ASSESSING THE RISK OF A DOUBLE-DIP RECESSION: KEY INDICATORS TO MONITOR

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Brianna Cobb
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sustainability of the economic recovery. Investor fears of a double-dip recession are becoming more widespread. There is clear evidence of a loss of momentum in both the U.S.

1 Weekly Economic Perspective ASSESSING THE RISK OF A DOUBLE-DIP RECESSION: KEY INDICATORS TO MONITOR August 2, 2010 Robert F. DeLucia, CFA Consulting Economist Summary and Major Conclusions: Heightened financial market volatility is likely to persist in future months, the result of growing uncertainty over the sustainability of the economic recovery. Investor fears of a double-dip recession are becoming more widespread. There is clear evidence of a loss of momentum in both the U.S. and global economies, accentuating fears of a double-dip recession. Consumer spending, exports, and manufacturing appear to be in a weakening trend, while construction remains in deep recession territory. It is important for investors to differentiate between sluggish economic growth versus an actual contraction in aggregate output and spending. While it seems clear that the U.S. economy will weaken further in future quarters, the probability of a relapse into recession is less than 50%. There are several factors that reduce the probability of a double-dip recession. While still weak and far from normal, conditions within the household and banking sectors have improved somewhat, as have overall financial conditions. Similarly, while labor markets remain extremely depressed, there has been consistent albeit moderate private sector job creation since yearend, which is boosting incomes. The most compelling argument against a relapse into recession is the extraordinary health of the U.S. corporate sector. Balance sheets are in the best condition in decades and corporate earnings and cash flow have surged in recent quarters. Strong corporate profits and healthy balance sheets should eventually translate into a broad recovery in business capital investment and private sector job creation. Another major argument against a double-dip is the likelihood of continued strong government stimulus. While longterm fiscal policy reforms are inevitable in future years, the U.S. has latitude in the medium term to provide further fiscal stimulus, and low inflation will permit the Federal Reserve to provide monetary stimulus. The most likely outcome is a period of very sluggish economic growth through the middle of 2011, with real GDP expanding at an anemic 1-2% annual rate. The risks to my forecast for economic growth are to the downside. Other key elements in the outlook include a sharp slowdown in profit growth, a rising unemployment rate, very low inflation, and continued low interest rates. INST-A023724

2 There are several critical indicators that investors should monitor in assessing the risk of renewed recession, the most important of which relate to the outlook for continued job creation and improving financial conditions. Other key indicators relate to business and consumer confidence, monthly business surveys, housing market trends, and conditions within the banking industry. U.S. HOUSEHOLD DEBT SERVICE BURDEN Ratio of Total Debt Payments To Personal Income Financial markets are likely to remain directionless and should continue to fluctuate within a wide trading range along with heightened volatility. A trading range in bond yields along with some further weakness in equity markets appears likely until there is greater clarity regarding the direction of the economy. The focus of last week's economic commentary was on long-term structural forces that would likely dominate the economic outlook over the next 3-5 years. The focus of this week's Economic Perspective is on short-term business cycle trends and the prospects for economic growth over the next 3-5 quarters. The basic concern relates to the sustainability of the recovery that began in the middle of last year, and the probability of a double-dip recession. Financial Markets - Market volatility has increased enormously since April in response to growing investor concerns regarding the sustainability of the current weak and fragile economic recovery. Fears of a double-dip recession have triggered a sharp and sudden decline in world equity markets, along with falling commodity prices and widening risk spreads in the corporate bond market. Plunging market yields on government bonds is a clear manifestation of the sharp rise in risk aversion and massive flight to safety. Market yields on 2- year (0.55%), 5-year (1.60%), and 10-year (2.90%) U.S. Treasury notes have declined to historically depressed levels. There has been an almost perfect statistical correlation in recent months among global equity markets, commodity prices, corporate bond credit spreads, and government bond yields. Economic Trends - As expected, following estimated real GDP growth of slightly more than 3% over the past year, the U.S. economy is entering a period of significantly slower growth that could persist through the middle of next year. The economic slowdown will be reflected in weak data for housing, consumer spending, manufacturing, construction, and state and local government spending. Job creation remains in a positive trend but additions to private payrolls are expanding at an anemic pace. The loss of economic momentum is primarily the result of two key factors: (1) An end to the inventory rebuilding cycle that contributed one-half the growth in GDP over the past year; and (2) Fading stimulus from the Obama fiscal package passed by Congress in early Growth in real GDP will likely slow from 3% over the past year to only 1.5% over the next year. DOUBLE-DIP RECESSION I have discussed at great length in recent years the underlying long-term structural headwinds to sustainable economic growth. These headwinds are likely to persist for years and will constrain economic growth over the next year. In addition to these worrisome long-term structural impediments to growth, there are several important short-term developments that could increase the risk of a double-dip recession during These risks relate to the housing market, consumer spending, continued caution within the business sector, the sovereign debt and banking crises in Europe, and economic and policy trends within China.

Risk Factors - While each of these factors are of great concern, renewed weakness in house prices is most worrisome because of the adverse implications for the banking system.

3 Risk Factors - While each of these factors are of great concern, renewed weakness in house prices is most worrisome because of the adverse implications for the banking system. Renewed weakness in consumer spending is another risk factor and is predicated mainly upon trends in the labor market and the sluggish pace of job creation. A third concern relates to continued caution and reluctance of the business sector to adopt expansionary policies, despite extremely healthy profits and balance sheets, because of widespread uncertainty and lack of clarity in the outlook. With respect to the eurozone, although financial tensions have eased in recent weeks, sovereign debt and banking problems are far from resolved, and continue to pose a major risk to the global economy. Finally, the future direction of credit policy actions and the risk of a hard landing in China also accentuate the risks to the global economy. Positive Factors - While an economic relapse and double-dip recession is certainly a possible scenario and should not be ruled out, I believe that the probability is less than 50%. Key fundamental factors that argue against a doubledip recession relate to traditional business cycle dynamics, the health of the business sector, the favorable outlook for capital spending, and preliminary evidence of modest improvement in the household and banking sectors. Continued support from government policy also argues against an outright contraction in economic output. Business Cycle Dynamics - A study of history reveals that double-dip recessions are rare and only occur as a result of major external shocks or serious mistakes in government policy. The shift from contraction to expansion is generally an ongoing and continuous process and tends to persist unless undermined by external shocks, as occurred in the early 1970s, or major mistakes in government policy, as occurred in the early 1980s. The key point is that despite the existence of formidable structural headwinds to economic growth, the normal dynamics of economic recovery appear to be unfolding, albeit at an extremely weak pace. U.S. INDEX OF LEADING ECONOMIC INDICATORS The Conference Board Economy: Absolute Level - The economic collapse that occurred during 2008 and 2009 pushed most sectors of the economy to extremely depressed levels. Despite the recovery of the past four quarters, virtually all measures of economic activity remain well below the all-time peak levels of 2007, including industrial production, retail sales, capital investment, income from wages and salaries, employment, and housing. The key point is that renewed recession would require a further contraction from these already extremely depressed levels, which appears unlikely. Corporate Sector Health - The current strong fundamental condition of the U.S. corporate sector is a major positive in the economic outlook. Ultimately, prospects for job creation and capital formation are predicated upon the business sector, which is extremely healthy in three respects: (1) Profitability and internally generated cash flow; (2) Balance sheets and financial strength; and (3) Operating efficiency. Profits have recovered strongly from the recession; balance sheets are the healthiest in decades; and companies are operating at efficient levels as reflected in strong productivity growth.

4 Capital Goods Market - The favorable outlook for business investment in equipment and software is not surprising in view of the strength in corporate profitability and favorable condition of business balance sheets. The historically wide gap between the cost of capital and expected returns on invested capital provides a strong incentive for businesses to commit funds to long-term investment projects. New orders for core capital goods are expanding at a robust 25%. Output in capital goods increased by 15% over the past year and should continue to expand at a robust pace over the next several years. Household Sector - Fundamentals within the household sector remain at depressed levels but are showing preliminary signs of improvement. Payrolls are expanding, albeit at an extremely moderate pace; wage incomes are also rising at a moderate pace; and the personal savings rate has risen to more than 7%, the highest level since the early 1990s. Finally, although the painful deleveraging process remains at an early phase, household debt levels are slowly improving. Household debt service burdens (see chart) are falling rapidly, the result of low interest rates and paydown of debt balances. The key point is that current trends are supportive of growth in consumer spending, although at a sluggish pace. Banking/Financial Conditions - While far from normal, banking and financial market conditions remain in a gradually improving trend, despite the setback from the European debt crisis and equity market decline. Bank earnings are rising, problem assets appear to have stabilized at a high level, bank capital ratios are improving, and delinquency rates are declining. Corporate bond issuance is booming and companies are able to secure long-term financing at a reasonable cost of capital. The key point is that although there remains enormous room for improvement in future years, banking and financial conditions are on a gradually improving track and supportive of economic expansion. U.S. PURCHASING MANAGER SURVEY ISM MANUFACTURING SECTOR Index of New Orders Government Policy - Last but not least, policymakers remain vigilant and are prepared to utilize further tools to support economic growth. Congress recently passed legislation to extend unemployment benefits and further federal aid to struggling state governments appears likely, while appropriation of funds to increase credit availability for small businesses also appears likely. At his recent testimony to Congress, Chairman Bernanke indicated that the Federal Reserve would continue to support economic growth as necessary. The key point is that government policy stimulus will remain intact as conditions weaken in future quarters. KEY INDICATORS TO MONITOR There are several key economic indicators that investors should continually assess in order to judge the risk of a relapse into recession. These forward-looking indicators relate primarily to the labor market, business sector expansion plans, household sector finances, measures of money and credit, and measures of consumer and business confidence.

5 Leading Indicators - The Index of Leading Economic Indicators compiled monthly by the Conference Board has a good historical track record of signaling future economic trends. Following 12 months of strong gains through March, the index has softened in recent months (see chart), signaling a future loss of economic momentum. The ECRI Weekly Leading Index has been in a declining trend in recent months, with more worrisome implications. In short, the trend in leading indicators is clearly consistent with a significant economic slowdown in future months, but is unclear regarding the severity of the weakness. Labor Markets - The single most important factor with respect to the economic outlook is job creation. A healthy and sustained rise in employment is necessary for the recovery to make the transition to a self-reinforcing economic expansion. Investors should monitor key leading indicators of employment, including: Average hours worked, demand for temporary employment agency workers, initial jobless claims, and surveys of job openings. These indicators appear to signal continued job creation in future months, but at a sluggish pace. Income Growth - Ultimately, growth in spending and output is driven by growth in incomes, both in the household and business sectors. The trend in business income is clear: Corporate profits and cash flow are rising at a healthy pace. Household income is expanding, but at a more moderate pace. However, income growth is a necessary but not sufficient condition for sustained growth in spending; actual spending also depends upon confidence within the business and household sectors. Confidence - Confidence levels remain depressed, especially among consumers, a manifestation of weak labor markets, continued recession in the housing market, and extreme volatility in financial markets. Business confidence has improved over the past year but is constrained by economic and political U.S. BUSINESS CONFIDENCE Index of CEO Confidence uncertainties. The key to strong job creation is improved business confidence and increased optimism regarding future business prospects. The major point is that elevated risk aversion and depressed confidence is an obstacle to economic growth. Housing Trends - The most significant housing-related data pertains to the trend in home sales and prices, the supply of homes for sale, and mortgage credit quality. The level of early stage (30-day and 60-day) mortgage delinquencies and the pace of new foreclosures are the best indicators of the trends in mortgage quality, while the Case-Shiller Home Price Index is the most closely watched indicator or real estate prices. While all of these measures have stabilized, risks to the housing market remain elevated. Resumed deterioration in housing cannot be ruled out and would have extremely negative implications for the banking system and the economy.

6 Money and Credit - Because the recession was induced by a massive credit crisis, normal functioning of both the banking system and the credit markets is a critical factor with respect to future economic growth. Therefore, growth in money and credit should be monitored closely, along with bank lending activity. Bank lending to the small business sector is of particular importance. The current message of these indicators is that: (1) The worst of the global credit crisis is over; (2) Credit markets are gradually healing; but (3) Both the banking system and credit markets are far from normal and remain impaired. Moderate growth in money and credit would be a positive indicator of future sustained economic growth. Monthly Survey Data - Surveys among large companies (The Institute for Supply Management) and small companies (The National Federation of Independent Businesses) provide timely information on trends within both the manufacturing and service sectors on a monthly basis. These surveys provide insight into trends in new orders, company hiring plans, pricing power, current production, credit availability, and export orders. The monthly ISM data peaked in the spring months (see chart) and has begun to soften during the current quarter; the small business survey data remains at depressed levels. My forecast assumes further weakness in these surveys in future months as economic conditions weaken. Company Guidance - Finally, investors can augment traditional government data with real time guidance provided by management to investors during quarterly earnings reports. Of special value is guidance from bellwether companies that operate in global markets - examples of which include General Electric, Intel, IBM, 3M, UPS, Federal Express, Wal-Mart, and Caterpillar Tractor - each of which enjoys a unique perspective on broad economic trends. Information from these companies is more timely in comparison with data supplied by the government. Economic Forecast - Investors should expect a continued weakening in broad economic trends over the next several quarters, with GDP growth in a decelerating trend. My forecast assumes that real GDP growth will decline from the 3% rate of the past year to a range of only 1-2% during the second half of this year and first half of The loss of momentum will be triggered by slower growth in consumer spending, inventory investment, and exports, along with continued weakness in construction and state and local government spending. In view of the fragile economic and financial environment, the risks to economic growth are to the downside. Higher Unemployment - The outlook for both corporate profitability and employment will be adversely impacted by the expected economic slowdown. Profit growth will slow from a 30% pace in the most recent quarter to as low as 5% during the second quarter of Job creation should remain positive but will not be sufficiently strong to absorb new entrants into the labor force; the unemployment rate is likely to drift somewhat higher over the next year to a level in excess of 10%. Consumer inflation should remain around 1% through much of The combination of extremely low inflation and rising unemployment implies a continued policy of monetary stimulus by the Federal Reserve. Yields in the government bond market should remain at historically depressed levels through most of Finally, equity markets will remain vulnerable to further declines in response to progressive weakness in economic data expected during the remainder of this year. Robert F. DeLucia, CFA, was formerly Senior Economist and Portfolio Manager for Prudential Retirement. Prior to that he spent 25 years at CIGNA Investment Management, most recently serving as Chief Economist and Senior Portfolio Manager. He currently serves as the Consulting Economist for Prudential Retirement. Bob has 35 years of investment experience. The information provided is not intended to provide investment advice and should not be construed as an investment recommendation by Prudential Financial or any of its subsidiaries. Prudential Retirement, Prudential Financial, PRU, Prudential and the Rock logo are registered service marks of The Prudential Insurance Company of America, Newark, NJ and its affiliates. Prudential Retirement is a Prudential Financial business.

TIMING THE NEXT RECESSION

TIMING THE NEXT RECESSION by Robert F. DeLucia, CFA Consulting Economist The single most reliable indicator of recession is the slope of the US Treasury yield curve. Also referred to as the term structure