Three weeks ago you barely heard a whisper about the chance of the United States entering a double dip recession. The majority of economists felt that our economy was growing, albeit more slowly than hoped for. The television pundits incessantly chattered about the strong earnings growth of the large U.S. multinational companies and how given these strong earnings the stock market (i.e. The Dow Jones and S & P 500 stock indexes) was fairly valued if not becoming a bargain.
My, how quickly things can change! The growth rate of the economy in the first and second quarters of 2011 was revised downward, news out of Europe was continuing to swirl and the political parties in Washington could not agree on raising the debt ceiling limit until the last minute to avoid an alleged impending default. As we all know, the latter element caused Standard and Poor’s to follow through on their threat to downgrade the United States’ creditworthiness last Friday after the markets were closed.
With little good news to hang their hats on, investors finally appear spooked and the stock market has had an incredible ride this week, with all 4 sessions having greater than 400 point swings in the Dow. Of course, with the S & P 500 down 14% from its April 2011 high and no bottom in sight, the negative wealth effect should hurt consumer spending going forward. Consumer spending represents 70% of GDP.
As you likely know, a recession is defined as 2 straight quarters of negative GDP growth. So far, it appears that we have avoided negative growth but we are awfully close to entering negative territory with first quarter growth coming in at .36% (it was revised down from 1.9%) and second quarter growth reported to be 1.3%. In May, the consensus was that second quarter GDP would be 3.3%. This estimate was subsequently revised down to 2.7%, but still was more than double the actual figure of 1.3%. Of course, this figure will be revised as additional information pours in over the next several months and if it is revised down as much as the first quarter’s figure was, we will be in negative territory. Rich Yamarone, Chief Economist at Bloomberg, reported that if year-over- year GDP growth dips below 2%, a recession ALWAYS follows. We are now at 2.3%.
Let’s examine what comprises GDP and how these elements are likely to fare going forward. Gross Domestic Product is Consumption (Consumer and Business) + Investments + Government Spending + Net Exports. Going forward from here growth in GDP is going to be difficult to come by. As we all know, in order to help us rise from the depths of the Great Recession, the federal government has been deficit spending with huge stimulus packages. QE2 ended in June 2011 and with the political environment in Washington, it is hard to imagine that we will see any further large stimulus packages. In order to stimulate the economy, the Federal Reserve just announced Tuesday that they will keep interest rates near zero until at least mid 2013. While this helps the economy, it only indirectly grows GDP by encouraging consumption and reducing money spent on interest. It does not increase government spending. In fact, in order to reduce our nation’s deficit and get it under control, we are talking about reducing spending to the tune of hundreds of billions of dollars per year. This is will reduce GDP.
A headline in today’s Wall Street Journal noted that Non-financial companies in the Standard & Poor’s 500 stock index have increased their cash and short term investments by 59% since 2008 from $703 billion to $1.12 trillion. If this extra $500 billion was deployed into the economy it would certainly help grow GDP. Does anyone seriously think that these companies are ready to deploy this capital and make significant capital investments given the uncertainty in our economy?
I would next like to examine the element of Exports. In order to increase our net exports there has to be increased demand from other countries. Our weak dollar does help with exports, however, there still has to be the demand. Europe is in more trouble than we are economically. Increased demand will not be coming from Europe. China’s economy is starting to slow and it is unlikely that the Chinese government will reinstitute loose monetary policy to stimulate their economy. In short, we are in the midst of a global slowdown which does not bode well for increased exports.
This leaves us with the final element comprising GDP and that is Consumption. Given the continued softness in the housing market, an elevated unemployment rate of 9.1% (with an additional 8.4 million workers involuntarily working part-time), a shaky stock market and a lack of confidence in our leadership in Washington, is there a strong likelihood that our growth is going to come from the consumer? The consumer who is trying to strengthen her own balance sheet by saving more? Remember the period of time prior to the 2008 crisis when the savings rate in the U.S. was actually negative? As a sign that consumers understand the need to save for their future, not to mention a rainy day, last month the savings rate climbed from 5.0% to 5.4%. None of this bodes well for the prospects of GDP growth being driven by the consumer. Along the same lines, it is hard to imagine businesses increasing their consumption in this crazy economic environment.
Given the foregoing, it is likely that we will see contraction in GDP that will amount to a double dip recession. This is especially true if the reaction to the Standard & Poor’s downgrade is to more swiftly and steeply cut government spending. Can a recession be avoided? Yes, if the spending cuts are delayed and additional governmental stimulus is instituted. Continued reduction in the social security tax rate for employees and extension of unemployment benefits will help with Consumption. Of course, that will just dig our deficit hole that much deeper. Given the political environment, things will likely need to get worse before we go too far down that road and if we wait for things to get much worse, we will be stimulating the economy to keep the downturn more shallow, not to avoid it altogether.
As the economic weakness is in its fourth year, more and more Americans are feeling the strain of the times. This will likely lead more and more of your former clients to search for ways to make ends meet. More and more of your clients will inquire about selling some of the structures that you assisted them in obtaining. While we know that selling a structure is almost always a bad financial decision on purely financial terms, many clients will still sell all or part of their structured settlements, even against your best advice. While it is appropriate to counsel your clients against selling their structures, it is also important to understand that your clients will not always heed your advice. Therefore, it is also appropriate and necessary to ensure that your clients deal with reputable companies who are going to treat them fairly and ensure that they come out of the transaction in the best financial shape possible.
Jay Fisher is co-founder of Vantage Capital Consultants, a buyer of structured settlements and annuities.