December 28, 2004 Mukund Sheorey is president of Modelytics Inc., a Customer Value Management services company.
The stage is getting set for the enactment of The Perfect Storm
U.S. Interrest Rates
The Fed has declared its intention to return short-term rates to “neutral”. While Alan Greenspan, not uncharacteristically, refuses to be pinned down to a specific number, with officially measured inflation already in the 2% - 3% range and rising, most observers think that the Fed will tighten to about 4% over the next 12 – 18 months. Starting at 1% in this cycle, this means an increase of 300 basis points.
Over the last 50 years, whenever the Fed tightened by 200 BP or more, we had a recession (57-58, 60-61, 69-70, 74-75, 80-82, 90-91) 75% of the time (6 out of 8 times). The only two exceptions were (a) the mid-60s amidst the Vietnam/Great Society spending boom and (b) 94-95 when the economy hesitated but resumed growth as the Internet boom unfolded. On the other hand, in 1999, a tightening of only 150 basis points brought on a recession since the Internet stock market bubble was already primed to pop.
Oil Price
Previous spikes in oil prices have also, without fail, led to recessions … in the mid-70s, early-80s, late-80s and in 2000. In the present cycle, oil prices have risen from ~ $12 per barrel in ’98 to $40+ currently … an increase comparable to the cumulative effect of the oil “shocks” in the 70s.
So, if history is any guide, it is almost certain that we are going to have a recession in the 2006-2007 period (historical lag of 2-3 years after the start of tightening).
Conditions in the rest of the world are not encouraging either. In Europe and Japan we have slowing growth. Interest rates are rising everywhere as higher energy costs stoke inflation fears – causing central banks to tighten. With large government budget deficits (3%+ of GDP) in the world’s major developed economies, there is not much room for further fiscal stimulus either.
In the U.S., amidst slowing auto sales, GM and Ford are cutting production. This will further exacerbate their pension problems. Delphi, the parts maker, is slashing staff. High energy costs are causing severe headwinds in the airline industry. The specter of higher long-term interest rates haunts the huge housing-related industries. In a recent consumer survey, intentions to buy a car over the next six months dropped to the lowest level in 40 years. Home buying intentions tied with the low in 1994 and was lowest over the past 20 years!
In Japan growth has petered out again. Consumers are reluctant to spend because of a lack of “confidence” … no doubt fueled by the huge rise in “temporary” jobs as a proportion of total jobs. With public debt at 160% of GDP and rising at the rate of 7% a year, there’s not much additional government stimulus likely.
In Germany, unemployment continues to rise into the low double digits. The rapidly strengthening euro will no doubt hit exports and the export dependent German economy.
In countries like UK and Australia, after a spectacular boom in house prices, a decline has already begun as their central banks are well into their tightening cycles. China is trying to slow down unhealthy growth by clamping down on credit.
So yes, it is clear that it is going to rain. But the key question is what kind of rainstorm? Is it going to be a plain “garden variety” recession like the 7 we have had over the last 50 years? Or are we going to have the dreaded “perfect storm” that capsizes supertankers? In other words, what’s different this time around?
For the U.S., five factors loom large in the economic calculus.
One, never before in the past 40 years has the Fed had fewer bullets in its interest rate gun. And it is desperately trying to reload the fun (from a low of 1%) against the backdrop of a weak economy (from the fundamental standpoint of the labor market, rather than GDP numbers).
Two, never before has the U.S. government been in a worse position to stimulate the economy with deficit spending. With red ink stretching out as far as the eye can see, fiscal stimulus will necessarily be limited (not that the politicians will refrain from trying!).
Three, never before has the dollar been so weak … a consequence of it being the currency of the world’s largest debtor nation. With the trade and current account deficits showing now signs of moderating, dollar weakness will continue. This means, above all, one thing … higher inflation in the U.S. And, continued inflationary pressures will force the Fed to continue tightening beyond what the economy can tolerate.
Fourth, the stock and housing markets are in bubble territory. While stock prices have declined from the ’99 – ’00 peaks, P/E ratios are still way above historical norms. House prices – both as a ratio to incomes as well as replacement costs – are at record levels. Reversion to the mean is inevitable.
Fifth, and most important in my analysis, never before have we “owed so much to so many.” The record debt burdens of all three sectors … Government, Business, and Household (cumulatively 300%+ of GDP) are truly the stuff of legends. For households, not only are the debt to income ratios at a record level, egged on no doubt by Sir Alan, they have increasingly converted fixed rate debt to variable rates … on credit cards, Home Equity Lines of Credit and Adjustable Rate Mortgages.
If significantly higher interest rates coincide with lower employment and incomes during a recession, the debt bomb will explode. Declining “wealth” – due to deflating bubbles in the housing and stock markets will add fuel to the fire. Rising defaults – mainly on the consumer side, will ignite a major banking system crisis requiring a government bailout. A financial crisis is what turns a recession into a depression.
Over the last 75 years, the probability of a “perfect storm” has never been higher.
