There seems to be general agreement that the steep slide in the global economy and financial markets is slowing down. There’s little consensus, though, on what happens next.
Has the stock market really bottomed out? Is the recession winding down, with the economy headed for recovery later this year? And why has the outlook gotten so muddy just when all these “green shoots” started popping up?
“Whenever you’re in a business cycle adjustment, which is what we're in, gauging the whole path of the economy becomes extremely difficult,” said Brian Bethune, chief U.S. financial economist at IHS Global Insight, an economic advisory firm.
Just as it took almost a year to declare that the current recession had begun, the economy likely will be well on the road to recovery before a bottom is declared. As the bottom of any economic cycle approaches, the signals are almost always mixed, with some data showing a positive trend and other indicators continuing to fall.
Some of those uptrends may turn out to be “false bottoms” — three months of improvement in, say, retail sales might be followed by another sharp drop. That’s why some economists have begun talking about a “sawtoothed” recovery: The graph of economic growth may not snap back like a V but follow more of a wavy line that gradually trends higher. This kind of pattern makes it even harder to proclaim “the bottom” until it's receding in the rear-view mirror.
The International Monetary Fund said Wednesday that the U.S. economy would shrink 2.8 percent in 2009 and show no growth at all in 2010, although the downturn will be even steeper in Europe.
Any economic forecast has to take government policies into account; it’s tough to find modern historical precedent to the government’s multitrillion-dollar response to the current recession. It’s even tougher to predict the course of future government policies. Given the strong backlash on Capitol Hill to the $700 billion bank bailout, the Treasury will have a tough sell getting more money, even if the banking system seizes up again.
A lot will depend on where you live. Just as the recession didn’t arrive in all parts of the country at the same time, it will leave some regions before others. That may help explain why two top Federal Reserve policymakers last week offered sharply different economic forecasts.
Dennis Lockhart, president of the Atlanta Fed, told an economics conference he expects the recession to end by midyear with growth slowly picking up in the following months.
San Francisco Fed president Janet Yellen, on the other hand, said that while she expects “slow and tentative growth” later this year, she doesn’t think the U.S. economy is out of the woods.
Even a relatively mild recession presents challenges when forecasting — or even recognizing — an upturn. When economic data point in the same downward direction month after month, the likelihood is pretty strong that the next month will bring bad news. But as the bottom approaches, the data can be subject to frequent shifts, flashing hopeful signs one month and disappointing the next.
That’s one reason economists tend to dismiss one-month moves and rely more on a three-month moving average. A “surprise” number may be a statistical anomaly, influenced by seasonal factors. Three-month averages also help correct for inevitable and frequent revisions in past months' data. (Alas, the popular news media tend to focus more heavily on those one-month numbers.)
When the economy does hit bottom, that only means it has stopped shrinking. Until it begins growing strongly again, adding substantial numbers of jobs, it will still feel like a recession to most people. Though many forecasters expect growth to begin by the end of this year, unemployment is expected to keep rising well into 2010.
Even when employers begin hiring again, it will take a long time to absorb the five million or more people who have been left jobless by the severe downturn. As long as unemployment remains high, the pressure on confidence and consumer spending will remain.
In addition, consumers will still have to recover from the loss of trillions of dollars in wealth from the collapse of the stock and housing markets. It also remains to be seen what will replace the trillions of dollars in phony credit that helped drive the economy during the boom. Some economists are talking about a recovery that “resets” the economy to a lower level of gross domestic product.
One thing is clear: This downturn is unlike any seen in a lifetime. The steep drop in housing prices — for decades considered an unimaginable event — cut a wide swath of damage through many sectors of the economy and the financial system. A housing rebound is usually a reliable sign of broader economic growth to come, but the recent uptick in housing sales may be flashing a false signal this time.
“A lot of the sales that are being transacted are not voluntary sales — they’re foreclosures,” said Bethune. “And so you really don’t necessarily have a strong line of sight to what’s the underlying demand.”
A pick-up in mortgage lending, usually a reliable indicator of a housing recovery, is this time around being driven by the Fed's unprecedented moves to force interest rates lower, sparking a wave of home refinancing. That will help many consumers but may not signal a strong housing rebound.
The current recession also has brought the usual steep pullback in demand for cars and new homes. As a result, there could be pent-up demand that ultimately helps push the economy forward again.
But the speed and depth of the housing collapse that began in 2006 could leave more lasting damage this time around.
“Typically once new home construction bottoms out you've got two to three years before the existing home sale market begins to show signs of life,” said Peter Sorrentino, a portfolio manager at Huntington Asset Management. “Look at the foreclosure backlog that we’ve got. And you think about all the property has to go through the mill. Clearly there are more hits going to be taken on (bank loan) portfolios.”
Financial system weakness adds another unknown to the economic forecast: without a healthy banking system you can’t have a healthy economy. The Treasury's current "stress testing" of big banks was intended to provide some confidence to investors and consumers. But identifying vulnerable banks won’t avert the prospect that one or more of them may still fail.
“The problem here is that during periods of financial stress like the one we've seen, you can have periods of what looks like the free fall in the economy is stopping,” said Frederic Mishkin, a Columbia University finance professor and former Fed governor. “And then if you get more shoes dropping, you're in big trouble. This is exactly what happened in 1931, where the economy looked like it was stabilizing and then you went through another set of bank panics, and then a much, much more virulent phase of financial crisis, and then the Great Depression. So we're by no means out of the woods."
The recent rally in the stock market provides another hopeful sign. Stocks have generally rallied ahead of an economic recovery as investors anticipate better times to come. But stock prices have been known to flash false signals too, only to fall back again as the downturn dragged on.
Looking for a bottom in stocks can be treacherous, which helps explain why there’s so much conflicting commentary from market watchers these days. Bulls argue that the panic that swept through the financial system last fall sent stocks to unreasonably low levels; since then the market has retraced some 20 percent of that lost ground. As the economy continues to rebuild, say the bulls, stock prices will anticipate the expansion.
But bears say that expectations of a prolonged rally are premature. A lot will depend on how well companies begin rebuilding their profits; so far the results are mixed.
Investors face another important unknown in trying to decide what their stocks are worth. In good times, the relationship between stock prices and earnings is relatively high, based in part on expectations that the good times will continue to roll. But during periods of prolonged economic downturn, that P-E ratio tends to contract.
“We think the S&P (500 index) can trade between 10 and 16 times (earnings),” said Kevin Caron, a market strategist at Stiefel Nicholas. The middle of that range would equate to a Standard & Poor's 500 index of 740 — more than 100 points below current levels.