A flurry of dire economic releases...

In the last couple of days we have observed a number of economic releases that seem to highlight the severity of this downturn. GDP figures in the U.S. have been released most recently for the fourth quarter of 2008. Although an estimate, at -6.2% (annualized), it is significantly worse than expectations and according to the data, the second quarter of contraction for the economy. January durable goods orders which measures household consumption of goods defined as lasting at least 3 years or more was more than twice as negative than expected. More telling, however, is the fact that this is the 6th consecutive drop in durable goods orders! A similar pattern has also been observed for a number of other critical indicators such as jobless claims which not only has been systematically worse than expectations but also adds to a consecutive series of negative results.
It should be noted that the U.S. is no exception and that dire figures are sprouting out almost everywhere. In Japan, for example, the latest industrial production figures indicate a drop of a whopping 10%, making it the largest monthly drop since records began more than half a century ago. It is also the 4th consecutive month in which a drop has been recorded. This comes on the back of a contraction of 46% in exports.

Yet another transmission failure...

Part of the dilemma facing authorities across the globe, and more specifically in the U.S., is to find a way to get consumers to start spending again. After all, consumption represents something in the region of 70% of GDP and therefore is central to any plan attempting to revive the economy.
Unfortunately, the household spending stimulation plan seems to be suffering from a similar ailment to that of monetary policy, namely a total breakdown in the transmission system.
To resume, monetary policy, especially in the U.S., has become completely impotent, not only because of the "liquidity trap" phenomenon in which room to maneuver disappears once interest rates come close to zero, but also because widespread distrust and lack of confidence in the marketplace meant that even when rates were not close to zero and were being cut aggressively, the various participants preferred to stay on the sidelines.
And now, it can be argued, we are observing a similar phenomenon in the household space. Part of the government stimulus plan is to revive household consumption that has been rapidly retrenching on spending. It is highly unlikely that they will succeed in this mainly because the largest spending segment of the population are made up of the so called baby boomers. This segment of the population are reaching retirement age and the economic crisis has erased a large chunk of their accumulated wealth, forcing many of those that were hoping to retire to get back into the workforce. Unfortunately jobs are scarce right now and are expected to become more so in coming months. So even if money is handed to them just as they were to the banks, it is unlikely they will be spending any of it. With rampant negative savings amongst households, it is more likely that they will be using the extra cash to rebuild their savings, just like in the case of banks where the money they received to revive lending was instead used to build reserves against their bad debts.
This begs the question as to how the authorities can possibly hope to revive the economy in light of these structural breakdowns? There is no doubt that the cycle will eventually reverse itself as the environment normalizes but to expect a revival in the next couple of months, I think, is just wishful thinking.

Investing in times of uncertainty...

The combined size of investment losses over the past year and a half and the growing uncertainty on the length of the current economic crisis has prompted an increasing number of investors to bail out of their investments and seek the relative safety of cash. Pundits that have been drawing parallels with the great depression of the 1930's point out that an eventual recovery of the stock market did not occur until 4 years after the crash! 

The recession is likely to deepen further, as the impact of the ongoing credit crunch spreads into the wider economy.  This will happen despite the robust government efforts to revive the economy given that there is still considerable debate as to what the correct policy response should be. Current economic measures also seem to be indicating that although government action to date may have succeeded in slowing or even stopping the "hemorrhage", the "patient" is still in intensive care as the antidote has yet to be administered. Trouble is that nobody seems to know what the correct antidote is, given that the crisis has no reference point in the past to draw lessons from!

In conclusion, given continued uncertainty, there is still a strong probability that assets decline further. For stocks, not having reached the bottom would mean that it is still too early to switch from defensive to cyclical sectors. Some asset classes seem more attractive than others, however. Take the bond market as an example. Treasuries have clearly been overbought (a result of the ongoing fear factor). If we compare their yields with the other end of the bond market spectrum (i.e. junk bonds), it is almost as if the "higher risk" spreads are pricing the equivalent of a world war (see graph). This makes them extremely attractive from a potential capital gains perspective. At the same time, however, it needs to be made clear that, as in the stock market, the yields are forward looking and, in this case, seem to be anticipating a much higher default rate, a scenario that could very well materialize the longer the recession drags on. 

Many corporate bonds that were issued some 10 years ago, for example, are maturing this year. Given that financing costs have literally exploded, many of the firms that opt for refinancing are going to find themselves in dire economic hardship, raising the probability of bankruptcy. So although non treasury bond yields look attractive, the risk of default should clearly be factored into the investment decision making process to limit damage in the event that the recession turns out to be a protracted one.

Where are we heading?

The graph above is of the seasonally adjusted month on month change in the U.S. Consumer Price Index. The 1.7% plunge in November 2008 has raised some red flags.

In our most recent newsletter entitled "The Great Deflation", we discussed the dire economic consequences of a deflationary spiral. Today the world faces a real risk of entering a deflationary spiral with grave repercussions as it has the potential of turning what is at the moment a benign recession into a full fledged economic depression. It is therefore not surprising that in light of this threat, nervous policymakers have been very active in trying to reinvigorate the economy. This is especially noticeable in the U.S. where the target interest rates has been brought down to zero and where billions (with a promise of more to come) are being spent on bailing out a growing number of institutions.

As consumers, we may perceive deflation, which is a general and sustained drop in the price of goods and services, as something that is desirable considering that it tends to improve our purchasing power. The problem, however, is when deflation continues over a sufficiently long period of time that it starts influencing expectations of future prices. If households believe that the drop in prices are likely to continue into the future, they will postpone purchases until a later date. Producers will also adapt to these changes by cutting back on capital expenditure as they see their return on investment drop.

With these developments the consumer may well end up worse off because although deflation will improve their purchasing power, they may end up being worse off as their standard of living could suffer if firms lay off more workers to counter the drop in sales.