Is the US headed towards a double dip?

There are serious concerns that the US economy is grinding to a halt and may slip into another recession. Growth in quarterly Gross Domestic Product in the United States has averaged 3.28% between 1947 and 2010. By comparison, growth was 1% in the second quarter of 2011 over the previous quarter, up only slightly from 0.4% growth in the first quarter.

As pointed out by Ruchir Sharma, the Head of Emerging Markets, Morgan Stanley Investment Management: "When US economic growth has fallen below 2% on a year-on-year basis in a quarter, the economy has entered a recession in seven out of the previous 10 instances. The economy grew below that threshold level in the second quarter of this year."[i]

However, the financial markets are not yet sending out any warning signs. The yield curve (the spread between 10 year and 3 month government bonds) continues to be steep. Most recessions in the past have been preceded by an inverted yield curve, i.e., 10 year interest rates falling below the 3 month interest rate. Based on the yield curve, the New York Fed predicts that the probability of a recession before July 2012 is less than one percent (0.8%).

Corporate profitability is also sending out positive signals. Usually, profits dip before a recession but they grew 3% in the second quarter, up from 1% rise in the first quarter.

While most of the reliable indicators are not suggesting a double dip scenario, economists are still not discounting the possibility of a recession. In fact, various informal polls, such as by Wall Street Journal and USA Today, suggest that the likelihood of recession has doubled over the past couple of months.

The cause for concern is that consumers and businesses are still apprehensive. Increase in consumer spending decelerated to 0.4% in the second quarter, compared with an increase of 2.1% in the first quarter. The Thomson Reuters/University of Michigan Consumer Sentiment Index has been indicating stagnation. The ISM Manufacturing PMI was at 50.6 in August, barely managing to remain in the expansion territory.

There are four primary factors that account for the current passive response from the private sector to the recovery process:

·    No jobs or low wages: The job market remains glum, especially for those who are unemployed. In fact, employment in sectors like construction, information, and government continues to fall. The unemployment rate in July was recorded at 9.1%, a slight dip from 9.2% in June, which was more a result of people dropping out of the job market rather than a net addition to the share of workers with jobs.

·     Beleaguered public finances: The government's ability to boost the economy and employment has been severely curtailed. Each level of government is under financial stress in the US. Adding to the uncertainty in the medium and long term (beyond 2012) is the impact of cuts in government expenditure in the aftermath of the recent deal in the Congress to restructure public debt. The deal envisages cuts worth $2.5 trillion—nearly $1 trillion in discretionary spending and an additional $1.5 trillion through a bipartisan committee process, which would also consider entitlement and tax reform (or cuts in mandatory spending). The most recent estimates from CBO (which include the impact of the $1 trillion cuts in discretionary spending) suggest that discretionary spending will barely increase from $1250 billion to $1301 billion between 2012 and 2021. This means that assuming a 2% rate of inflation over this period, discretionary spending will shrink by nearly 13% in real terms over the next decade. Compare this with an increase of 6.2% per year in real terms between 2000 and 2010. The cuts envisaged by the Congress will mean that government spending will no longer make a positive contribution to GDP growth in the medium and long term.

·   Housing market still in slump: Suppressed housing prices have a negative bearing on consumer confidence and spending, creating a vicious cycle as it reduces the chances of a strong recovery in the housing market further. Barring minor upticks here and there, the broader story remains that of continued housing market slump.

·     The never ending EU crisis: The situation in the EU has only worsened over time. Greece, Portugal, and Ireland have been given junk ratings and Italy seems to have caught the contagion. With political difficulties within each nation and the economic union, a clear solution to the crisis is still not apparent. The Economist has compared the current scenario in the US and Europe to the case of Japan, which experienced the "lost decade" because the policy makers couldn't agree on a course of action in time. The risk is that the EU may be headed towards a financial crisis, which would impact the US and global market negatively.

The entire developed world appears to be pinning all their hopes on the 'emerging economies' to pull them out of the current morass. Evidence, however, suggests that the emerging economies have not really 'decoupled' from the developed world. Signs of weakness in the developed economies will likely result in weaker growth in emerging economies.

The Federal Reserve's announcement to keep the Federal funds rate—the overnight lending rate between banks—"extremely low" until at least mid-2013 (suggesting that the funds rate will likely remain between 0% and 0.25% through 2012, and most likely, until mid-2013) may only have added to the uncertainty and lack of confidence. Given that the economy appears to be in a liquidity trap, it is unlikely to boost the recovery process.

Given the present state of affairs, the US economy is likely to underperform this year and will likely grow only moderately in the medium term. As the Conference Board, the not-for-profit research association based in the US, put it: "Episodes of slower growth, alternating with only moderately firmer growth is the current reality in this post-crisis expansion." [ii]

The possibility of a recession in the US in 2012 appear very real, especially if the high-unemployment-low-wage scenario coupled with the slump in the housing market results in weak or negative growth in consumer spending and private investment gets strangled due to political and economic uncertainties across the globe.

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[i] http://economictimes.indiatimes.com/view-point/another-us-recession-would-be-consistent-with-its-financial-history-ruchir-sharma-head-of-emerging-markets-morgan-stanley-investment-management/articleshow/9950225.cms

[ii] "Economic forecast for the US economy," The Conference Board, July 13, 2011, <http://www.conference-board.org/pdf_free/economics/2011_07_1311.pdf

What did the S&P downgrade mean?

Standard and Poor's downgraded the US to AA+ from AAA. The event generated a lot of controversy. However, in practical terms, it turned out to be a non-event. Overall, if anything, the downgrade seems to have strongly affirmed the safe-haven status of US treasuries. Since the downgrade, the yields on US treasuries are not only closely mirroring German bonds, they have also gone down. If S&P's action had altered the risk perception of US sovereign debt, we would have seen a rise in interest rates on US treasuries. The rating downgrade, however, certainly added to the uncertainties and spooked stock markets, wiping out some more wealth for the US consumers.

The reasons for the declining yield on US treasuries are fairly obvious. No other debt market in the world compares with the depth of the US debt market. In an uncertain economic environment, there is a flight to safety and US treasuries still continue to represent that. Investors have diversified into gold and the sovereign debt of some of the better performing European economies, but these markets are hardly a substitute for the $14 trillion US government debt market. Further, the US government debt is not merely held by domestic institutions and public. Other countries hold nearly $4.5 trillion of US treasuries. China and Japan hold nearly $2.1 trillion. Given their export surplus with the US and China's need to maintain a currency peg with the US dollar, it is highly unlikely that these economies would diversify away from dollar-denominated US treasuries in a short span of time.

The response to the debt downgrade is also muted because other rating agencies, such as Moody's and Fitch, have not followed S&P. They have their reasons to do so—looking at the current debt-to-GDP ratio, there is still considerable headroom for the US to accumulate debt before the risk of default becomes a real possibility.

However, what has mostly gone missing in the entire debate is that S&P's decision to downgrade the US from AAA to AA+ never amounted to much in the short term. Looking at the definition of these two ratings, it is clear that the difference is not huge: 

AAA: Extremely strong capacity to meet financial commitments—the highest credit rating.

AA: Very strong capacity to meet financial commitments. It differs from AAA only to a small degree. AA+, equivalent to Moody's Aa1, means high quality, with very low credit risk, but susceptibility to long-term risks appears somewhat greater.

The downgrade, therefore, did not amount to much, except a warning that the long-term fiscal health of the US is under question, an assessment that few can argue with, except those who do not want to accept reality. Even after accepting the $2 trillion error by S&P, the debt-to-GDP ratio is expected to reach 85% by 2021. We don't need to take S&P's word for it. The projections by the Congressional Budget Office in the US paint a fairly grim picture of the US fiscal position in the long-term. Going by one of these projections, the US could end up spending its entire revenues in Mandatory spending (social security, pensions etc.) by 2035. In one of the papers, it did not rule out the possibility of a Greek-style sovereign debt crisis. As the CBO states, "There is no way to predict with any confidence whether and when such a crisis might occur in the United States; in particular, there is no identifiable tipping point of debt relative to GDP indicating that a crisis is likely or imminent. But all else being equal, the higher the debt, the greater the risk of such a crisis."[1]

Why then the controversy surrounding the rating downgrade? After all, S&P was not stating that the US is headed towards a default, as has been made out by some. It was merely pointing out that the long-term sustainability of US fiscal situation is an area of minor concern. Ratings are, in any case, meant to be forward looking. So, was S&P and its CEO shot for calling a spade a spade?

While the rating downgrade may not have amounted to much in economic terms, the politics associated with it did reveal a lot. Rating agencies have long been blamed for not being proactive in their risk assessments. However, every time a country is downgraded, it results in a very strong backlash. Greece lashed out strongly at the rating agencies whenever they downgraded its credit rating. The EU has proposed to set up its own rating agencies, voicing no confidence in the US based rating agencies. In the US, three municipalities dropped S&P after the downgrade. There has been some speculation in the media that Deven Sharma may have been forced to quit as the president of S&P, though others speculate that it has nothing to do with the political backlash and Sharma had begun looking for other opportunities due to the impending split of S&P into two—the McGraw-Hill Financial and S&P credit rating services.

The political nature of credit rating, and the clear conflict of interest (in that rating agencies are supposed to be paid by those whom they rate), has been a matter of debate for a long time. It has been a key reason for a lot of heartburn across the world. For instance, closer home, India had a lower rating (BBB- or barely investment grade) than Greece for a long time after the signs of a fiscal crisis in Greece had become apparent. It still continues to have a lower rating than Spain (AA, one grade lower than the US), Italy (A+), and Ireland (BBB+/A-2). Ireland was downgraded to junk status (Ba1) only recently by Moody's. China is rated AA- and Korea A+ by S&P, both lower than Spain. Meanwhile, media reports say that police raided the Milan offices of S&P and Moody's to check whether they "respect regulations as they carry out their work" following the threat that they may downgrade Italy's bond rating.

All of it means that ratings will continue to be looked at with suspicion. The recent episodes with sovereign credit ratings have not done anything to boost confidence in the credit rating system. The system probably requires an overhaul, the primary issue being  the need to make credit rating agencies truly independent of their clients. While the US has done a lot to reform the audit system by introducing the SEC, it has not been at the vanguard of reforms so far as the credit rating system is concerned. Given that two of the top three credit rating agencies (S&P and Moody's) are US-based, it will always generate controversy, being often seen as another tool in the hands of the US-based entities to manipulate the global economic environment, as the recent pronouncements from the EU appear to suggest. 

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[1] Congressional Budget Office, "Federal Debt and the Risk of a Fiscal Crisis", July 27, 2010, < http://www.cbo.gov/ftpdocs/116xx/doc11659/07-27_Debt_FiscalCrisis_Brief.pdf>.