Environment Not Ripe for Quick Economic Recovery
The U.S. stock market rally took off within hours of the first allied bombers heading for Iraq, as investors anticipated a short, popular war. They are also expecting a speedy end to the current recession, arguing that if the Gulf crisis was its only cause, then the economy should revive quickly.
But I would suggest that the successful end to the Gulf War will not necessarily lead to a recovery, at least not a long and solid one. Instead, serious recession, primarily the outgrowth of the excessive debt buildup of past decades, will continue to threaten the economy in years ahead. And it is a global threat--only Japan and Germany among the major powers have yet to enter the downward spiral.
Investors, however, continue to think otherwise, just as they did in 1973, when they anticipated a normal, mild postwar recession.
The Dow Jones Industrial average declined from a January, 1973, peak of 1,052 to 788 in December--a 25% drop--in anticipation of the recession. The economy topped out in November, 1973, and the initial decline in early 1974 was mild. Investors figured that was it for the downturn, bought stocks to prepare for a quick recovery and drove prices up 13% in the next three months. They were correct--at least briefly--as the economy grew modestly in the spring.
But then things came unglued, and everyone learned the hard way that the “mild” recession was merely the prologue to the main event--the massive correction of the huge inventory buildup of the early 1970s. Wage and price controls, the Soviet wheat purchases and the 1973 oil embargo convinced people that shortages would last forever, so many businesses had double- and triple-ordered from suppliers to insure adequate deliveries. The economy plummeted straight down for three quarters, and the Dow fell 35%.
Similarly, investors anticipated that tight money policy and credit controls would generate a mild recession in 1980, and they were right. The Dow shed 16% from February to April, 1980, and the recession lasted from January to July. Convinced that the downturn was over, investors mounted an exuberant and broad-based rally in April that carried the blue chip index up 35% in one year.
But the Federal Reserve Board, spooked by the near runaway inflation of the late 1970s, tightened credit again in the fall of 1980. The result? A new recession started in July, 1981, and became the second-most severe in postwar times.
An even closer parallel to today occurred in 1929. The 1920s in many ways resembled the 1980s--plenty of greed and glitz, lots of speculation and mountains of new debt. As in the 1980s, stock prices were so strong that they continued to rise after the economy had peaked in August, 1929. The economy, however, began to fall sharply as a result of staggering cutbacks in spending--on capital goods, housing and consumer items. The cutbacks were not surprising since businesses and consumers in the late 1920s had been on a spending spree, with, for example, 50% of consumer durable goods purchased through installment loans. Sound familiar?
Most economists will assure you that the current recession must be mild because inventories are under control, and in a typical recession, inventory liquidation accounts for 80% of the decline in economic activity. However, in another parallel, inventory correction played a relatively minor role in the contraction that started in August, 1929. And that certainly didn’t make it any milder: Real GNP fell a breathtaking 17% from the business peak through the end of 1930.
But few believed that the economy was suffering anything more than a normal correction. The Black Friday stock market crash was seen as a useful cleansing of speculation, and the Dow regained nearly half of its loss. The New York Times picked as 1929’s most important event, not the Crash, but Cmdr. Richard Byrd’s South Pole expedition.
However, the crisis continued to spread, with banking failures and a severe credit crunch.
In all three of these previous downturns, the initial economic rebounds were premature, and the initial stock market rallies were false starts. In each case, people thought the downturn was normal and mild and were unaware of its true function. In the mid-1970s, that function was reducing excess inventories; in the early 1980s, it was the elimination of serious inflation; in the early 1930s, it was wiping out the debt and other speculative excesses of the 1920s.
The latter, of course, most resembles today’s situation. I’m not forecasting a similar depression, but I do regard it as a 10-20% probability. I also believe that the current correction is far from complete. Problems with under-collateralized debt, leveraged buyouts, Third World countries, consumer debt and collapsing real estate remain unsolved.
In this environment, predictions of an early revival should be greeted with great skepticism. Any further stock rally should be regarded cautiously. High-quality bonds may flounder as long as people expect near-term recovery to bring renewed credit demands and anything but further monetary easing by the Fed.
Yet I maintain that one or perhaps a series of serious global recessions is on the menu and will eventually reduce long-term Treasury Bond yields from their current 8 1/4% to 4%.
