The Shape of Things To Come

Explaining various forecasts for when the current recession will end and what the aftermath will look like seems to involve the use of shapes.  Depending on the report, some economists see a “V-shaped” economic recovery, some a “U,” others a “W” or an “L.”  For investors, how the recovery plays out matters greatly, especially now that equity markets have recouped their losses for the year on expectations that the recession has reached a bottom.

The shapes, or letters, themselves merely represent what U.S. economic growth (or contraction) would look like on a graph showing GDP along the side (y-axis) and a timeline along the bottom (x-axis).  Thus, a “V” would depict a rapid decline/contraction followed by an equally-rapid expansion.  A “U” depicts a rapid decline with a rapid-expansion as well, but with a long bottoming/sideways period in between.  An “L” suggests that the economy has fallen off a cliff and will not return to growth for any reasonably foreseeable future.  Finally, the “W” suggests a roller-coaster ride, where, following a rapid-decline, the economy picks up, only to fall again, before ultimately rising into a long-term expansion – this is also known as a “double-dip” economy.

An investor should plan his or her asset allocation, in part, on macroeconomic conditions.  Thus, if one expects a V-shaped recovery, then it would be ideal to allocate more assets to the equity markets because stocks, having been beaten down during the decline, would be likely to rise quickly in the face of good-news, or as we are seeing now, less-bad news.  A U-shaped recovery expectation is a bit trickier.  Even though the expectation is for economic expansion in the future, the key question with the U-shape is how long does the economy flounder at the bottom of the “U” before recovering.  While an investor would like to allocate more assets toward equity markets, he or she would not want to do so sooner than necessary; otherwise, those assets would likely sit idle until the recovery appears.  An L-shape would dictate an asset allocation away from equities, and a W-shape presents a scary investing environment given the false recovery in-between the major decline and recovery.

So, what can we expect in the U.S. and globally?  Unfortunately, arguments have been and are still being made for all four of these economic scenarios.  We will now examine each to see if there are compelling reasons to believe in one of these scenarios over the others.

“V” for Victory

The V-shaped recovery has its roots in the “Zarnowitz Rule.”  Victor Zarnowitz, a longtime guru of the National Bureau of Economic Research (NBER – the Business Cycle Dating Committee officially determines when recessions began and ended) and world renowned expert on business cycles, posited that forecasting recessions and expansions was extraordinarily difficult, but there was one reliable regularity about business cycles and business cycle forecasts: deep recessions are almost always followed by steep recoveries.

In a recent study, Robert J. Gordon, a longtime member of NBER’s Business Cycle Dating Committee, reasons that May or June 2009 could mark the trough of the recession.  Gordon examines cyclical peaks in unemployment claims as the basis of his conclusion.

Michael Mussa, senior fellow at the Peterson Institute for Institutional Economics, is similarly optimistic (Mussa’s analysis).  He sees accelerating growth in the Chinese economy in the first half of 2009, combined with substantial policy stimulus, helping to bottom out the U.S. recession by the middle of 2009, and then spurring U.S. growth to a 4 percent annual rate by the fourth quarter of 2009.  The rest of the world will generally lag behind the U.S. and China, but Mussa believes that the global economy will be in recovery by the end of 2009.

Wossamotta “U”?

That’s the “university” attended by Bullwinkle J. Moose (I say attended because I am not sure whether he graduated, my apologies to Bullwinkle if I’m wrong).  It also provides a nice metaphor for discussing a U-shaped economic recovery.

The International Monetary Fund (IMF) believes that, due to the fact that the current world-wide recession was caused by a financial crisis, it will be longer and deeper than the average recession (IMF report).  Essentially, the IMF forecasts a recession lasting roughly two years, followed by a slow, weak recovery.  Using the NBER’s official start of the recession in December 2007, the economy would bottom by the end of 2009 and show weak signs of recovery in 2010.  Like Rocky the Flying Squirrel observing Bullwinkle stumbling his way toward resolving a problem, we and world central banks will watch the financial industry as it somehow pulls itself together and wins the day.  This will just take longer than any of us are used to, and we will spend many days sighing like Rocky, knowing that there are better, faster ways, but, alas, Bullwinkle must be Bullwinkle (“Oh, East, I thought you said Weest!”).

Not So L-lectric

An L-shaped recovery is an interesting animal, if only because it is not a recovery at all.  Rather, this model predicts a catastrophe in which the economy suffers some kind of shock (like a financial crisis), sustains a sharp decline in activity, later stabilizes, but does not recover.

Simon Johnson, of the Peterson Institute for International Economics, along with Peter Boone, Effective Intervention, and James Kwak, Yale Law School see such a stark future (study).  Despite the improvement in credit spreads and the “less bad” news with regard to corporate earnings (many first quarter returns beat analysts’ extremely lowered estimates), Johnson, et al., note the following dangers to the economy still lurk:

Deleveraging by consumers (paying down debt, voluntarily or involuntarily), leading to reduced consumption and increased saving;

Deleveraging by companies, leading to reduced investment;

Reduced supply as well as demand for credit, constraining even those who want to borrow and spend;

Continuing falls in real estate prices.

The discussion of their U.S. outlook very nicely details the fundamental problem: the economy may be stabilizing but that does not mean there won’t be problems for large companies due to the issues listed above.  Concluding the U.S. portion of the analysis, the paper states:

On balance, we believe that the Obama administration, and Fed Chairman Bernanke, are making every effort to combat the financial and economic crisis. However, some aspects of the response, most notably the fiscal stimulus, have been underpowered. And a combination of ideological and political constraints has hampered the administration’s efforts to rescue the banking system. For these reasons, we still do not see the mechanism that will cause the economy to turn around.
In this context, we interpret the recent stock market rally as indicating that the economic decline is slowing; it does not necessarily denote that rapid recovery is just around the corner. We would also emphasize that credit markets are pricing in a substantial risk of default for some leading brand names, both in financial services and manufacturing—as the system stabilizes and bailouts become harder to justify, the probability of default for large companies may continue to rise.

Investment Decisions in Varying Macroeconomic Environments

V, U, L?  What’s an investor to do?  The first thing to do is probably take a deep breath and understand that we are in the midst of one of the most complicated economic crises the world has ever faced.  So, don’t beat yourself up if you feel confused when experienced phDs cannot come to a consensus on what’s coming next.

The worst thing any investor can do is to gamble on one outcome or another.  The presentations cited in this article are all well-researched and well-reasoned, even though they come to vastly differing conclusions.  If the recovery is a V-shape, we do not want to miss the new bull market (or if a W, we do not want to get clobbered one more time before the new bull market arrives), if it is a U-shape, we do not want our money to sit stagnant in the equity markets waiting for the rally, and if an L-shape is upon is, we do not want lose any more money than we already have.

This is why diversifying one’s investments is so crucial, especially now.  And that does not mean being 100 percent in equities, but diversified across sectors of the economy.  I literally mean diversifying your investments so that you have some exposure to equities, so that if a bull-market has begun, you will not miss out entirely on the beginning, but by keeping such exposure low, your risk of being burned by further economic decline or stagnation is limited.  Counter that exposure with safe, income-producing investments, such as Treasuries, corporate bonds, and municipal bonds.  With corporate and municipal bonds, seek out corporations and governmental entities that have strong balance sheets and are rated investment grade.  Keep in mind your risk tolerance and investment goals.

It is also comforting to recall that your investments are not locked in for life.  If a new bull market forms in equities, and your portfolio is underweighted, you can always shift resources to adapt to market changes.  That is what active management is, after all.  So, if you’re paying someone else to manage your future, make sure they have two hands on the steering wheel at all times.  If they’re too busy for you, that’s OK (for them) – you need to take your portfolio elsewhere.

The shape of things to come will dramatically affect returns-on-investment.  Careful planning and a full understanding of the implications of turns in the economy will be essential to navigate the future.  While considering the shape of the economic future, also consider what shape your investment portfolio is in.