The basic idea behind the “Road to US recovery – 10 crucial steps” presentation was to identify the crucial steps that needed to happen in order for the US economy to recover and then to plot the progress of the recovery. We indentified 10 crucial steps on the road to recovery and out of the 10 steps the first 5 have been completed. The remaining 5 have all shown a partial improvement, but critically, the improvement remains insufficient for most people to be convinced about the sustainability of the US economic recovery.
As you read through the update it might be worthwhile to keep in mind, last week Friday’s comments from the Federal Reserve Chairman, Ben Bernanke: "For a sustained expansion to take hold, growth in private final demand - notably, consumer spending and business fixed investment - must ultimately take the lead. The prospects for household spending depend to a significant extent on how the jobs situation evolves".
The ten crucial steps:
Step 1: Banking and financial market stability
This has been achieved, although at an enormous cost. Inter-bank lending is functioning appropriately (see graph on the TED spread), bank stress tests have been completed, the US banking system has got more than sufficient capital and the VIX index has mostly settled down, although the index is not back to the levels that prevailed prior to the credit crisis. Banking sector regulation is being explored and implemented.
Step 2: Monetary and fiscal policy relief and stimulus for the consumer and business sector
The US government and Federal Reserve have implemented an unprecedented quantum of fiscal and monetary stimulus. This stimulus has taken the form of record low interest rates, the purchase of a large amount of Mortgage Backed Securities, extensive financial assistance to motor manufacturing companies, tax incentives to purchase houses and cars as well as the purchase of government securities by the Federal Reserve. The balance sheet assets of the Federal Reserve rose from around $900bn prior to the crisis to around $2300bn currently. The US government’s fiscal deficit increased to around 10% of GDP. While the success of this stimulus is currently being debated (a lot of the additional liquidity in sitting as excess reserves in the banking sector, and not as an increase in money supply), the authorities had little choice but to try to cushion the extent of the credit crisis and provide sufficient stimulus to allow for an economic recovery.
Step 3: Elimination of the massive global inventory overhang
The speed and severity of the economic crisis and subsequent recession caught most businesses, especially manufacturing, by surprise. The result was that the US inventory to shipments ratio rose sharply from 1.27 months to 1.48 months. As the economy moved further into recession, industry desperately tried to de-stock. The de-stocking process meant that industrial production and global trade collapsed. This de-stocking process was also, unfortunately, accompanied by a massive loss of employment and further weakness in the housing sector. This process was at the heart of the recession. Fortunately, within a period of a little less than a year the de-stocking had been completed. In fact business stock levels were reduced to levels below what was required.
Step 4: Increase in new orders/PMI indices/leading indicators
Once the de-stocking had been completed, industry then adjusted production levels to meet the existing level of final demand / consumer spending. The level of final demand was significantly below the levels achieved prior to the crisis. This matching of production to final demand meant that production actually rose. The de-stocking process had, in fact, been overdone. This increase in production reflected as rising PMI indicators (especially the new orders component) and rising leading indicators and ultimately a pick-up in GDP growth. This improvement in GDP did not signal a sustainable recovery, but rather mostly an inventory adjustment.
Step 5: Reduction in the rate of increase in unemployment
The de-stocking process and accompanying collapse in production, trade and housing activity meant that millions of people lost their jobs. The US unemployment rate rose from 4.8% prior to the crisis to a peak of 10.1%. At its worst the US lost 8.4 million jobs or around 6.1% of total employment. However, once the de-stocking had been completed and production started to improve, the rate of increase in unemployment slowed significantly and eventually rose in October 2009.
Step 6: Increase in consumer confidence and stabilisation of the housing market
Once the rate of increase in unemployment slowed and finally stopped, it was then feasible to expect consumer confidence to start to rise and the housing market to at least stabilise. There has been some success in this regard, but both consumer confidence and the housing market remain fragile. US consumer confidence reached a record low in February 2010, but then edged higher to a near-term peak of 62.7 in May 2010. It has since eased back down to 50.4. While confidence is above the record low, it is still well below the long-term average level of around 95. Housing activity fell off very sharply through the credit crisis, but appeared to reach a bottom in around April 2009. Since then housing activity has mostly drifted sideways, although the most recent housing data reflects renewed signs of weakness, which is clearly a concern.
Step 7: Increase in consumer 'final' demand
Final demand is mostly represented by consumer spending and fixed investment spending. Consumer spending is the key area of focus given that 71% of US GDP takes the form of consumer activity. The improvement in final demand is the most crucial step in the recovery process. Overall, while there has been some improvement in final demand, the rate of improvement is far from convincing. Consumer income and spending declined for most of 2009, despite the lower interest rates and various tax incentives. However, in late 2009 consumer income and spending finally turned positive and has continued to improve in 2010. Crucially, the consumer is unwilling /unable to indulge in credit. Consumer credit demand continues to contract and has declined by a total of $160.5bn since October 2008. While this is good news in terms of balance sheet repair, it translates into a less than exciting improvement in overall consumer activity.
Step 8: Meaningful rise in capacity utilisation
A sustained rise in consumer spending would quickly lead to a rise in industrial production (given the current low inventory to shipments ratio). This would eventually push capacity utilisation levels higher. Historically in the US, as soon as capacity utilisation levels breach around 78% there seem to be a tendency for businesses to look to expand. US industrial capacity utilisation fell very quickly from 80.9% at the start of 2008 to a low of 68.2% in June 2009. Capacity utilisation levels have since risen to around 74.9%, but this is still well below the level at which industry looks to expand and invest.
Step 9: Increase in fixed investment spending
The expansion in businesses (once capacity utilisation levels reach around 78%), is normally accompanied by a more meaningful increase in private sector employment. US fixed investment spending declined for all of 2008 and 2009, but turned positive in H1 2010, off a low base. This improvement is obviously very encouraging. Unfortunately, very recently, US core durable goods orders declined very sharply, increasing the uncertainty over the pace of the recovery in investment spending.
Step 10: Increase in employment
The final step in the recovery path is a sustained and meaningful increase in US employment. On average the US has to create just over 100 000 jobs a month in order to absorb the growth in population. As mentioned above, during the recession the US lost well over 8 million jobs. However, the private sector has added jobs in each of the last 7 months. In total, the private has created 630 000 jobs since the beginning of 2010, at an average of 90 000 jobs a month. While this is a clear improvement relative to the extreme job losses that occurred during the recession, it is not sufficient to ensure a sustained and reasonably robust economic recovery. According to Bernanke "incoming data on the labor market have remained disappointing. Private sector employment has grown only sluggishly, the small decline in the unemployment rate is attributable more to reduced labor force participation than to job creation, and initial claims for unemployment insurance remain high. Firms are reluctant to add permanent employees, citing slow growth of sales and elevated economic and regulatory uncertainty".
Conclusion
Combining the information obtained from the 10 steps above, the following conclusion seems reasonable:
The credit crisis and subsequent economic recession in the US was extremely severe by historical standards, negatively impacting almost every sector of the economy, especially housing. At some point there was a real risk that the US banking system could have collapsed. The fiscal and monetary policy response to the crisis was very aggressive, and unprecedented. The Federal Reserve and Government adopted a number of untried and untested policy measures, and remain committed to maintaining extremely low interest rates and the extreme liquidity stimulus.
Most components of the US economy have stabilised with signs of a tentative, but still unconvincing, recovery. It seems clear that a certain portion of the US unemployment problem is now structural, it also seems clear that US banks are unlikely to aggressively start to extend credit anytime soon. There is also a structural over-supply of housing, which argues against any meaningful recovery in the US housing market for a number of years. Housing is, however, extremely cheap on a relative basis which implies that current price levels could be maintained despite the most recent signs of weakness in housing activity.
It can be argued that the pace of the US economic recovery should be a lot more convincing by now given the unprecedented policy response. However, this argument perhaps underestimates that magnitude of the crisis and the damage inflicted on the economy by the bursting of the housing bubble. It may well take years to fully recover. It is also entirely possible that the monetary and fiscal policy response was ‘too quick’. In other words, there was always going to be a massive ‘fall-out’ effect once the housing and credit bubble burst, and that instantly throwing huge amounts of money at the crisis was always going to be relatively futile exercise given the extent of the problem. Fire fighters don’t rush into the middle of a blazing inferno, quickly using up all the available water, but rather assess the extent and severity of the fire and then strategically work out what can be done to contain the damage as best as possible given the available resources. It is also fair to argue that consumers need time to repair their balance sheets. It would be unrealistic to expect consumers to immediately rush back into housing and credit after having just experienced a major crisis.
The US economy is facing, at best, a muted and below trend recovery, but what about the chances of a double-dip recession? Bernanke acknowledged last week Friday that the “recovery of output and employment in the United States has slowed in recent months, to a pace somewhat weaker than most Federal Open Market Committee (FOMC) participants projected earlier this year. Much of the unexpected slowing is attributable to the household sector, where consumer spending and the demand for housing have both grown less quickly than was anticipated. Consumer spending may continue to grow relatively slowly in the near term as households focus on repairing their balance sheets”. As the data disappointed, we systematically increased our probability estimate of a US double-dip recession to 35%, which implies that it is still not our base case but that the risks have clearly risen.
Lastly, but importantly, the key economic variables which we are currently focusing on so as to determine the near-term trajectory of the US economy are, trends in private sector employment (a decline in private sector employment at this stage would be a clear signal of a return to recession), a desire by households to increase savings (households savings in the US rose to an average of 6.2% in Q2 2010, which suggests that US consumers have been in the process of repairing balance sheets. However, a further significant rise in savings would imply less consumer spending and that consumers wish to further repair their balance sheets), and the price of housing (a relapse in house price would almost certainly undermine the fragile recovery).
The speech by Bernanke on Friday is worthwhile reading, especially the discussion on what further policy measure the Fed could adopt should the economy weaken noticeably further.
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