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Tuesday, March 10, 2009

Has Anybody Seen the Bottom Yet?

By Martin Hutchinson

Last week’s economic data told us two things. First, this recession is almost certainly going to be the worst since World War II. Second, the pit isn’t bottomless; there are faint signs of a landing - although it is still some considerable way further down.

For investors, the prospect of a not-quite-bottomless pit in the United States is unexciting, to say the least, so it’s worth looking internationally for areas where the news is rather better.

Friday’s unemployment number for February was just about as bad as everybody feared, with non-farm payrolls losing 651,000 jobs. But the real news was the revisions made in the non-farm payroll numbers for December and January, boosting the job-losses for those months to 684,000 and 655,000, respectively.

This had the perverse effect of making February look better by comparison, since it was now the second month in which the number of jobs lost had slightly declined. Job losses have now been holding approximately constant for each of the last four months at about 650,000; thus, it doesn’t appear as though the economic decline is getting any steeper.

Other reports confirmed that the decline is not steepening, and even suggest that a turn may be on the way. The Institute of Supply Management manufacturing and non-manufacturing indices for February were both approximately flat - unchanged - from the previous month, suggesting again that the rate of economic destruction is constant at worst.

In the short term, help is on the way, partly from the continual gradual easing of credit conditions, assisted last week by the unveiling of a $1 trillion Treasury Asset-backed Securitized Loan Fund, which will help to restart the securitization market for consumer loans of all kinds.

Healthy banks will not welcome this new competition, since it will cut into their margins. Even so, when this new program starts in the spring, it will combine with two other government initiatives to create a trifecta of heavy-hitting stimulus programs that, in combination, should provide the U.S. economy with a shot of adrenaline - the results of which could start to show themselves by the May/June timeframe.

Those other two initiatives are:

The modest tax cuts for consumers in the lower and middle incomes.
And the first of the outlays from the $787 billion package passed and signed into law last month.
That’s where the bottom may be coming into view. If the downward slope is not getting any steeper - and we can expect some upward force in a few months - then there must be a good chance that the economic bottom is only a few months away.

Should that prove to be the case, the recession will have lasted about 18 months - about as long as the most severe recessions since World War II - and will have produced a drop in gross domestic product (GDP) of about 5%, slightly worse than the 1974 and 1982 recessions, which had previously been the post-war period’s deepest.

Still, this recession’s 5% drop in GDP will not seriously match up against the Great Depression’s 25% GDP drop, or against various other fairly severe recessions experienced in other advanced economies during the last 50 years.

Recovery is a different matter. Once the recession has fully bottomed out, perhaps in the third or fourth quarter of this year, the economic recovery from the bottom will be hampered by two factors:

First, the federal budget deficits will be continuing at a level of more than $1 trillion per annum - equal, perhaps, to 10% of GDP. Thanks to a manifestation known as the "crowding out effect," government financing of these huge deficits will tend to drive private borrowers out of the credit markets and restrict funds availability for business expansion.
Second, the huge increases in money supply in the last six months - the St. Louis Fed’s "Money of Zero Maturity" broad money index (the best broad money-supply measure left over since the central bank stopped reporting M3 money-supply statistics in March 2006) has been rising at an annual rate of over 20% since October - will almost certainly cause a resurgence in inflation once the economy has bottomed out. Combined with the afore-mentioned budget deficits, this surge in inflation will probably cause a steep uptick in interest rates unlike anything we’ve seen since the late 1970s. With rising interest rates and rising inflation, economic recovery will be very sluggish indeed, with full recovery delayed for several years.
If the recovery of the U.S. economy is exceptionally sluggish and delayed, it is unlikely that stock market returns will be satisfactory: Indeed, the U.S. market may remain at or below its current depressed levels for several years.

On the other hand, economies that have not incurred such huge budget deficits - or taken such huge risks with inflation - may find that their recovery arrives at the normal pace: Those markets could be rising rapidly from their recessionary low points by the middle of next year.

This suggests that the major East Asian countries, which have ample liquidity and generally positive trade balances, will be particularly well-positioned to be able to expand through domestic growth, boosting their companies’ profits and stock prices, accordingly. The best-run countries of Latin America - particularly Colombia, Brazil and Chile - may also benefit from Asian growth, without suffering high inflation or financing difficulties, since they have reacted to the global recession much more conservatively than the United States or Europe.

So, there you have the good news and bad news, all in an economic nutshell. And that brings us to the bottom line. Let’s look at all three:

The good news: We may be only a few months away from the bottom of the U.S. recession, which may be only a moderate distance below where the economy is right now.
The bad news: Any recovery that does manifest itself is likely to be very sluggish indeed.
The bottom line: Look to Asia and Latin America (particularly Colombia, Brazil and Chile) for the next investment bull markets.

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