In the first two installments, I laid out the reasons why the U.S. economy, despite current strong consumer spending and the recent euphoria of investors over stocks, will weaken into a recession as the year progresses, led by renewed consumer retrenchment.
If my forecast pans out, the Federal Reserve and Congress may be compelled to take further action to bolster the economy.
-- Mixed data: Personal-income growth continues to be weak. So job creation remains central to any increase in real household after-tax incomes, which declined in February for a second straight month, gaining just 0.3 percent compared with February 2011. Consumers are still saddled with high levels of personal debt. Housing activity remains weak, and I expect a further 20 percent decline in house prices.
Then there was last week’s very disappointing jobs report showing that just 120,000 nonfarm jobs were created in March, far fewer than the 205,000 or so that had been forecast. The unemployment rate ticked down to 8.2 percent from 8.3 percent in February, but only because people dropped out of the labor force. In response, equities plunged in the U.S. and elsewhere as worries were revived about the true strength of the recovery from the Great Recession.
Gross domestic product has been accelerating in recent quarters, but not after inventory investment is excluded to yield final sales. In the fourth quarter of 2011, inventory growth accounted for 60 percent of the increase in GDP; that accumulation may not have been desired, suggesting future production cutbacks. At the same time, industrial production growth is already sliding. The liquidation of excess inventories is responsible for a major share of the decline in economic activity in recessions.
Recall that late last year, retailers, worried about being stuck with unsold Christmas goods, held early sales, even opening on Thanksgiving Day. The possibility that inventories are already larger than desired is also suggested by the recent decrease in containers coming into the ports of Los Angeles and Long Beach -- the principal entry points for Asian imports -- and the decrease in U.S. rail-ton miles.
Finally, the U.S. economy is overdue for a recession. I believe that it entered the down phase of the long cycle in 2000, and the five to seven years that remain in the age of deleveraging are part of this period of weak economic growth and more frequent recessions. History reveals an average business cycle length of 3.7 years in the down phase. The economy peaked in the fourth quarter of 2007, meaning the present cycle is long in the tooth.
-- Fed action: In his March 26 speech to business economists, Federal Reserve Chairman Ben S. Bernanke concentrated on the weak employment picture and said further reductions in joblessness would require “more rapid expansion of production and demand from consumers and business, a process that can be supported by continued accommodative policies.”
Investors read this as suggesting the economy might be weak enough in future quarters to require another round of quantitative easing via Fed purchases of Treasuries and mortgage-backed securities. They seem to believe that the negative effect a weak economy would have on corporate profits and dividends pales in comparison with the impact of the money received directly by sellers of securities to the Fed.
Stocks took off after Bernanke’s remarks: The Dow Jones Industrial Average closed out its best first quarter since 1998; the Standard & Poor’s 500 Index (SPX) ended the quarter above the 1,400-point mark for the first time in almost four years; and the Nasdaq Composite Index topped the 3,000 level for the first time in more than 11 years.
Beyond the money received directly by sellers of securities to the Fed, investors certainly can’t expect any multiplier effect from the member banks’ reserves created by the central bank’s policies. The two rounds of quantitative easing helped pile up those reserves, which now exceed requirements by about $1.5 trillion. Banks will lend only to the most creditworthy, and are so loaded with cash they don’t need to borrow much.
Given the recent euphoria, stocks might rally if the economy strengthens, and the prospect of more quantitative easing disappears. Can you have it both ways? This reminds me of the ad published by the National Association of Realtors in the Wall Street Journal several years ago when house prices were collapsing. In screaming headlines across the top of the page, it read, “Now Is a Great Time to Buy a House!” and in identically large print at the bottom, it read, “Now Is a Great Time to Sell a House!”
-- Congressional action: In addition to a possible QE3 by the Fed, rising unemployment and increasingly negative economic data could also spur a push for stimulus in Congress before the November elections. The payroll-tax cut, along with the Bush-era income-tax cuts, are set to expire at the end of this year. Meanwhile, unemployment benefits are scheduled to plunge, at a moment of what I believe will be rising joblessness. This fiscal drag would knock 3 percent to 4 percent off GDP. Representatives and senators seeking re-election -- of both parties -- don’t want to face opponents’ charges that they did nothing as the economy tanked.
Some renewal of the earlier tax cuts and extension of unemployment benefits seems almost certain. But with gridlock in Washington, how will it play out? Congress and the administration will no doubt act before the election if the economy is in bad shape. Otherwise, they could come back for a so-called lame-duck session in December. Or, as they did this year, they could act after the new Congress is installed in January and make the renewed tax cuts retroactive to the beginning of 2013. Continuing uncertainty over eventual congressional action will only further depress the confidence and spending of U.S. consumers and business.
Meanwhile, a number of economic indicators are pointing in the direction of a faltering economy. The Economic Cycle Research Institute index remains in recession territory. The ratio of coincident to lagging economic indicators, often a better leading indicator than the leading indicator index itself, is declining. Electricity generation, though influenced by the warm winter, is falling rapidly.
In Part 4, I will look at the recent hunger for stocks despite the increasing reasons for caution and recent volatility.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. Read Part 1 and Part 2 and Part 4 of the series.)
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