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Forecast 1: Recession of 2011

January 2, 2011

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That was Wall Street’s favorite bear, David Rosenberg. More from him later in the podcast.

As an economic recovery denier, Demand Side can hardly be expected to have the optimistic view of the world going forward that most economic forecasters are demonstrating. Even Rosenberg’s “getting better in dribs and drabs” to us is bouncing along the bottom, with as much bad news as good. The blue chip forecasters are in the stratosphere compared to our assessment of the probable experience of the economy in 2011 and beyond.

Over the next three weeks, we will be updating our bi-annual, once every two years, view of GDP, net real GDP, employment, inflation and investment. Subsequently we hope to begin looking back at our calls and how they worked out, compared to our rivals.

Our short form for 2010 was the economy would continue to bounce along the bottom, with significant downside risks from European debt and banking problems and from domestic weakness in commercial real estate. We saw only modest manifistation of those risks in 2010.

The short form for our 2011 outlook is that those risks will be put in play in 2011, triggered by the traditional trigger, rising oil and commodity prices. 2011 will witness significant new disruption to the American and global economies, likely within the first eight months of the year. The potential for bubbles in emerging economies to burst is growing. And since the structural dilapidation of mega-banks and investment houses has not been repaired, only papered over, and the paper has all been used up, a new and severe crisis in the financial sector is a non-trivial possibility.

The key to the call is the trigger, rising oil prices.

In our view, we have returned to 2008, when political constraints and economic ignorance resulted in over-reliance on the Fed and a very poorly designed stimulus package under George W. Bush. The stimulus design had its advocates in the Democratic camp too, and might be most correctly laid at the feet of Larry Summers, who descended from Harvard with a mantra: Timely, Targeted and Temporary. Public infrastructure spending was deemed too slow a mechanism. The tax cut package cobbled together was weighted toward business, and although everyone appreciated the $400 or $800 bonus from the government, the economy did not respond.

Meanwhile a huge commodity bubble rose out of the ashes of the housing bust, as investors scrambled for returns and a hedge against the inflation that was assumed to be inevitable from aggressive Fed action. This commodity bubble has largely been ignored to this day. Yes, everyone remembers the $147 dollar oil, but do they associate it with a financial bubble? Mostly not.

Rising oil prices, combined with higher interest rates, have been the surest early warnings of impending recessions. This same trigger was operative in 2000. Oil prices and interest rates rose together in 1999, when then Maestro, now buffoon, Alan Greenspan raised short-term rates right into the explosion of oil prices. Demand Side listened to Warwick University’s Andrew Oswald, and joined him in predicting the recession of 2000. This was the collapse of the New Economy.

And the same two factors triggered the 2007 recession.

Interest rates are low in the current environment, but credit terms are tight and dropping real estate values means collateral is not as handy as it is in normal times.

Oil and broader commodity prices are the match that will start a new conflagration in 2011. In our view, the American economy is fundamentally weak and burdened with debt, public policy has chosen the madness of austerity, and the corruption of the financial sector is structural. That is, the economy will not be able to bear the shock. This is not your father’s economy.

Oil prices are the trigger for two reasons. One, a rise in oil and gasoline acts as a tax on consumers, constraining their purchases of other goods and services and weakening their confidence. Two, resource extraction industries, particularly oil production and distribution, are by far the worst producers of jobs. A dollar spent on gasoline or heating oil employs fewer workers than a dollar spent on any other activity. Thus, returns to oil up, returns to labor down, and labor produces demand when oil does not.

A new research paper is just out from James Hamilton describing the connection between oil shocks and recessions. Link online.

Now what is cause of the commodity bubble now unfolding? Many have pointed to new demand from emerging markets or supply disruptions. But commodities prices are rising together, and the surge in demand is not confirmed by the Baltic Dry Index. The BDI, as Wikipedia informs us, measures the demand for shipping capacity versus the supply of dry bulk carriers. The demand for shipping varies with the amount of cargo that is being traded or moved in various markets (supply and demand).

The supply of cargo ships is generally both tight and inelastic — it takes two years to build a new ship, and ships are too expensive to take out of circulation … So marginal increases in demand can push the index higher quickly, and marginal demand decreases can cause the index to fall rapidly.

Well, the index is not collapsing as it did post July 2008, but it is in a slump and has been for some time. Hard to connect to booming commodity prices. In fact, as we’ve said, commodities have been bid up by the Fed’s printing of money.

We’ll see if we can get the chart up on the transcript.

There is no doubt that commodity prices are making new highs. The CRB Index which incorporates both spot and near-term futures prices is in new territory. And as David Rosenberg said in his most recent note


Food price inflation is starting to bind in emerging economies, as it did in 2008. Food riots in Africa and soaring prices in India and China.

Quoting Rosenberg:

… movements in oil prices still exert a statistically significant impact on the economy and earnings with a 12-24 month lag. In other words, growth was still receiving a tailwind from the sharp downdraft in crude prices experienced from mid-2008 to early 2009 right through last year. But the gig is up and the economy is going to feel the effects of the near-120% surge in oil prices for the balance of 2011 and into 2012 barring a reversal. Only once in the past did the U.S. economy fail to sputter or head into outright recession after such a two-year surge in oil prices (food will only make matters worse in terms of depressing real wages) and that was in 2006 when the economy generated over two million jobs, the unemployment rate was 4.5%, wages were rising at a 6% annual rate, home prices rose an average of 8%, and bank credit expanded 10%. Those offsets are not in play this year.

Rosenberg goes on to the point of commodity price inflation:

And the question is whether the Fed would dare embark on QE3 with headline inflation in acceleration mode (even if core is still well contained). It’s one thing to bring on QE1 when oil prices are at $45/bbl and the CRB spot index is sitting at 325 (futures at 215) as was the case in March 2009. And then to announce QE2 nearly 18 months later when oil is sitting at $75/bbl and the CRB is sitting at 380 (futures were at 270). But can the Fed really be serious about yet another round of balance sheet expansion to please the stock market when oil is now above $90/bbl and the CRB is at a record high of over 530 (futures now north of 330)? Talk about rolling the dice with the bond market vigilantes.

Also, have a look at The Latest American Export: Inflation in the op-ed pages (A17 to be precise) of the WSJ. Indeed, not only has the Fed managed to create an illusion of prosperity by stepping up the print press and swinging the stock market around with QE2 chatter last summer, but now it is actually helping the government cause a de facto real appreciation of the yuan by pursuing a back-door policy of boosting inflation in China. Bernanke is a true magician, no question about it.

David Rosenberg. We note that the lag has not been very long in the most recent recessions.

So there is a trigger. Dramatically lower state and local government spending — meaning employment — will provide further downdrafts. States have already raided their reserve funds and pulled every accounting gimmick they can find. They have cut deeply into schools, parks and public transit systems. They have had to put away the rosy scenarios and are now cutting into the bone.

In California, once and now again governor Jerry Brown has proposed cuts to Medi-Cal, in-home services for the elderly and higher education with a five-year extension of income, sales and vehicle taxes. In New York Gov. Andrew Cuomo proposed eliminating 20 percent of state agencies by combining duties, as part of “radical reform” to pull that state out of its fiscal crisis. Gov. Chris Christie in New Jersey skipped a $3.1 billion payment to the state’s pension system in a push to cut benefits for public workers, while proposing higher employee contributions and a boost in the retirement age from 62 to 65.

In Illinois, lawmakers voted for a dramatic 66 percent hike in personal income tax, from 3 percent to 5 percent, in a bid to resolve a $15 billion deficit, which amounts to more than half of the state’s entire general fund. The tax increase will be coupled with strict 2 percent limits on spending growth.

Note: This account relies heavily on a Huffington Post survey.

In Texas, where education and social service spending is relatively low and Republican Gov. Rick Perry has railed against government spending, the shortfall is projected to be between $15 billion and $27 billion over the coming two-year budget cycle.

In South Carolina, outgoing Gov. Mark Sanford has proposed a spending plan that would end funding for museum and arts programs, slash college funding and give many state employees a 5 percent pay cut.

In Georgia, deep cuts appear to await the state’s popular HOPE scholarship program that provides public college tuition to students who earn good grades. States are expected to collect 6.5 percent less than they did in 2008.

Meanwhile, support from the federal government is about to fall off the table. No new assistance is likely, Republicans in Congress say they will try to provide states with relief by reducing mandated programs, not by giving them more money.

When the issue is jobs and services, allowing states to reduce services does not help.

The states with the greatest concerns about their fiscal health are those with costly public employee pensions that are underfunded. Many public pension systems use overly optimistic rates of return and do not provide a true, long-term cost to taxpayers. A recent study by the Pew Center on the States found states face a $1 trillion funding shortfall in public-sector retirement benefits, but said that likely underestimates the problem.

And weakness in cities and counties is likely to increase the damage to states, as municipalities look to the state for bailouts.

The new decline in demand and jobs at the state and local level is on top of the stagnation in the household sector as a result of huge mortgage debt and other forms of consumer debt. At the same time, large corporations are sitting on what is said to be trillions of dollars in ready cash. This is an object lesson in which comes first, the demand or the investment and hiring by the private sector.

Nevertheless, there is no shortage of commentators who predict if not good times, at least less bad times. We’ll get to some of them in a moment. First, let’s finish off Mr. Rosenberg’s comments.


David Rosenberg

As we said, there are plenty of folks who think the economy is going to do well. The front page of the December 31 edition of the Seattle Times featured the banner headline “Happy days may be near again.” With growth projections from Macroeconomic Advisers, Moody’s Analytics, and IHS Global Insight fetured in colored boxes. That’s the first time I’ve seen such a thing. Parenthetically, Macroeconomic Advisers predicts 4.4 percent growth in 2011, Moody’s 3.9 percent and Global Insight 3.0 percent.

We predict negative growth in Q3 and Q4 and just 1.0 overall, after a so-so start. Our view is shared not so much by other forecasters, as by American consumers. The University of Michigan consumer sentiment survey remains in recession territory. It has been bouncing along between 65 and 75 since the so-called end of the recession in June 2010. Such a protracted low reading is unprecedented in the history of the survey. Except for the turn of the year 1992, readings such as these have occurred only within or leading directly to recessions. And it took another dip during December.

Consumers have been much better at predicting economic reality than professional economists, being fully six months ahead of the majority of economists in calling the last recession.

Others on the positive side include our favorite whipping boys, the Fed. Notoriously wrong and late to change their calls, the Fed has been tightening up the act in the last eighteen months. Not to last. Typical of their bias is Dennis Lockhart, President of the Atlanta Fed. In a recent paper
Lockhart predicted: “Sustainable Growth despite Headwinds” for 2011. According to Lockhart, the economy seems to have gained durable momentum. Growth in gross domestic product, personal income, and jobs should be better this year compared with 2010. Lockhart thinks that although the growth pace is likely to remain relatively modest, economic performance could surprise on the upside.

This is also the view of Calculated Risk, from whom we borrow the following:

In Lockhart’s view, the recovery continues to be constrained by … the interplay among the housing market, household finances and consumer spending, ongoing credit market repair, and lingering uncertainty restraining business and consumer spending. Lockhart believes these headwinds to a significant degree reflect structural adjustments that in the longer term will place the U.S. economy on a stronger footing.

CR’s Note: I think the key headwinds are 1) housing market issues, 2) State and local government cutbacks and debt, and 3) European financial issues.

Ah, we hope so. But when you paint the positive predictions with such dark colors, it makes us doubt. In fact, however, we see the failure to correct housing and debt burdens, to restructure large banks, to reduce joblessness by hiring people, and to help states and localities is about to sink us. The ship is weak, and the shock of higher oil and commodity prices will start the chain reaction.

This is

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