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Monday, 31 October 2011

Too early to give US economy the all-clear; Unemployment rate remains high and risk of a recession is real

Andy Mukherjee, Senior Writer


IF HISTORY is any guide, it may be unwise for investors to give too much importance to a report last week that suggests the US economy is speeding up again.

Data released last Thursday by the US Commerce Department showed that gross domestic product (GDP) expanded at an annualised 2.5 per cent rate in the third quarter, almost double the 1.3 per cent pace in the previous three months.

The data release was impeccably timed. News that Europe's politicians had finally managed to come up with a plan for containing their region's sovereign debt crisis already had traders itching to extend their risky bets.

The fine print of the US GDP report, which showed spending by households grew at a faster pace than expected by economists, only added to that sense of optimism. The S&P 500 Index shot up 3.4 per cent last Thursday.

Amid this carnival of enthusiasm, investors chose to more or less ignore the US Department of Labour's more sombre assessment of the unemployment situation. That report, which was also released last Thursday, showed that in the week ended Oct 22, initial jobless claims had stayed resolutely above 400,000.

In the past 29 weeks, there have been only two weeks when the claims have been below that danger mark. This is entirely consistent with a bleak picture for the overall labour market.

The US economy is driven by household spending, which can grow meaningfully, and in a self-sustaining way, only if people have jobs that pay decent wages. With the US unemployment rate refusing to budge from a very high 9.1 per cent in the past three months, that's unlikely to happen soon.

So what's going on with the GDP data? Why is it pointing to a recovery'

For a possible answer, we need to go back a decade.

On April 27, 2001, the Commerce Department announced its advance estimate of 2 per cent GDP growth for the first quarter of 2001. That was double the pace of expansion in the final quarter of 2000.

That data release caught Wall Street by surprise. Few analysts had expected the economy to show such remarkable resilience following the dot.com collapse.

Indeed, the bond market was by then expecting a full-fledged recession, and Mr Alan Greenspan, who was then chairman of the US Federal Reserve, had confirmed the debt market's pessimism by unexpectedly cutting interest rates on April 18, nine days before the Commerce Department issued its clean bill of health for the economy.

Then, on May 25, 2001, the growth estimate was lowered to 1.3 per cent from 2 per cent. Another tweak, one month later, saw the figure being clipped further to 1.2 per cent. The revised number, while significantly lower than the advance estimate, still suggested a decent level of expansion for the economy in the first quarter.

Then came the Sept 11 terror attacks on New York and Washington, and all remaining optimism in the economy vanished. Stocks came under heavy selling, which continued until the third quarter of 2002.

Much later, the very last revision to the data would show that the pessimists - and Mr Greenspan - had been right all along, and that instead of expanding, the US economy had actually contracted in the first quarter of 2001 by as much as 1.3 per cent.

Separately, the National Bureau of Economic Research confirmed that the US economy had entered into a recession in March 2001, almost two months before the Commerce Department issued its advance estimate of 2 per cent growth.

This history lesson has a simple message for investors: Advance GDP estimates are a rather unreliable gauge to assess the strength of the aggregate economy. They are especially useless around tipping points.

And by all accounts, we are close to one. Goldman Sachs currently estimates the chance of a new US recession at 40 per cent, while Societe Generale's economists believe the likelihood is as high as 65 per cent. According to the New York-based Economic Cycle Research Institute (Ecri), the odds are 100 per cent. The Ecri, which has a solid track record in predicting past recessions, has warned its clients that a new one is inevitable.

But if there is indeed a recession, how bad will it be? According to Mr Zach Pandl, a senior economist at Goldman Sachs, US housing, auto sales and investments in business structures - factories, hotels and shopping malls - have already fallen so much that scope for further declines in these activities may be limited.

So a new recession may not do colossal damage to total economic output. Mr Pandl's estimate is for a contraction of 1.4 per cent in US GDP, less than the 2.3 per cent shrinkage seen on average during recessions since World War II.

However, there is a flip side to the story. After almost four years of battling the 2008 financial crisis and its aftermath, the fiscal and monetary policy arsenal in the US is almost depleted. The Republicans won't let the Obama administration loosen its purse strings any further, while there is little more the US Federal Reserve can do short of raining money on people from helicopters.

Under these circumstances, climbing out of even a shallow hole may prove to be an onerous task for the economy.

'A US recession today would be painful,' Mr Pandl says. 'Given its high level, even a 'small' increase could take the unemployment rate to 11-12 per cent.'

Even a shallow US recession may have a deep impact on corporate profits and stock prices. 'If there is a recession, even a mild one, I would expect a substantial setback to corporate earnings,' notes Morgan Stanley's global developed market strategist Gerard Minack. 'To the extent corporates have maintained a tight cost base, there would be less-than-usual scope to cut costs in a downturn.'

The recession risk is quite real for the US economy. It will take more than an ebullient GDP estimate to make the danger go away.

andym@sph.com.sg

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