Are we back?
I recently heard an interesting argument as to why the economy was doing well and the recession for all intents and purposes was over. The argument justifying the health of the economy was that the S&P is up by 23% since 2009. Furthermore, since the credit spread is close to the pre-Lehman levels, the economy should have followed suit. I have a few concerns with this statement both in regard to the logical fallacy and because I believe there are some other issues that we must be cognizant of before prematurely celebrating the revival of the economy. However it is important to note that while I disagree with this statement I do think that the economy has taken a turn for the better and is on the path to recovery. However, I feel the road to recovery is going to be a lot longer.
My rebuttal to the statement is as follows: though the credit spreads are a good indicator of the health of the economy, it is naive to ignore the other aspects of the pre-Lehman economy that are being overlooked by the above statement. The unemployment rate in the pre-Lehman days was a relatively high 7.2%. Currently the unemployment is projected to reach a whopping 11%. Unless unemployment is curbed, it is impossible to posit that the economy is out of a recession.
Furthermore the effect of the withdrawal of stimulus funds like TARP (which is due to expire in December) and the first time homeowner tax break (which will essentially expired at the end of November) are just some of the stimulus withdrawals that should have an interesting (and possibly negative) effect on the economy. Although the S&P did reach highs for the year in mid November, many experts believe that equities are disconnected from fundamentals and a correction is expected in the coming weeks. It is also important to keep in mind that 48% of companies on the S&P have foreign sales. Thus, the increase in the stock prices may not solely reflect the condition of the domestic economy. Finally, until the people sitting on the sidelines decide to move back into the market and trading volume increases, the market is going to continue to trade on low.
While on the topic of things to be worried about with regard to the economy, I was discussing the condition of the economy with my mentor and was surprised at the numbers when looking at the projected default rates for speculative-grade corporate debt. According to Moodys research, the global speculative-grade default rate was up to 11.5% in August; to put this in perspective, the default rate a year ago stood at only 2.5%. Thus, it is awfully bold to proclaim that the recession is over.
It is important to realize that some of the major factors that are considered the origins of the crisis still remain unresolved: the US still has over extended consumers and the banking system remains significantly reliant on debt formation and asset prices (an example of the latter would be housing). Commercial real estate has been on a thin life line due to extensions on credit by banks and is sure to have a nasty decline in the coming year. Currently the US is more of a stimulus based economy than the service or manufacturing based economy of old. The strength of the economy will be tested when the Fed eventually stops buying mortgage backed securities and normalizes monitory policy by increasing short term interest rates. The dollar is weak and cannot strengthen unless the Fed takes some positive steps. The Fed needs to either raise interest rates, announce some plans to re-lever its balance sheet or have some sort of positive commentary regarding the future of the dollar.
This leads me to my next point: there is no debate on if there will be strong inflation, the debate is in regards to the timing of when inflation will occur. It is safe to say that we can expect significant inflation in the next 24-36 months, and depending on how the markets react, this will play a big part in the complete exit from the current recession. Things are getting better but we are certainly not back!
Note: Greg Curl the chief risk officer of the Bank Of America has brokered a deal to pay 45B in TARP money back to the government. Could this be a preliminary move before he takes over the job as CEO, or will the B of A opt for new blood to lead the organization? Only time will tell.
