U.S. Economic Outlook Still Offers No Reason

by Inya Ivkovic, MA

Without a doubt, the U.S. is going through the worst recession since World War II ended. The economic slowdown actually began in the second half of 2006, when the housing market and business investment started to stagnate. The full-blown recession hit the fan in January of last year, when employment numbers first started going downhill. And the first significant contraction of economic output happened in the third quarter of 2008, coinciding with consumer “capitulation.”

In the second quarter of last year, the perfect storm conjured mighty winds, including tight lending standards, high gas prices, declining home prices, anarchy in the credit markets, a sharp increase in unemployment, and the virtual disappearance of investor and consumer confidence. The third quarter offered little in consolation. Stock markets sold off on Lehman Brothers’ demise, eradicating a staggering $8.0 trillion in household debt in the process. As more and more people lost their jobs, income growth became negative, while overall consumption dropped 3.7% in Q3 and 4.3% in Q4, realizing in aggregate the largest decline since the 1980s.

Obviously, there is little to no reason for optimism in the short term. The U.S. GDP contracted by 6.3% during the last three months of 2008 and, based on higher than expected inventory-to-sales ratios and other microeconomic data coming out on industrial production, the GDP is likely to shrink by about the same amount in the first quarter of 2009, too. Once that’s out of the way, the second and third quarters of this year are going to be much of the same, but most likely at a diminished pace. Provided the economic stimulus package works, the first positive — albeit miniscule — growth of GDP could be seen in the fourth quarter of this year. Going into 2010, economic growth should accelerate gradually, carried by increasing housing activity, consumer spending, and hopefully and eventually, new business investment.

As far as headline inflation is concerned, it will disappear entirely in 2009. In fact, as oil prices are expected to remain stubbornly between $40.00 and $55.00 per barrel, consumer prices are actually likely to decline 1.4% in the next nine months. By the same token, core inflation, which doesn’t incorporate food and energy prices, will continue to moderate as unemployment hits the 10% level and economic output reaches new lows.

Over the past year and a half, the Federal Reserve has reduced its key interest rate by five percent to just about 25 basis points. Now that the policy rate is more or less zero, it also means the monetary policy has been technically pushed to the limit, although the central bank claims it is not without ammunition. What the Fed means by this could involve buying various assets, including troubled ones, and through the quantity bought, effectively reducing the market interest rate associated with such assets. For example, the Fed has promised to by an additional $750 billion of mortgage-backed securities, about $100 billion tied up in corporate debt, and up to $300 billion of Treasuries with longer expiration dates. The Fed will keep troubled markets on its balance sheet for the remainder of 2009, with the expectation that the “weaning off” will commence in 2010 and policy interest rate will start increasing sometime in 2011.

In a nutshell, we are in for a rough ride for the rest of 2009, so investors should be wary of bear market rallies, the kind we have seen lately, for they may indeed be misleading. In 2010, the economy may finally find its true bottom, but signs of true recovery may not be seen until 2011.