Recovery Watch 2009

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Updated December 2, 2008

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

When my first two "Recession Watch" reports were published in August 2006 and September 2007, they drew a lot of bemusement, given that the economy appeared to be humming along (although the credit crisis kicked into gear in mid-2007). Indeed, the call was early, but ultimately correct. I was finally vindicated on December 1 when the National Bureau of Economic Research (NBER), the official arbiter of recessions, declared the recession began in December 2007. So, we're a year in … now it may be time to look ahead for the types of signals we would expect to get to suggest a recovery is in our sights. We know that fixing the economy will be President Obama's top priority in 2009.

A purely academic exercise?
So, we finally got the official call from the National Bureau of Economic Research (NBER)—does it even matter? If an official recession call seems academic, it often is. In fact, by the time a downturn has been labeled a recession, it's usually close to wrapping up. That's certainly why economists (and strategists) follow so many economic indicators—so they can maintain their own gauges of how the economy is performing. However, by officially declaring the beginnings and ends of recessions, the NBER helps economists, historians and policymakers chart the past and find patterns in the downturns we've already experienced.

Looking at history since (and including) the Great Depression, a typical recession has lasted about four quarters, though they've become shorter and milder over time. Recessions tend to coincide with episodes of credit contractions and asset price busts, though not typically both. That's one differentiating factor this go-around: For the first time since the Great Depression, the two biggest assets supporting household net worth—stocks and real estate—are deflating simultaneously in the midst of a credit crunch. According to the International Monetary Fund (IMF), one in six global recessions historically was driven by a credit crunch, with one in four accompanied by a real estate bust. We've got both in spades, as do many other nations. For that reason alone, we expect this to be a protracted recession. The good news: We are already a year in.

A look at duration
We're also in the midst of a rapidly deteriorating job situation. October's contraction in payrolls was the 10th consecutive drop. In the 70-year history of the payrolls report, there have only been seven other periods in which the economy shed jobs for 10 or more straight months. In four of the seven periods, the contraction stopped at the 10th month. The three most recent recessions saw longer employment contractions: 17 months in 1981–1982, 11 months in 1990–1991 and 15 months in 2001–2002.

It's reasonable to assume that our current employment downturn has legs into 2009. But in all three longer-duration cases, the recession was over before the job losses peaked. Don't forget how lagging an indicator employment is. Dramatic downward revisions are quite common during recessions, and we could see the jobless rate tick up to 8% or higher before it begins to turn back down. We believe the surge will likely extend beyond the recession's end, as is typical.

Perhaps a more telling—and leading—indicator is the so-called Anxious Index, which measures professional forecasters' views on the expected decline in real gross domestic product (GDP) in the following quarter.

Anxiety on the rise

Blue-shaded areas represent recession periods. As of September 30, 2008. Source: FactSet.

As you can see in the graph above, it appears that the 40% probability level is the critical level for predicting a decline in GDP in the following quarter. That level was breached in the beginning of 2008—not far from year-end 2007, when the recession began. After falling below 40% for one quarter, the index breached the 40% mark again in the third quarter of 2008. This suggests that forecasters are expecting a decline in GDP for at least one more quarter, which would take us into the second quarter of 2009. That may not be too far off the mark, however I do think the recession's end is more likely in the latter half of 2009. That would make it even longer than the prior two longest post-Depression recessions of 16 months (November 1973 – March 1975 and July 1981 – November 1982). Although I expect the Anxious Index to continue to accelerate, it tends to peak within recessions.

Consumer confidence implodes ... a bad thing?
The excesses that put us into this recession took years to percolate—and will take years to unwind. The credit crunch is deep, the consumer is under great pressure, global growth is universally weak and the housing depression lingers on. Indeed, consumer confidence recently plunged to all-time lows. But is this a leading or lagging indicator? As you can see in "Confidence Sinks ...," not only do plunges in consumer confidence tend to be of the V-bottom variety, but they also tend to correspond to bottoms in GDP. We did just see a bit of a jump in confidence (from 39 to 45) … not a compelling jump, but worth keeping an eye on over the next several months.

Confidence sinks … but is it necessarily bad?

Blue-shaded areas represent recession periods. As of November 30, 2008. Source: FactSet.

Another embedded aspect of consumer confidence is the spread between how consumers feel about their futures and how they view their current situations (see "Future Looks Brighter Than Present"). According to InvesTech Research, there's never been a time during the past 40 years when this spread has continued to improve without the economy coming out of recession in the next six to nine months. So, watch this spread carefully for continued momentum.

Future looks brighter than present

Blue-shaded areas represent recession periods. As of November 30, 2008. Source: FactSet.

We've gone global
Another differentiating characteristic of this recession is its global nature. Nary an economy on the planet has escaped the pain, and global interconnectedness makes forecasting a recession's end a more arduous task. The IMF is now predicting that developed economies' GDP will shrink for the first time since World War II. One once-obscure indicator that may prove a good forecaster in today's global economy is the Baltic Dry Index, a measure of global shipping rates that provides a clear view into global demand for commodities and raw materials. This index is a simple, real-time indicator that is nearly impossible to manipulate, as speculators do not participate in this market (unlike in commodities themselves). As you can see in "Global Shipping Rates Implode," the index has tanked ... down 94% since May! So, a turn back up in this index would likely signal that global economies are starting to grow again.

Global shipping rates implode

As of December 1, 2008. Source: FactSet.

It's what we do about recessions that matters
It's crucial to look not only at economic realities, but also at the reactions of policymakers. Responses to recessions typically come in three varieties: monetary policy, automatic fiscal policy (the increase in government spending resulting from increased unemployment insurance claims, welfare disbursements, etc.) and discretionary fiscal policy (stimulus packages and/or tax cuts). We're also now seeing an unprecedented global response to the financial crisis, and we can't underestimate the potential this coordinated stimulus has to lift growth, albeit with the typical lags.

We see monetary policy starting to work, albeit mildly. Numerous Federal Reserve and Treasury liquidity facilities and capital injections are bringing some interest-rate spreads down, while commercial paper issuance is beginning to recover. Of course, unclogging the credit markets is only the first step. Housing, at the root of our economic woes, remains depressed. But inventories are finally in retreat, and pending sales—a good leading indicator—are generally trending ever-so-slightly higher after a deep drop.

In the past, stimulus packages have had a shoddy record of working, given how long they typically take to move through Congress, not to mention the implementation time. However, a broad stimulus package that would involve infrastructure along with tax cuts could go a long way to boost confidence. Confidence is a key force behind recessions—its absence brings them on, its renewal ends them.

Mr. Market—a great leading economic indicator
Confidence will also come into play in the stock market—that ultimate mechanism of sentiment. Typically, stock markets bottom about 60% of the way through recessions. We've had 13 recessions since (and including) the Great Depression, 12 of which had accompanying bear markets or major corrections. Only once (2001–2002) did the market continue to sell off after the economy began to recover.

The fourth quarter of this year is likely to post the steepest decline in GDP during this cycle, with a drop of 5% or more in the cards. The worst single quarter ever for GDP was the fourth quarter of 1958, when it declined by a whopping 10.4%. The stock market had been weak heading into that quarter, but 18 months later it was up 52%—and a steady ascent at that. That's by no means a prediction of what we might look forward to, but is a reminder of the market's tendency to price in the worst case scenario before it unfolds, not after.

So, keep an eye on the stock market. Often when it begins to rally on still-bad news, it's a good sign for a pending economic recovery. However, be careful trying to pick a stock market bottom simply based on past recession-related performance.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not intended to imply future results.

Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

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

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