 in the U.S. Since first quarter GDP is expected to decline, this means that the later quarters of the year will most likely be up, with most of the increase attributable to inventory re-stocking and most of that occurring in the latter part of the year. Once inventories are built back, economic recovery will be further slowed by the sluggish worldwide recovery, by the long process of re-establishing healthy corporate margins and by the fact that the Fed will no longer be easing. Hence, 2003 growth is likely to be in the 3 to 4% range. This is certainly not a “snap-back” or “V”-shape recovery and falls far short of the 6% and 7% growth rates turned in during the first year of past recoveries.
As is typical of the first year of any recovery, inflation will continue to fall. Pricing power has disappeared, the lack of global growth is causing pockets of deflation and commodity prices recently hit a fifteen-year low. By mid-year, when the recovery is expected to start, the run rate of core inflation is likely to be less than 1.5%.
Continued low inflation and low interest rates, along with an economy poised to emerge from an output and profits downturn, should create a rewarding post-recessionary environment for investors. In our view, a steady and patient investment demeanor is the one most likely to reap these rewards.
