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U.S. Economic Forecast: Still Treading Water

S&P August 2011

On August 5, Standard & Poor's Ratings Services lowered its long-term sovereign credit

rating on the U.S. to 'AA+' from 'AAA' and kept its negative rating outlook, which increased

worries that the economic recovery has faltered. The downgrade and concerns that the

eurozone sovereign debt crisis was spreading north to France caused markets to go into a

tailspin last week. This likely forced the Federal Reserve to take more policy action, which

helped calm markets.

However, while the market panic subsided, recovery concerns that helped launch it are still

very real. After the recession officially ended two years ago, the outlook for growth is

worsening and the U.S. economy is still treading water trying to stay afloat. The "temporary

shocks" sound less convincing, even to the Fed, as an explanation of paltry growth during thelast two quarters. The lack of underlying momentum was highlighted in second-quarter GDP

report, where backward revisions showed not only how much worse the recession was, but

how anemic the recovery really is.

While July data finally showed a slight improvement in the U.S. economy, it's not enough to

support expectations that the second half of the year will see a bounce in growth. We now

expect to see an even slower recovery than the half-speed we earlier expected. We now

expect just 1.9% growth in the third quarter and 1.8% in the fourth, to bring 2011 calendar

year growth closer to 1.7% instead of 2.4% we earlier expected. We also downwardly revised

growth expectations for 2012 and 2013, as a more drawn-out recovery is factored into our

forecast.

It is disturbing that policymakers do not seem to have the weapons or the political resolve to

fight the economic crisis. Those policy problems are a large reason why we believe the

economy is more vulnerable to another recession. Once again the Fed is willing to step in,

just like it did in 2008 when Congress refused to pass legislation (including TARP), as

markets spiraled out of control. But this time, the Fed is confronting the collapse with a sling

shot, not a bazooka, so its measures will have less bite.

We are not surprised that in the aftermath of the worst recession since the Great Depression,

the recovery would be slow and uneven. As history has shown, financial crises are often

followed by prolonged recessions, and after that, a long bout of sub-par growth. Severalstudies measure just how much damage a financial crisis can cause, and how long it can last.

According to these studies, economic growth will be slower than normally expected, which

most people won't recognize as a recovery.

Just Like Old Times

The markets' violent swings in early August resurrected fears of the market meltdown, such

as the one in 2008 when Lehman Brothers went under and Reserve Fund broke the buck.

Currently, the crisis is considered to be much more severe, with U.S. sovereign debt at risk of

default. The low Treasury yields indicated that markets were expecting Congress to come to

its senses and reach a deal. However, the wait and the last-minute deal, which left a lot to be

desired, only increased worries that the government will do more harm than good.

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Confidence in the recovery and in U.S. policymaking has hit new lows. After U.S. sovereign

debt lost its triple-A status and financial markets unwound, consumer confidence hit a 31-

year low and manufacturing sentiment readings contracted. While some hard data, such as the

stronger-than-expected July retail sales and recent jobs report, show that not all news is bleak,

the preponderance of evidence to the contrary explains the sour moods. Though we still

expect weak growth, not a recession, the data indicate a more drawn-out, painful recoverythan the half-speed one we earlier expected.

Continued weak growth after sharply downward GDP revisions has made the "temporary

argument" a less plausible explanation for the slew of bad news for the first half of the year.

At least the GDP revisions make the persistently high unemployment rate make more sense.

But the revised data also indicate a much weaker outlook than we previously expected. As the

boosts from rebuilding inventories and fiscal stimulus unwound, consumer spending and

housing couldn't cover the hole, because the former is still working off excess debts and the

latter excess supply. The recovery comprised a first-half average growth of just 0.8%.

The storms that blanketed the U.S. this winter kept people away from the mall and Japan'snatural disaster supply-chain disruptions can only be partly blamed for lower sales. More

importantly, the consumers have been squeezed by higher commodity prices which wiped out

any benefit of the payroll-tax credit. The high unemployment rate, at 9.1%, kept people

cautious, worried that even if they have a job, they may lose it next week. Amid sluggish job

market and stagnant wages, the wallets are empty after people fill up their gas tanks.

There are some signs that the second half of 2011 won't look as bad as the first; however,

anything slightly better than a 0.8% average growth rate is not impressive. The jobs market

will likely remain weak into 2013, so housing will remain soft. We expected some

improvement in the jobs market to help revive household formation to absorb excess supply.

So without that jobs-related boost, housing won't contribute to the recovery. However, maybe

it was retail therapy after all the sour news, but the July retail sales data showed that

consumers began to spend more. Total sales jumped an upbeat 0.5% over June numbers, and

it's not because of a hefty price tag at the pump. Excluding autos, gas, and building materials,

sales were up 0.3% in July after a 0.4% increase in June (sharply revised up from a 0.1%

gain). This comes while the government payrolls report posted a better-than-expected

117,000 job gain and the unemployment rate slipped to 9.1% from 9.2% in June. The results

by no means suggest that we are in the clear. But at least the economy is inching away from a

double-dip recession.

Ready To Take Another Dip?

Does the Great Recession have company? Many think that another crisis will follow the

Great Recession. The global stock-market plunge reflected fears that a double-dip recession

is coming. The bad news during the last few months suggests that these fears may not be

unfounded. The supply shock due to the earthquake in Japan, climbing energy prices, and

massive storms have certainly contributed to the slowing U.S. economy. But even the Fed

admitted that those events alone may not explain the extent of the decline. As I said in my

last monthly forecast report, if a couple of one-offs can do so much damage, it shows just

how fragile this recovery is.

As the economic data continue to disappoint, we have become more worried about the

strength of the recovery. We have been expecting a half-speed recovery for some time.However, the onslaught of dismal news puts even that forecast at risk. We now expect below-

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potential growth through the end of next year. And while the numbers are still positive, the

smaller they get, the greater the risk of dipping into another recession. On August 5, we

increased the chance of a recession in the next year to 35% from 30% in June, and well above

the 25% odds we expected in March.

Given a lag in the release of economic data, which is often revised, it's hard to identify arecession in real time. It takes the National Bureau of Economic Research (NBER) many

months to announce the start of a recession, and in case of the 2001 recession, it ended just

when NBER declared that it began. But markets still keep trying to predict. There are a lot of

rules of thumb that the investment community uses to signal a recession. One, backed up by a

Fed study, says that when real GDP growth drops below 2% year-over-year, a recession

follows within a year roughly 70% of the time. Second-quarter GDP growth was 1.6% over

last year, so we have a little more time. The three-month unemployment average rate is

another important indicator. Since the Second World War, if unemployment rate climbs by

more than 0.3%, a recession has always followed. We would need the three-month average

rate to reach 9.3%, in order to top the 8.9% trough in March, to say with more certainty that

recession has started. Given the July figure edged down 0.1% to 9.1%, we still haven't arrivedat that point. While a market sell-off is also watched, a plunge in stocks during the past three

weeks doesn't necessarily mean a new recession (the economy avoided a recession after the

stock market crash of 1987). However, amid the fragile economy, the shock of another stock

market drop and resulting loss of wealth could be the tipping point.

Trying to use various rules of thumb to determine a coming recession can be dangerous. And

in this case, where we have a very sluggish recovery, the normal rules may not apply. We

may still be in a sustained, though weak, recovery with intermittent declines bringing the

growth rate so close to zero, which would imply that the economy is falling into recession.

But the signals are disturbing, and at a minimum they show an economy with very feeble

growth prospects.

With the odds of a double dip at 35% and climbing every time stock market sells off, credit

spreads widening, and consumer confidence dropping, when does a double dip becomes the

most likely outcome for the U.S.? As the recovery is on a precipice, there are a few things to

watch. Another shock to the economy, even a mild one, could push the recovery back into

recession. We'd watch whether the deterioration in financial conditions persists or if leading

economic data worsen. Another plunge in the stock market, a deeper contraction in already

weak consumer confidence levels, one more spike in initial claims that holds, or sub-50 ISM

readings for several months would push the recession gauge to the brink.

It's Only Just Begun

Why are we surprised that in the aftermath of the worst recession since the Great Depression

the recovery would also be slow and uneven? As history has shown, financial crises are often

followed by prolonged recessions, which is followed by a long bout of sub-par growth.

Several studies measure just how much damage a financial crisis can cause and how long it

can last. According to these studies, recoveries from financial crises are typically a hard

climb. The economic growth will be slower than normally expected and won't be felt as a

recovery by most.

The McKinsey report (Debt and deleveraging: The global credit bubble and its economicconsequences, 2010) found 45 episodes of deleveraging since the Great Depression, of which

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