Slowdown or Double-Dip Recession

In his most recent comment on the economy, the Federal Reserve Chairman Ben S. Bernanke described the economic outlook as “unusually uncertain” and also suggested that policy makers were prepared to take action as and when needed. The latest consumer confidence data also slumped to a nine month low indicating increasing concerns on the sustainability of economic growth and job creation.

The important question for policy makers, consumers and investors is – Are we headed for a slowdown or a double-dip recession. The discussion below tries to figure out the probable direction of the US economy and the extent of slump it can witness in the next few quarters. Also discussed are the likely measures to be taken by policy makers (in event of slowdown or recession) and its impact on asset classes.

In my personal opinion, another recession in the next few quarters is very unlikely for the US economy. However, a significant slowdown in economic activity is a very probable outcome for the near-term. I would also add here that the US economy is likely to remain in a low growth phase for much longer than expected.

In trying to predict the probability of a recession or slowdown, the signals given by the market are of extreme importance.

Looking at the Treasury yield curve, one can safely assume that the probability of a double-dip recession is very low. The 2.41 per cent point gap between yields on the two and ten year bonds is around the same levels as in 2003 when the economy grew at 3.6 per cent. One can argue that over optimism is being reflected in the bond markets. However, even if more conservative estimates were taken, recession probability would still be extremely low in the foreseeable future.

The equity markets are giving mixed signals reflected in a narrow range in which the markets are trading and also from the mixed bag of corporate earnings. However, the markets have not slumped substantially to indicate that market participants are discounting another recession.

When talking about equity markets, I would like to mention about Wal-Mart and its price movement in the last one year. The stock has gone up by only 6 per cent in the last one year as compared to a 15 per cent increase in the Dow Jones index. For an economy, which is 73 per cent consumption based, the stock price movement of Wal-Mart is an indicator of the sluggish growth the economy is expected to experience in the near-term.

Another major reason for not predicting a recession is the likely action by the government and the Federal Reserve in case of a sharp slowdown. One can say with absolute certainty that on further signals of slowdown coupled with decline in equity markets, the government will resort to quantitative easing.

The nature of the stimulus package can be debated. However, it will largely focus on stimulating consumption rather than stimulating capital spending. A focus on consumption will ensure an immediate positive impact on the GDP. The same will not be the case if another round of stimulus package is directed towards capital spending.

Therefore, any such quantitative easing initiative will help in propping up the economy in the short-term. It is also important to remember that the steepest period of downturn in the last recession was after the collapse of Lehmann Brothers and the subsequent credit freeze. Such a scenario is very unlikely in the next few years as the liquidity scenario has eased substantially for financial institutions (indicated by pre-crisis level of TED spreads).

Another major area of concern is the problem in the Euro zone. It is widely believed that the slowdown in the Euro zone coupled with austerity measures by several governments will negatively impact growth in the US. Without doubt, any crisis in Europe can negatively impact growth. However, with the bailout of Greece, the scenario has improved (in the near-term) and the likelihood of Euro zone slipping into recession is also low.

Moreover, governments, which have promised austerity measures, will again resort to spending if their respective economies slow down. Talking about such measures is easier than implementing them and slowdowns can force governments to spend with the hope of cutting back on deficits when the economic growth finally turns robust.

From an investment perspective, avoiding equities and commodities at current levels would be the right strategy. When the scene of a slowdown is clearer, the equity and commodity markets are bound to react negatively. A steep correction in these asset classes can be used as an entry point for long-term. I would personally prefer equities and commodities as the slowdown would mean further quantitative easing. This in turn would flood the financial system with more liquidity. Such a scenario would be positive for the above mentioned asset classes.

In conclusion, a slowdown for the US economy is very imminent. Also, this is going to be the economic trend as long as the economy is supported by government stimulus. Robust economic growth for the developed world might still be years away.

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