How Bad Can It Get?

by David Kastner, CFA, Director, Market Analysis Group, Schwab Center for Financial Research
January 6, 2009

Reprinted from the December 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

The U.S. stock market has recently experienced some of its worst declines and highest volatility since the 1930s. Does this mean the economy is heading down the same road? We don't think so. But how bad can it get? We've laid out three possible paths:

A garden-variety recession. Unfortunately, we think that we may have already blown right through this scenario.
A lost decade. While we can't rule out the possibility of a situation similar to the Great Depression, we think that it's very unlikely.
A deep and extended recession. At this point, it appears that the United States is on a trajectory for this type of recession.

Of course, no one can be sure what will happen—and history is an imperfect predictor. But an analysis of past downturns can provide at least a rough road map. Since the core of this recession is a slump in consumer spending, we looked at past consumer-led downturns. Based on that analysis, we settled on three possible scenarios (for a summary of the economic signposts for each and where we believe we stand now, see our "Recession Dashboard").

Which of these roads we ultimately travel will likely be determined by the success of federal stimulus (see Help Is on the Way) and consumers' willingness to start spending again.

Click to enlarge

Scenario: Garden-variety recession (low probability)
The 1990 recession was a good example of a garden-variety recession driven in part by a slowdown in consumer spending. Like the current downturn, the eight-month recession of 1990 was born out of home price weakness, though back then the decline in real house prices was a modest 8.1%, and the slump in gross domestic product (GDP) was a shallow 1.3%.

In the current recession, not only has the financial contagion far exceeded that of the early 1990s, but the impact of the housing and credit crises has spread through the real economy. The negative feedback cycle of weak consumer spending, tighter lending standards, dour business sentiment and job losses is now in full swing. And with the National Bureau of Economic Research setting the official start of the current recession in December 2007, it's already lasted longer than the 10-month post-World War II average.

As you can see in our dashboard, the LIBOR spread to the fed funds rate (measuring the difference between short-term rates charged by the Federal Reserve and banks) has been falling—a positive trend. But relative to precrisis levels, the spread still reflects elevated uncertainty, even with the Fed backing many areas of the credit market. And November's jobless rate of 6.7% is relatively low only because it looks to the past. We expect it to top 8%, following initial jobless claims to levels consistent with a deep, extended recession.

Scenario: Lost decade (moderate probability)
The Great Depression of the 1930s is commonly used as a worst-case benchmark for our market and economy. The 86% decline in the S&P 500® Index back then led a multiyear, double-digit-percentage decline in personal consumption, a collapse in industrial production and international trade, and a 25% unemployment rate. GDP growth fell by nearly double digits for three consecutive years. Could we reach these numbers this time?

We may experience a multiyear period of low or negative GDP growth, moderate deflation, high unemployment and other financial problems, but we think a Great Depression repeat is highly unlikely. Why? The government isn't making the same mistakes it made back then.

Most important, instead of raising interest rates, the Fed has cut them aggressively. A lost decade would be akin to the 1990s in Japan. But the U.S. government is working overtime to boost liquidity and bolster bank balance sheets to get credit flowing. The Japanese government took years to begin truly aggressive measures.

Global protectionism was another root cause of the Great Depression. International trade is currently being curtailed, but due to shippers' inability to secure letters of credit—not because of protectionist legislation. Is this the modern-day version of the Smoot-Hawley tariff? That's a concern, but the government is working toward fixing the liquidity issues that should help get shipping back on track.

Also blamed for the Great Depression was the lack of fiscal stimulus, though somewhat unfairly. There were questions as to the efficacy of public spending, which rose 50% between 1929 and 1932, but fiscal stimulus had been pumping before President Roosevelt's 1933 New Deal initiatives. Now, we have a possible $700 billion stimulus package being hammered out in Congress. Although some of the same questions about the potential effectiveness of fiscal stimulus arise today, we think government spending can help defuse the deflationary cycle currently building up steam.

And stimulus doesn't stop at our borders: Countries around the globe (developed and emerging alike) are quickly ramping up monetary and fiscal stimulus that could eventually underpin world growth and trade.

Of course, there are risks associated with regulation and ballooning government deficits. Eventual tax hikes, which will be needed to address these deficits, could rob future growth potential. Nonetheless, we believe that the combination of robust fiscal stimulus, hyperstimulative monetary policy and government action to spur trade all argue against a lost decade.

Scenario: Deep and extended recession (higher probability)
As best we can tell, the United States appears to be on track for a deep, extended recession. What might this look like? Back-to-back recessions in the early 1980s and the deep 1973–1975 recession may offer benchmarks for a deep, consumer-driven slump.

A nearly 4% annualized decline in consumer spending characterized the 1980 economic trough. Although the 1980 recession is commonly coupled with the 1981–1982 recession, the latter was more of the business-led variety. Nevertheless, during that entire three-year period, real GDP retrenched 2.2% and 2.6% during the respective recessions, and the unemployment rate reached 10.8%. The 1973–1975 recession was also deep, with GDP falling 3.1% over a 16-month period and unemployment reaching a 9% peak.

While many variables during these recessions differed from current circumstances (e.g., particularly rampant inflation in both periods), there are many similarities. Real (adjusted for inflation) home prices fell significantly during the early 1980s—ultimately falling 14.2%, according to the Federal Housing Finance Agency. And a bear market led the 1973–1975 recession, with the S&P 500 Index falling 45.1% between January 1973 and December 1974.

Home and stock prices can each have a big impact on consumers' wealth and spending habits, as seen during those recessions. Currently—as many of us are likely well aware—both falling stock and home prices are rapidly destroying wealth, so there's a growing risk the recession we're in now could be worse than the benchmark examples.

On the heels of the housing bust, consumer spending has gone into a nosedive, as consumers face rising joblessness and rapidly tightening lending standards. Meanwhile, commercial lending standards are also tightening: Amid few signs of stabilization in housing and with heavy debt loads being unwound, the cost of borrowing for businesses has risen to its highest level since the 1930s. Combined with lower sales, this is crushing business sentiment and increasing job cuts.

The yield curve (a snapshot of interest rates for short- to long-term U.S. Treasury securities) has recently started to flatten. This could be in anticipation of the Fed's unconventional monetary policy to try to lower longer-term yields to help the mortgage market. But we think the flattening could also be the traditional sign that economic conditions are worsening and that recovery is not imminent.

The higher probability that this will be the first synchronized global recession since World War II has also significantly raised the odds, in our opinion, that this recession will be deep and extended. Thus, we're watching the U.S. dollar and commodity prices closely. The dollar did rally sharply from record lows, as its status as the reserve currency of the world shone amid spreading woes around the globe; it has since stabilized as global growth expectations have dropped.

We think a moderate pullback in the dollar would indicate improving conditions, while a sharp rally, extreme volatility and more severe weakness in commodities would likely signal a rapid deterioration in global economic sentiment. We believe continued steadiness in the dollar might reflect a deep and extended recession throughout which most major countries attempt to cheapen their currency in a bid to thwart deflation. In such a competitive devaluation environment, no single major currency would be able to depreciate significantly.

Market implications
These aren't cheery trends we're seeing. But plenty is being done to try to reduce the risk of something worse than a deep recession. And we believe the stock market has already priced in significant damage to the economy. Not only has the market decline exceeded that of the post-war average recession-related bear market, but the pace of the decline is typical of deeper recessions. That is, there are likely worse economic numbers still to come.

While stock market signals are one of the best leading economic indicators, most investors are interested in where the stock market is going, not the economy. However, using our dashboard indicators, we can compare stock market reaction to economic and earnings uncertainty and try to determine if the market appears to have already priced in extremely pessimistic views of the road ahead. Given the current weight of the evidence, we believe that it has.

Stock prices have dropped faster than earnings, which means the market is pricing in the risk of yet lower earnings—about 11% lower, based on recent data. That would mean 12-month earnings would drop nearly 37% from the June 2007 high-water mark, fitting a deep recession scenario. But that's still less than half of the estimated decline in the early 1930s.

At this point, the market appears to be forming a bottom, built in part on expectations that aggressive fiscal and monetary measures will be fully implemented and successful in thwarting a lost decade or worse. So far, most of our dashboard items agree—but we'll keep watching the indicators closely.

Important Disclosures

Economic indicators from the "Recession Dashboard" table:

LIBOR (three-month London Interbank Offered Rate) less Federal Reserve effective fed funds rate, as of December 11, 2008.

Moody's Baa corporate bond yield less 10-year U.S. Treasury yield, as of December 11, 2008.

Weekly initial jobless claims (four-week moving average) and unemployment rate from U.S. Department of Labor, as of December 6, 2008.

Lending standards are an equal-weighted average of consumer lending standards and commercial and industrial lending standards. Consumer lending standard: equally weighted average of senior loan officer opinion survey for lending standards on consumer credit card loans and other loans, as of the third quarter 2008. Commercial and industrial lending standards: equally weighted average of senior loan officer opinion survey for lending standards on commercial and industrial loans for large, medium and small firms, as of the third quarter 2008.

Home prices: Case-Shiller 20-City Composite Home Price Index month-over-month percentage change, as of October 2008.

Real retail sales: Second-quarter average year-over-year, from U.S. Department of Commerce. Retail sales data as of November 2008; November Consumer Price Index based on consensus estimate per Bloomberg.

U.S. Dollar Index: New York Board of Trade Dollar Index, as of December 11, 2008.

Commodity Research Bureau Commodity Index and Commodity Research Bureau Continuous Commodity Index, as of December 11, 2008.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

(0109-7502)

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