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Ecri get ready for more recessions

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  • 1. Get Ready for More Recessions June 2010Today I’d like to share with you what I think is an unusual perspective, rooted inour group’s longtime focus on business cycle research.As you know. most analysts are working from pretty much the same toolkit –using some variation of econometric modeling as the foundation of theirthinking.But at ECRI we’re not economists. We are, and have been for generations,students of the business cycle.To be clear, our analysis is not model-driven.Rather, it is based on insights into the dynamics of the business cycle.>>> Let’s begin with a simple question about business cycle basics… How do you get a recession? 1
  • 2. A Stylized View of Recession 0 Recessions ©Economic Cycle Research Institute (ECRI)One way to think about it is that in market economies economic growth cycles up anddown around some sort of long-term trend.Take a look at this rather simplistic picture, sort of a stylized view of recession whichis meant to make a straightforward point: every time economic growth cycles belowthe zero line you get a recession.Here’s the zero growth rate lineHere’s economic growth cycling up and down around trend growth,and these red areas are recessions.So how could we minimize recession frequency, and move towards very longexpansions, preferably without recession for decades?>>> In principle its quite simple, all we need to do is take the wavy line and lift it upand we get this… 2
  • 3. Effect of Higher Trend 0 ©Economic Cycle Research Institute (ECRI)As you see, the only difference in this chart is that the trend line has been shiftedhigher.And now, economic growth remains above zero.The poster child for this approach is of course China which has had 10% trend GDPgrowth for two decades without a recession, because even while experiencing notabledownswings in economic growth it’s very hard to go from a 10% trend growth rate tobelow zero.We’ve seen similar experiences in India since the mid 1990s and postwar WesternEurope.>>> With this in mind, let’s move from a stylized view to reality in the United States. 3
  • 4. Annualized Pace of Growth in U.S. GDP in Postwar Expansions (%) 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 49-53 54-57 58-60 61-69 70-73 75-80 80-81 82-90 91-01 01-07 ©Economic Cycle Research Institute (ECRI)Here’s how things looked BEFORE the Great Recession.Each of these bars shows trend U.S. GDP growth in successive postwarexpansions.What you see is that trend growth has been stair-stepping down at least since the1970s, and the 2001-2007 expansion clearly had the lowest trend GDP growth ofany postwar expansion.>>> How about another key coincident indicator, employment? 4
  • 5. Annualized Pace of Growth in U.S. Employment in Postwar Expansions (%) 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 49-53 54-57 58-60 61-69 70-73 75-80 80-81 82-90 91-01 01-07 ©Economic Cycle Research Institute (ECRI)OKAYSo much for employment.>>> Let’s broaden this exercise to include all the key coincident indicators. 5
  • 6. Annualized Pace of Growth in U.S. Coincident Indicators in Postwar Expansions (%) 12 10 8 6 4 2 Industrial Production 0 Mfg &Trade Sales 49-53 54-57 Personal Income 58-60 61-69 GDP 70-73 75-80 80-81 Employment 82-90 91-01 01-07 ©Economic Cycle Research Institute (ECRI)This may look like a complicated chart, but the point is simple.It’s not just employment and GDP, which are the first two rows of bars, that havebeen stair-stepping down over decades -- it’s also income, sales and industrialproduction.On all counts trend growth in the U.S. has been falling in successive expansions,and this was clearly the case before the onset of the Great Recession.In fact, in August 2008 this chart was picked up by Floyd Norris at the NY Times,but since that was just before the Lehman failure – not a lot of people paidattention.So, in the context of raising trend growth to reduce recession frequency,we’re clearly going the wrong way.>>> Well, back to square one!! 6
  • 7. A Stylized View of Recession 0 Recessions ©Economic Cycle Research Institute (ECRI)Looking at the basic challenge, if raising trend growth looks like a non-starter,how else to reduce recession risk?>>> How about squishing the wavy line and making it flatter -- like this? 7
  • 8. Effect of Lower Cyclical Volatility 0 ©Economic Cycle Research Institute (ECRI)This is the same as the previous picture with one key difference:the economic growth curve shows less cyclical volatility, so even though trendgrowth didn’t go up, economic growth no longer cycles below zero.This was at the heart of the so-called Great Moderation of business cycles thatgave us long expansions and a couple of mild recessions from the mid 1980sthrough 2007.>>> Again, let’s see how we’re fairing in terms of reality… 8
  • 9. Volatility of U.S. Economic Growth 16 14 12 10 8 6 4 2 0 Jan-94 Jan-98 Jan-02 Jan-06 Jan-10 Jan-50 Jan-54 Jan-58 Jan-62 Jan-66 Jan-70 Jan-74 Jan-78 Jan-82 Jan-90 Jan-22 Jan-26 Jan-30 Jan-86 Jan-34 Jan-38 Jan-42 Jan-46 ©Economic Cycle Research Institute (ECRI)Here we have the volatility of U.S. economic growth going back to the early1920s.In the first part of the 20th century cyclical volatility was really high, a lot ofboom-bust which quieted down significantly in the postwar period. Then, startingin the mid 1980s it calmed down even further, and here’s the period many callthe Great Moderation.After the 2007 - 2009 recession I shouldn’t have to tell anyone that the GreatModeration seems to be history.But I know there are still some who believe that we’re going back to theGreat Moderation and that the Great Recession was a one-time anomaly.>>> To judge if a return to the Great Moderation is likely, we need to understandwhy people think it happened in the first place. There’s actually quite a bit ofacademic literature aimed at this question and the focus lands on three differentthreads of reasoning – 1) better supply chain management,2) better monetary policy, and 3) luck. 9
  • 10. Exports as a Percentage of GDP in Asia-Pacific Exports as a Percentage of GDP in Europe Taiwan 71 63 54 48 Korea 55 47 Germany 42 China 39 31 36 India 23 France 30 15 24 Japan U.K. Italy 7 18 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Exports as a Percentage of GDP in North America 48 44 Canada 40 36 32 28 Mexico 24 20 16 U.S. 12 8 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 ©Economic Cycle Research Institute (ECRI)In the context of the supply chain theme, let’s look at exports as a percentage of GDP sincethe end of the Cold War. What you find is a remarkable pattern.In practically every case export dependence has risen dramatically;Since 1990 in China, Japan and Germany exports as a percentage of GDP have doubled.In India its tripled, and in the U.S. we’ve seen a 50% rise in exports as a percentage of GDPup to 12%.Overall, in the twelve economies shown on these charts, exports as a percentage of GDPhave more than doubled to 35% since 1990.What unforeseen risks go along with this picture? After all, during the 1990s boomprominent observers declared that “globalization would help bring about the end of thebusiness cycle,” as strength in one part of the world balanced out weakness elsewhere.What they missed has long been called the Bullwhip Effect, where relatively mildfluctuations in end demand are dramatically amplified up the supply chain, just as a flick ofthe wrist sends the tip of a bullwhip flying in a great arc.Now, because even state of the art supply chain management systems are always blindsidedby cyclical turns in front-end demand, the Bullwhip Effect makes greater export dependencevery dangerous to supplier countries, actually adding to cyclical volatility… which of course,is the opposite of moderating cyclical volatility (or squishing the wavy line shown a coupleof slides back).>>> Let’s take a look at how this manifested itself during the recession. 10
  • 11. Industrial Production in Key Economies (July 2008=100) & U.S. Great Depression (August 1929=100) 130 China 120 India 110 Taiwan Korea 100 U.S. 90 Japan Germany 80 70 60 U.S. in Great Depression 50 40 May-10 Nov-09 Mar-10 Nov-10 May-11 Nov-11 Jul-09 Jul-10 Jul-11 Mar-09 May-09 Sep-09 Jan-10 Sep-10 Mar-11 Sep-11 Nov-08 Jul-08 Sep-08 Jan-11 Jan-09 ©Economic Cycle Research Institute (ECRI)After two decades of increasing export dependence this is what happened.In comparison to the decline in U.S. production during the Great Depression(longer line), look at how production in Japan, Germany, Korea and Taiwan faredduring the 2007-2009 recession.In each case the downturn in production was much sharper.This real-world experience is far from the aforementioned theory that bettersupply chain management would help smooth out the business cycle.Given this picture, I don’t know that you can rely on supply chain management tohelp resurrect the Great Moderation.>>> So what about the other argument, which is that monetary policy timingskills have improved so much that we can reliably pull off soft-landings? 11
  • 12. Evolution of ECRI’s and Fed’s Views About Inflation and Growth Risk 25 24 9/08 8/08 23 6/08 22 4/08 21 3/08 20 19 18 17 1/08 9/08 Risk to Growth Risk to Growth 16 9/08 15 12/07 4/08 14 13 12 3/08 8/08 11 10 1/08 10/07 10/07 10/07 6/08 9 8 9/07 9/07 7 12/07 6 8/07 8/07 5 4 3 Inflation Risk 2 ©Economic Cycle Research Institute (ECRI)Well, this chart shows ECRI’s interpretation of how the Fed’s assessment of inflation risk and risksto growth evolved in the lead up to the Lehman crisis. You also see how our own views evolved inthat timeframe.We tried to make this as unbiased as possible. We based each data point on official Fed statementson the one hand, and the performance of ECRI’s Weekly Leading Index of economic growth andthe Future Inflation Gauge on the other (which, by the way, are both released publicly).What this shows is dramatic.In contrast to a steady and more timely evolution of ECRI’s views whereby recession risk wasincreasingly trumping inflation risk, the Fed’s position effectively showed their views flailing backand forth until they belatedly recognized the reality of recession following the Lehman failure.It’s actually instructive to look at each of the points in time and understand just how far behind thecurve they were, but I’ll just ask you to think back to June 2008 <POINT TO DATE> when, basedon what the Fed was saying, Fed Funds futures were pricing in 100 basis points of tightening from2% - 3% by year end.To be clear, this was when we were already six months into the recession.But this episode is hardly an exception. Think back a few more years to June of 2003 when the Fedcut rates to 1% to battle deflation risk. In just a matter of weeks following that cut, GDP growthwas already surging to a 20-year high.With episodes like these it’s hard to argue that we have good monetary policy timing.Who knows, they might get their policy timing just right this time around. As the New York Statelottery slogan goes, “Hey, you never know.”>>>This brings us to the 3rd explanation offered by academics for the Great Moderation, which isluck 12
  • 13. Average Percentage of G5 Economies in Business Cycle Expansions During U.S. Business Cycle Expansions 100% 95% 90% 85% 80% 75% 1956-69 1970-82 1982-90 1991-2003 2003-10 ©Economic Cycle Research Institute (ECRI)Now, if you look at this chart showing the synchronicity of international expansions,what jumps out -- as missing -- is the 1990s, which was at the heart of the GreatModeration.In essence, during that time the major economies took turns going into recession, withthe English-speaking recession in the early 1990s being followed by recessions inJapan and continental Europe and so on.As a result there was significant disinflationary global over capacity that enabled theFed to remain relatively loose without a major inflation problem. This was in additionto capacity unleashed by the end of the Cold War.What happened for those dozen years was hardly by design, nor was it a lastingpattern.Essentially, it was luck.>>> Let me ask -- are you comfortable counting on a repeat of this sort of good fortuneas it were? If not, we must return to the now familiar slide. 13
  • 14. A Stylized View of Recession 0 Recessions ©Economic Cycle Research Institute (ECRI)To be clear, we are really talking about higher cyclical volatility, not a return to asuper-mild business cycle.And remember, we’re also talking of a well-established pattern of lower trendgrowth.This is exactly the opposite of what we’d like to see in the context of this chart.We’d like to see the trend line rising, but it’s falling.We’d like to see the wavy line flatten, but instead the swings are bigger.>>> Still, how well does this chart conform to reality?In the real world is the length of expansion driven by trend growth and cyclicalvolatility as the chart suggests? 14
  • 15. Estimates of Recession Frequency * FR (1973-84) 100 100 * US (1907-33) 90 * NZ (1966-91) US (1973-84) 80 Higher percentage of recessions * SA (1967-93) KO (1997-09) 70 MX * * IN US (1946-72) * * US (1934-45) ** (1958-80) GE CH * 60 * * JA (1990-09) UK (1973-84) ** SW TW* NZ 50 (1997-09) IT * ES *(1992-09) US (1985-09) SA FR (1985-09) OS * * AU * FR (1956-72) 40 * (1994-09) * * * TW (1965-96) 30 IN (1981-09) * UK (1985-09) * JA (1954-89) ** KO (1967-96)* 20 * CA 9.18 7.27 7.27 ty CN * tili 10 5.31 ola 4.58 lv 0 10 4.28 4.28 ica * UK (1953-72) 4.13 4.13 ycl 0.49 1.77 2.33 2.54 2.62 2.90 rc 3.04 3.08 3.37 Higher trend e 3.39 3.59 3.59 3.69 gh rate of grow 4.42 5.02 2.28 2.28 Hi 6.16 8.65 8.65 9.78 th 10.44 ©Economic Cycle Research Institute (ECRI)Here we pull together the international evidence showing that trend growth andvolatility largely explain the length of expansion.What you see is a three dimensional regression surface relating trend growthand cycle volatility on the two horizontal axes, to the vertical axis showing thepercentage of slowdowns that become recessionsThe asterisks are the actual percentages, and the dots are the regressionestimates.So, when you have high cycle volatility and low trend growth you have the mostslowdowns becoming recessions <TOP AREA>And when you have lower cycle swings and higher trend growth you have moresoft landings without recession <BOTTOM AREA>>>> Let’s boil this all down to the U.S. experience… 15
  • 16. Predicted and Actual Lengths of U.S. Expansions (months) 125 91-01 61-69 100 82-90 Actual Length 75 01-07 75-80 50 49-53 54-57 70-73 25 58-60 80-81 0 0 25 50 75 100 125 Predicted Length ©Economic Cycle Research Institute (ECRI)Here on the horizontal axis we have the predicted length of U.S. expansions based simply on trend growth and volatility. On the vertical axis you have the actual length of expansion.You can see there is a pretty good relationship with trend growth and volatility explaining 70% of the variance in the length of expansions.So what I’m sharing with you today is much more than theoretical.The convergence of a pattern of lower and lower trend growth combined with higher cyclical volatility it just dictates more frequent recessions.Quite simply, in the coming decade we’re unlikely to see the kind of long expansions that we’ve become used to since the early 1980s. Rather, we’re likely to see more frequent recessions.This view is in sharp contrast to the forecasts of most economists and their models, which show a relatively smooth projection into the future.Maybe these forecasts show anemic growth with a few bumps and squiggles thrown in, but that is a far cry from the cyclical instability that we foresee.Why should anyone care if we’re right? Let me offer a few things to think about:For policy makers a key takeaway is that the next recession will begin long before the jobless rate is anywhere near full employment, with the attendant monetary and fiscal policy implications.For investors, the problem goes further in that recessions are associated with major bear markets. So more frequent recessions demand the ability to ride the cycle in both directions, not a buy-and-hold mindset. Separately, frequent recessions tend to raise the equity risk premium and crunch P/E multiples. Case in point is the U.S. economy which between 1969 and 1982 saw four recessions in 13 years. During that time the stock market gyrated quite a bit but ended up where it started, even though earnings had clearly risen. Even worse is Japan, which has also seen four recessions since the popping of its asset bubble and the Nikkei is now about a quarter of its 1989 value, again even though earnings are up.>>> Which brings me to the worst case scenario… 16
  • 17. Inflation, Deflation and the Relative Durations of Expansions and Contractions 4.5 1932-2010 3.5% 3.6% -0.1 1920-1932 -3.1% -6.9% 0.6 1896-1920 3.7% 5.1% -0.2 1864-1896 -2.0% -3.2% 1.7 1843-1864 2.5% 4.7% -0.1 1814-1843 -2.8% -3.1% 1.1 1789-1814 3.0% 3.1% -8 -6 -4 -2 0 2 4 6 ©Economic Cycle Research Institute (ECRI)This chart shows alternating inflationary and deflationary ERAS in the U.S. over the last 220YEARS.The green and yellow bars represent the average rate of inflation in each era as measured by theCPI and WPI respectively.So we’ve had four inflationary and three deflationary eras, each including several business cycles.The red bars are where things get interesting as they show the average length of expansionrelative to the average length of recession in each of those eras.When the red bars extend to the right, more time on average is spent in expansion than contraction.When the red bars extend to the left, more time on average is spent in recession than in expansion.It is striking that in every era where the economy spent more time in recession it resulted insustained deflation.This worst case scenario, where frequent recessions also mean we’re spending more time inrecession than expansion, is not without precedent. In fact this is the essence of Japans challenge.Well, I think I’ve made my case. To wrap up, the business cycle landscape is likely to be quitedifferent in the coming decade, resulting in a profound shift in the kinds of challenges that decisionmakers are likely to face. 17