Thursday, August 27, 2009

Will Economic Recovery Be Behind Door V, U, or W?

Economist's say that there are three major possibilities for how the economy will exit the current recession, but the outcome remains highly uncertain. Some new information on the leading indicator of new orders for manufactured durable goods may provide some clues on what to expect. The following post from The Capital Spectator describes some factors that may shed light on the type of recovery that is most probable.

Is today's update on new orders for durable goods a sign of an approaching V, U or W? Translated: Is the economy poised to rebound sharply and deliver strong growth—a V recovery? Or is a U-type future, with slow to negligible growth, approaching? Even worse, could an imminent rebound be little more than a prelude to a second recession, a.k.a. the W cycle?

That summarizes the great questions that prevail as the world attempts to handicap the winding down of the Great Recession. As always, the central challenge is that we're left with a great unknown, even if today's news on durable goods suggests otherwise.

As monthly numbers go, July's update for the series is undoubtedly encouraging. New orders for manufactured durable goods in July increased 4.9%, the U.S. Census Bureau reports. That's the third increase in the last four months and the largest percent gain in two years.

No one can deny that such news constitutes progress. Ditto for the accumulating evidence in other economic reports that the economy, if not quite on the mend, is no longer contracting. A number of clues have been suggesting no less for months, as we've been discussing on these digital pages for some time, including the all-important weekly updates on initial jobless claims. Additional support for thinking the economy's stabilizing arrived in yesterday's upbeat news on consumer sentiment and housing prices: both are rising.

None of this is particularly shocking, although the timing was always in doubt. But surely no one expected the U.S. economy, still the world's largest, to remain in downsizing mode indefinitely. The emotional bias in the dark days of this year's first quarter may have convinced us to see a continually dire future. But the recession at that point was already more than a year old, by NBER's accounting, and the natural economic order tells us that recovery arrives eventually. Meanwhile, the massive countercyclical efforts of the Federal Reserve, plus the fiscal stimulus embraced back in February, was sure to have an impact. In fact, one might argue that President Obama's reappointment of Fed Chairman Ben Bernanke to a second term is formal recognition of the success in the central bank's aggressive actions intent on slowing if not ending the downturn.

What's more, the financial and commodity markets have reacted by elevating prices, in effect offering additional corroboration that the business cycle was turning. But while it's tempting to see us headed for a V recovery, the odds seem to favor a U. We've been forecasting just that future for some time by emphasizing that the "technical" end of the recession was imminent if not already here but it would be followed by a tepid recovery.

As welcome as that revised outlook is relative to what preceded it, there's a danger of overlooking the risk that follows this time around. Namely, a series of generational adjustments that threaten to conspire by leaving the economy in a weakened state for an unusually lengthy stretch. The most conspicuous risks: the likelihood that consumer spending growth will remain subdued for some time and the labor market will be slow to respond to so-called recovery.

There are any number of other challenges looming as well, starting with the nuances tied to the timing and magnitude of the Fed's so-called exit strategy. The challenge looks unusually bland at the moment, but it won't stay that way. Indeed, to the extent the economic recovery is stronger than expected, the exit strategy problems will be that much bigger.

Perhaps then the principal question is: Has the crowd priced in the post-recession risks that await? The first half of the business cycle has been unusual on a number of levels, as the last two years remind. We're probably just about midway, perhaps a bit more, through this extraordinary period. Thinking that the second half will be any less rocky and risky is asking for too much.

Still, it's easy to remain complacent. Looking at positive short-term changes in economic measures that are cut in half over longer stretches is reassuring. But climbing out of this hole will take time and the task faces many pitfalls. It's only human to minimize the potential hazards, but strategic-minded investors can't afford such luxuries. As we've arguing in The Beta Investment Report, the time for aggressive portfolio decisions was in this year's first quarter. From here on out, the money game is about to get much tougher.

This post has been republished from James Picerno's blog, The Capital Spectator.

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