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News : International Last Updated: Jul 1, 2010 - 7:45:44 AM


US Economy: Facing a wobble, a double-dip recession or fragile long painful process of recovery?
By Michael Hennigan, Founder and Editor of Finfacts
Jun 30, 2010 - 5:32:16 AM

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President Obama speaks to the media about the strengthening economy and the necessity of financial regulatory reform after meeting with Federal Reserve Chairman Ben Bernanke at the White House, June 29, 2010.

US Economy: Tuesday's sharp 9.8-point dip in the Conference Board’s index of US consumer confidence in June, together with other data, particularly from the housing sector, have raised questions as to whether the economy is facing just a wobble, a double-dip recession or a fragile recovery that will be a long, painful process?

US Federal Reserve Chairman Ben Bernanke and President Barack Obama agreed at a Tuesday meeting in the Oval Office that the economy is strengthening, but continued jobs weakness and the situation abroad remain top concerns. “I think in our discussions we share the view that the economy is strengthening, that we are into recovery, that it’s actually led by some interesting sectors, like manufacturing, that we haven’t seen in quite some time,” the president said. “But what we also agree is that we’ve still got a lot of work to do.”

The president suggested that sovereign debt troubles in Europe have led to “skittishness and nervousness on the part of the markets and on the part of business and investors.” The Fed chairman pressed the need to take a global outlook. “I think, very importantly, we also talked a lot about the international context. What’s happening around the world in emerging markets, in Europe affects us here in the United States, and it’s important for us to take that global perspective as we discuss the economy,” Bernanke said.

RDQ Economics said in a note that "confidence has double-dipped in the last two recoveries (in early 1992 and early 2003) without the economy falling back into recession and the June pullback in confidence is far less severe than either of those two episodes. Furthermore, we think that the response to the oil leak in the Gulf of Mexico is depressing confidence. First, we note that the employment indicators posted only a very modest drop compared to the decline in overall confidence. Second, we note that the three regions that have states affected by the spill posted the largest declines in confidence in June. Third, confidence plunged in September 2005 following the perceived inept response to Hurricane Katrina. As a result, we do not think that the consumer confidence data are pointing to a double-dip in the economy or consumer spending."

In an article on Finfacts today, Prof. Peter Morici of the University of Maryland, says US economists expect the private sector created about 110,000 jobs but government employment dropped twice that amount, as many temporary census jobs disappeared. "Twelve months into recovery from such a deep recession, this is a terrible performance. The economy must add 13 million private sector jobs by the end of 2013 to bring unemployment down to 6 per cent, and President Obama’s policies are not creating conditions for businesses to hire," he says.

Discussing what the double-dip recession tipping point is, with John Mauldin, Millenium Wave Advisors:

Uncertainty the enemy of growth

Richard Berner, Co-Head of Global Economics and Chief US Economist at investment bank Morgan Stanley says that uncertainty is the enemy of growth.  In the MS view, uncertainty is the enemy of both risky assets and growth, so he said the economists took comfort from the reduction in uncertainty evident in US consumer and business surveys and in market risk premiums through mid-April.  Despite several economic headwinds, reduced uncertainty helped to nurture what they saw as a sustainable recovery as financial conditions and policy traction improved.  Markets went beyond that, pricing in a typical cyclical economic recovery.  The MS Business Conditions Index (the MSBCI) hit record highs.

That was then. Two months later, markets have swung towards fears of a double-dip slowdown, and risk-aversion is palpable. In contrast, Berner forecasts a moderate, sustainable recovery as the most likely outcome.  But MS says that new uncertainty around economic policies at home and abroad is creating downside risks to US and global growth through two channels:

  • First, consumers and businesses may hesitate to commit to spending and hiring decisions until policy uncertainty diminishes.
  • Second, renewed uncertainty and consequent renewed weakness in asset prices has reversed some of the easing in financial conditions that has revived economic activity. 

Together, those effects could turn market fears into a self-fulfilling prophecy; the interplay among them could magnify the headwinds from each considered individually. In that context, MS agrees that declining Treasury yields are scant comfort; they are barometers of risk-aversion rather than props for growth.  Conversely, however, more clarity about some of these policy issues could reduce both of these headwinds.  Two kinds of clarity are needed: Specific remedies where appropriate and, where specifics aren't immediately available, stating the goals of policy and indicating how officials will respond to changing circumstances - - akin to what central banks refer to as their ‘reaction function'.

Jim Iuorio, TJM Institutional Services; Arthur Hogan, Jefferies; Peter Navarro, University of California and Art Hogan, Jefferies Global Equity Product; CNBC's Bob Pisani & Rick Santelli:

Domestic policy limbo: The economist says that such hesitation by households and businesses and weakness in asset prices can be traced to uncertainty around economic policies is hard to prove.  But there is no mistaking the growing list of domestic and global policy issues that has left investors in limbo.  At home, there is uncertainty about coming tax hikes, more stringent financial regulations, who will shoulder the costs of healthcare, policies to mitigate mortgage foreclosures, latent protectionism and policy attitudes towards business.

Uncertainty around taxes could promote higher consumer saving at the expense of spending; uncertainty about needed regulatory reform likely is stymieing willingness to lend; and uncertainty about the burden of healthcare reform may be a hurdle to hiring.  Moreover, a slow start to new mortgage foreclosure remedies has left housing in limbo; latent protectionism could fan fears of a destructive trade war; and uncertainty about government attitudes toward business may give an incentive to delay actions until the outcome of the November Congressional elections and their implications for any policy changes are clearer.   

Global erosion of risk appetite worrisome: Berner says global uncertainties centre on the impact on growth of Europe's sovereign credit risks; on the ability and/or willingness of policymakers to address weakness in the European banking system; and on the impact of fiscal restraint in Europe.  "To be clear: We continue to expect tepid growth in Europe; additional weakness there would have only a small direct impact on global and US growth.  Fiscal restraint will be phased in over time, so the near-term growth impact should be far smaller than feared.  What worries us is the corrosive effect on risk appetite stemming from fears of contagion from the European sovereign crisis," Richard Berner says.

Strong Asian and Latin American growth continues to be a key ingredient in the MS view that US exports and earnings will outpace domestic demand, and policy tightening there is consistent with the rapid rebound in the region.  The bank now see growth in both regions this year even stronger than just a couple of months ago.  And the recent decision by China to revalue the renminbi has important implications: "We think it means that Chinese officials won't tighten policy further, and it should at the margin promote global rebalancing and stronger export growth to Asia.  Market participants have decisively turned up their nose at this move, possibly waiting to see whether China will deliver a meaningful move in the currency," he says.

Looking backward, most surveys seem to evince little evidence of such uncertainty, at least through June:  Berner says for example, measures of consumer confidence in June and the NFIB (National Federation of Independent Business) small business optimism index in May rose to two-year highs. He says analyzing such indicators using the time-honoured business cycle metrics of depth, duration and dispersion suggest that the current recovery, while moderate, has staying power.  The Fed's April Senior Loan Officer Survey showed a further easing in financial conditions; that is good news for growth.  In contrast, the headline reading for the MS Business Conditions Index has plummeted in the past two months at the fastest pace on record.  While forward-looking subcomponents of the canvass of analysts still point to healthy gains, the disconnect between those readings on one hand and the headline index and market sentiment on the other is disconcerting.

Looking ahead, however, uncertainty may depress those measures:  To assess some of them, MS update three metrics that might help to quantify uncertainty and its influence on the economy and markets: the gap between consumer expectations and current conditions; the residual between consumer sentiment and its determinants; and the extent to which real variables in recovery explain stock market volatility.  Comparing the reading of these metrics last February with their current levels, none of them yet shows signs of deterioration that would trigger a change in view.  But all three show deviations from the norm that testify to increased risks.  In coming weeks, Berner says the economists will monitor these and other measures to validate their tentative conclusions.

Mind the sentiment gap:  The economist says surveys of consumer sentiment ask respondents how they assess current business conditions and their personal finances, plus their expectations for each of these over the next year or so.  The gap between these two indexes is one simple measure of uncertainty or risk-aversion.  For example, a persistently negative gap between current conditions and expectations would suggest a high degree of risk-aversion.  At present, the gap between the index of current economic conditions and that for expectations compiled by the University of Michigan stands at plus 15.8 - - about 3 points below the mean -  - but 11 points above year-ago levels when the economy was just starting to trough.  The sign of that gap suggests that risk-aversion is not extreme, while the size of the gap suggests little change to uncertainty.  However, this survey is flawed because it does not control for macro factors that account for fluctuations over the business cycle. 

Determinants of volatility: Berner says volatility in equity markets is often viewed as a measure of uncertainty, but it arises from many sources.  And parsing the sources of volatility is hard.  To determine what kind of economic environment drives a high or low volatility market, MS colleagues Sivan Mahadevan and Chris Metli have tried to determine how economic variables like the ISM (Institute of Supply Management)  drove volatility in the past six economic recoveries since 1970, using data from just after the market bottom in each recession through roughly one-and-a-half years after.    

The economist says: "What's striking is that while economic factors helped to drive volatility lower over the past year-and-a-half, actual market volatility has itself been much more volatile than what economic variables alone would have predicted.  We think that policy uncertainty and systemic risk increased market volatility: The model underpredicted volatility in the late 2008/early 2009 period when the global financial crisis was still unfolding, and then again in May 2010 during the height of the sovereign debt uncertainty (although the model did catch the recent uptick in direction, just not magnitude).  Indeed, in our view, this underscores how much policy uncertainty can influence economic and financial market outcomes.  So, while policy choices and results may be slow in coming, any reduction in uncertainty could play a constructive and self-reinforcing role for both."

Reducing policy uncertainty would be a plus:  Richard Berner concludes that uncertainty is a headwind to growth makes intuitive sense and seems to be borne out empirically.  Recent work confirms this intuition, underlining how uncertainty produces negative growth shocks.  Nicholas Bloom shows how a rise in uncertainty makes it optimal for firms and consumers to hesitate, which results in a decline in spending, hiring and activity.  Moreover, this line of reasoning suggests that uncertainty reduces the potency of policy stimulus.  That's because the uncertainty can swamp the effects of lower interest rates, transfer payments or tax cuts.  In effect, uncertainty raises the threshold that must be cleared to make a business choice worthwhile, and as uncertainty declines, the threshold falls with it.  That squares with the MS long-held view that policy traction from easier monetary policy, improving financial conditions and fiscal stimulus was lacking through much of last year, but improved as uncertainty fell. 

These results suggest that reducing policy uncertainty now could be a tonic for growth.  That won't be easy or come quickly at home, given the political backdrop in this election year.  Nor will it be simple in Asia, given the need to reduce policy stimulus, or in Europe, given the depth of the fiscal problems faced by the countries on the periphery. But even some incremental clarity on policies in any of these three theatres would offer investors a chance to assess the fundamentals again - - fundamentals that the MS economists still see as improving.

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