Global Economic Outlook, 1st quarter 2012

The sharp edge of a razor is difficult to pass over; thus the wise say the path to Salvation is hard.
      The Katha-Upanishad

Published in 1944, Somerset Maugham's The Razor's Edge chronicled the cultural and economic history of Europe's "lost generation" and its search for meaning in a world where the difference between life and death on the battlefields of World War I had often been separated by the razor's edge of luck.

The U.S. economy today stands on the razor's edge. The path to recovery remains a very narrow one, made hard by a consumer that is tapped out, recession overseas that puts domestic banks at risk, and government austerity at home that will impact growth.

While the U.S. economy's performance improved in the fourth quarter of 2011, real GDP growth remains at a stall speed below 2 percent on a year-on-year basis. The recent data has been better than expected but still pretty mediocre. Employment growth is still averaging about 125,000 net jobs a month, less than half of what's needed to sustain a recovery. The unemployment rate has dropped due, in part, to people leaving the labor force — a sign of weakness in the labor market. Consumer spending has been held up by a declining savings rate.

U.S. consumers are tapped out

Real incomes have fallen for four months in a row from a year ago, something that only happens during recessions. Recall that last January, the worker's contribution for social security was cut from 6.4 percent down to 4.4 percent as part of a tax holiday. The cut gave a $90 billion boost to household incomes. Without that cut, real incomes would have been down for the past six months in a row.

Household net worth fell $2.4 trillion in the third quarter, an annualized rate of decline of 15.4 percent from the second quarter. This followed a small decline in the second quarter. There has never been a time in the past 60 years when household net worth fell two consecutive quarters that the economy did not fall into a recession.

Oil prices have remained high on worries over Iran even as other commodity prices have fallen, further cutting into household purchasing power. There is a risk of conflict in the Middle East, which could send oil prices substantially higher and the economy lower.

The business sector remains challenged

Corporate profit growth in Q3 slowed to just 7.4 percent from a year ago, and profits for financial services firms were down 9.2 percent from a year ago; most of the profit earned by the banks came from reserves and debt value adjustments, rather than operations. U.S. banks face the need to raise capital to meet new Basel III requirements — a move that will likely affect lending.

Manufacturing is doing better in the United States than in the rest of the world because it is contracting in much of the rest of the world. Autos have done particularly well. However, auto manufacturing has not only translated into sales, but it has also contributed to a buildup of inventories . Inventory to sales ratios are near their highest levels in two decades. Auto inventories are up 22.0 percent, and total manufacturing inventories are up 11.5 percent from a year ago. While the recent rise in inventories will give a boost to Q4 GDP, it will mean less contribution by the manufacturing sector to future growth.

Business investment in equipment and software has been one of the bright lights of the economy. Spending is up 9.7 percent from a year ago through the third quarter. Business investment enjoyed a boost from favorable tax treatment that was part of the December 2010 tax package. Those incentives expire in 2012.

New orders for computers rolled over at the end of the year. In November, for the second month in a row, production of computer equipment slipped 0.1 percent, a sign of weakening business investment in technology. The three month moving average for new technology orders has fallen for the last three months, and it is 9.5 percent below its mid-2007 peak. With shipments exceeding new orders, book to bill ratios for the computer industry are falling, putting future growth at risk.

The global growth risk

Excluding the rest of the world, the United States could probably limp along with weak growth and stagnant profitability for some time. Unfortunately, it is plausible that much of the rest of the world is likely to fall off the razor's edge into recession or worse.

Purchasing managers' indices from around the world indicate manufacturing is in a global recession. Europe is at 46.4, its lowest reading since July 2009; the UK is at 47.6; China is at 47.7; Germany is at 47.9; and Brazil is at 48.7. A reading below 50 is a sign of contraction. Industrial production in India fell 5.1 percent in November from a year ago after being up 8.7 percent as recently as July. Since the U.S. recovery began in Q3 2009, exports have accounted for 48.2 percent of all U.S. economic growth. Weak growth around the world negatively affects U.S. exports, which have been one of the bright spots of the recovery.

Turning to Europe, a recession and a financial crisis represent material risks to the U.S. banking system and to U.S. exports to Europe, given the interconnectivity of financial markets coupled with the exposure of U.S. banks through derivatives and direct investments in Europe. Losses at U.S. banks will have a negative effect on already-weak profitability. It may also force some U.S. banks to raise additional capital, which will likely reduce lending and dampen growth in the United States.

A recession in Europe would also take its toll on U.S. exporters. Trade with the European Union makes up more than 18 percent of all U.S. trade. Exports to Europe have grown sharply over the past two years (see figure 1). Manufacturing in the United States is already at risk from the perilous condition of the U.S. consumer. A loss of demand from Europe will only add to manufacturers' woes.

The other region of the world that is growing more worrisome is China. Its manufacturing sector is contracting. Their yield curve is deeply inverted, which is a very good leading indicator of recession. Real estate prices are falling. The government has cut reserve requirements for the banks in hopes of getting them to lend more. Local governments have delayed debt payments on past projects that were part of the 2009 stimulus.

In the late-1980s, Japan ran into troubles when investment reached 30 percent of GDP. With nearly 50 percent of their GDP going into investment, there are probably many investments in China that are not likely to pay off. These losses would work their way back into the banking system, causing a financially driven slowdown or possibly even a recession.

A slowdown in China would severely limit China's ability to invest in the United States. We have already seen a sharp reduction in Chinese purchases of U.S. government paper (see figure 2). If they started liquidating their investments, it could create severe problems in U.S. credit markets. Interest rates would go higher, hurting interest-rate-sensitive sectors of the economy and making U.S. government finances all the more challenging.

The oil price risk

Four of the last five recessions have all been associated with a spike in the price of oil, the 2001 recession being the exception. While there is always a risk of oil supply disruptions in the Middle East, that risk has grown in the past year with the unrest from the Arab Spring and the growing tension over the possible development of nuclear weapons in Iran. A cutoff of oil from the Persian Gulf would mean a sharp spike in oil prices and a recession in the United States. While not as bad as a recession driven by a European financial crisis, it would mean a contraction in GDP that would endure for as long as the cutoff in oil lasted.

The lack of policy response: Government is contracting

Not since the end of the war in Vietnam have we seen as sharp a decline in real government spending as has occurred in the past year (see figure 3). With austerity and the need to reduce deficits the order of the day at the federal, state, and local government levels, future declines in government spending can be expected.

Stimulus spending by the federal government over the course of the last recession totaled nearly $2 trillion. With the debt-to-GDP ratio of the federal government now exceeding 100 percent and political gridlock the order of the day, it is hard to imagine another round of stimulus spending in the face of future economic distress.

Monetary policy hits a wall: The collapse of velocity

The velocity of money is the speed at which money changes hands over a period of time. When times are flush, the velocity of money will rise; in anticipation of and during recessions, it will fall as businesses and consumers hoard cash. The velocity of money rose sharply from the middle of the 1980s up through the peak of the internet bubble in 2001 (see figure 4). It was thought at the time that this increase was driven by significant innovations in the financial services sector. Velocity was also pushed up by improved cash management capabilities by both businesses and consumers.

When the recession of 2001 hit, the velocity of money fell sharply. While velocity did revive modestly during the 2002–2007 recovery, it fell again sharply during the 2007–2009 recession. After a very brief recovery, we find velocity falling sharply once again. Velocity falls in recessions as businesses and households hold greater levels of cash against the risks of uncertainty. What is remarkable is that velocity today is at levels not seen since the early-1960s. The sharp decline in velocity over the past nine months is another sign that the U.S. economy is at risk of a recession.

A decline in velocity makes policy execution for the Federal Reserve more difficult. With velocity falling sharply, monetary policy becomes less effective. In such an environment, increasing money supply becomes an exercise that is often referred to as "pushing on a string." Instead of spending the additional liquidity, businesses and consumers tend to hoard it.

Conclusions and observations

The U.S. economy is muddling along with low GDP growth, weakening business investment in technology, slowing profit growth, and banks that are troubled and exposed to the debt crisis in Europe. Household balance sheets are shrinking while real spendable income is contracting. Both developments make it difficult for U.S. consumers to continue spending at their current rate.

Outside of the United States, growth is slowing. Europe is no closer to dealing with sovereign debt. China is looking shaky with their economy at risk. Uncertainty arising from the Arab Spring and worries over Iran could send oil prices substantially higher.

The best-case scenario for Europe is that the Europeans are able to put off the day of reckoning. They have been doing it successfully since May 2010. It is possible that they can manage another year or two. A deep European recession will mean a mild recession in the United States with GDP contracting 1–2 percent, resulting in profits and business investment contracting in the low double digits.

A recession in China would not have the kind of impact a European recession represents, given the smaller size of China's economy. A significant issue with China is how their sovereign investments are managed. Barring some kind of geopolitical event that would put the United States and China at odds, it is unlikely that the Chinese will aggressively sell their dollar assets. They may, however, continue to avoid buying more, but they have too large of a vested interest in the U.S. economy to see it tank. A Chinese recession that did not involve a liquidation of their U.S. investments would cut 1–1.5 percent off of top-line U.S. GDP.

An oil price spike has been a key factor in all but one recession since the 1973 Arab oil embargo. Today, an oil price spike would have a particularly hard impact on consumer purchasing power. Energy-intensive businesses would also be negatively impacted as they were hit by rising costs and weakening consumer demand. At the very least, an increase in oil prices above the 2008 peak of $147 a barrel would take a couple points off of GDP and put the U.S. economy into a mild recession.

What makes these risks greater is the lack of traditional fiscal and monetary responses available to the U.S. government to fight another recession. The best-case scenario is that the U.S. economy continues to pass over the razors edge, none of these disasters happen, and we continue to muddle along. For the economy, this would mean growth similar to what we had over the past 12 months or possibly slightly less. The worst-case scenario as that all of these risks come to pass and the United States experiences a severe recession akin to what happened in 2008–2009. The more likely scenario is something in between with at least one of these downside risks manifesting itself, resulting in a mild recession in the United States.