Monday, July 5, 2010

Problems That Could Trigger a Double-Dip Recession

With stock prices spiraling downward and treasury yields tanking, the market has been sending a clear message this week: The fragile economic recovery is in trouble. But just how bad is the outlook? In the aftermath of a bleak second quarter, experts are still divided about the likelihood of a double-dip recession. What's becoming clearer with each new report, though, is that the economy--even if it doesn't double dip--is steadily losing ground.

The economic souring is, of course, being spearheaded by a familiar cast of characters: An anemic labor market, a skeptical consumer base, a weak housing market, and a global debt crisis that threatens to overwhelm national governments, just to name a few. Further deterioration in even one of these arenas could be enough to trigger a double-dip, which is loosely defined as a period during which a recovery is interrupted by economic contraction, usually in the form of negative GDP growth.

For some experts, the prospect of a double-dip still seems distant. "I still think it's very unlikely that the economy will fall into a double-dip," says John Ryding, a cofounder of RDQ Economics. "Double-dip fears are quite prevalent right now and have been ... but I find the situation very similar to the last two so-called jobless recoveries where feelings of double-dip constantly bubbled up to the surface but never materialized."

Peter Morici, a professor at the University of Maryland's Robert H. Smith School of Business, is less optimistic. Morici says the likelihood of a double-dip is at least 50 percent. "What's going to happen here is either the economy is not going to collapse, or it's going to avalanche. Because once you start cycling down, then it develops a momentum of itself. And if it goes down a second time, then it becomes very difficult to resuscitate [it]," he says.

For investors, a double-dip, if it materializes, would be a throwback to 2008, with a floundering economy punishing stock returns. Jeff Tjornehoj, Lipper's research manager for the United States and Canada, says the Dow Jones industrial average could touch 9,000 by the close of 2010. "Is it reasonable to expect it? I think it's reasonable to put some odds on it," he says.
With that in mind, U.S. News has examined eight phenomena which, given the right conditions, could send the economy--and the financial markets--reeling.

Unemployment. In the aftermath of a recession that wiped out 8 million jobs, the lackluster labor market has perhaps been the biggest thorn in the side of a sustainable economic recovery. June's job report, which is due out Friday, will likely dampen the mood even further. Notably, the consensus prediction is that the report will indicate the economy shed jobs for the first time since last year. In 2008 and 2009, payrolls contracted in 23 out of the 24 months, but year-to-date through May, each month had seen positive jobs growth. Still, the losses expected in Friday's report will largely stem from a drawdown in the number of census workers employed by the federal government. Since these jobs were always expected to be temporary, their disappearance from the payrolls isn't much of a negative indicator. The bigger problem, economists say, is that even in months in which there was net job creation, the rate of growth has been too slow. Without robust job creation in the coming months, the weak labor market could help thrust the economy into a double-dip recession. "By the end of 2011, we can get into the low teens if things really come apart," Morici says of the unemployment rate.

Housing. In early 2009, President Obama introduced a first-time home buyer tax credit of $8,000 that was later extended to any qualified buyers who signed a sales contract by April 30 of this year. That tax credit, like other stimulus programs, has expired, and it's left many experts wondering whether or not the upsurge in home buying will continue. So far, the numbers don't look promising. Sales of new homes in May fell to an all-time low since numbers were first recorded in 1963. The concern is that now that the tax credit has expired, where will the demand come from? "We have a bit of an unknown ahead," says Keith Gumbinger of "To the extent that that falloff in demand diminishes economic growth, we pull ourselves a little bit closer to what could be the double-dip scenario." Chances are, prospective home buyers rushed to sign contracts before the tax credit deadline, so Gumbinger is concerned that demand could slow over the next few months.

Expiration of stimulus. One of Obama's first acts as president was to authorize a massive stimulus package that cost $787 billion. It included a number of provisions that were intended to help jumpstart the economy. Some economists are concerned that the stimulus plan is the only thing driving GDP growth in the United States. "Absent fiscal and monetary stimulus, there's been no recovery; it's been at best an ['L-shaped'] recovery, not a ['V-shaped'] recovery, except for the sugar rush of stimulus. " says Rob Arnott, chairman of Research Affiliates. "When you give a kid with ADHD a big bowl of M&Ms, they get a sugar rush, and if you take away the bowl of M&Ms, they get a sugar crash. So what we have is an economy on a sugar rush." With many stimulus programs wearing off, there are concerns that the private sector is not ready to support itself yet.

Spending cuts. At last week's G-20 summit, countries from around the world pledged to cut their deficits over time. Everyone agrees that it's a noble goal, but experts are torn over when it's appropriate to begin cutting spending. Many countries in Europe, most notably Greece and Spain, have already begun instituting austerity programs (through a combination of spending cuts and tax hikes) because of their enormous budget deficits. Here in the United States, deficit hawks voted down a bill last week that would have extended unemployment benefits and offered some aid to state and local governments. Politicians in developed nations are caught choosing between cutting spending now to begin to chip away at their massive deficits and risk stunting growth, or authorizing further stimulus to pump life back into the fragile global recovery. "The question is how long is it appropriate for the authorities to hold off before engaging," says Brian Gendreau, market strategist for Financial Network. "It's a danger of getting what you wish for." It's estimated that over the next year, spending cuts throughout the developed world will chop a full percentage point off of GDP growth, according to Gendreau. That's a big number given that many European countries are projected to grow at a very slow rate.

Tax hikes. Most experts say it's not a question of whether taxes will go up in the United States, it's more a question of when. The Bush tax cuts will expire at the end of the year. If they lapse, taxes will go up. Research has shown that there is a 3 to 1 ratio that can be applied to how tax hikes affect GDP growth, according to Arnott. For instance, if taxes go up by 1 percent of GDP, then GDP will fall by 3 percent. When the tax cuts expire, Arnott says, that will be equivalent to a 2 percent jump in taxes as a percentage of GDP. That means GDP growth next year should be 6 percent lower than it would be without the tax hike. "So that is really the big issue that we think creates a catalyst which can make a second dip pretty high odds and reasonably imminent," he says.

Consumer confidence. A recent report by the Conference Board shows that consumer confidence is plummeting. In June, the group's Consumer Confidence Index dropped by nearly 10 points, its second-biggest one-month decrease in a year. The report also shows that consumers' assessments of their current situations and their future job prospects are turning increasingly negative. This has touched off concerns that a skeptical consumer base could stand in the way of a recovery. Still, Lynn Franco, director of the Consumer Research Center at the Conference Board, says she hasn't seen evidence that sentiment is bad enough to spark a double-dip recession. "It doesn't look like it's an indication of a double-dip. It's really just the fact that until consumers see more proof--and that being more growth in the labor market--we're likely to continue at these levels," she says. Also, consumer confidence is by no means easy to measure. Just a few days before the Conference Board released its numbers, a Thomson Reuters/University of Michigan survey indicated that consumers are actually quite content. In stark contrast to the Conference Board's results, this survey showed consumer sentiment at its best levels since January 2008.

Consumer spending. Poor consumer sentiment generally translates into stagnant spending levels. Recent data from the Commerce Department suggests that Americans are dialing back their spending and tucking more money away in savings accounts. Notably, spending levels increased by a meager 0.2 percent in May, and chances are good that more substantial growth is a ways off. "The fact that confidence is so low, the fact that consumers are concerned about the labor market outlook--and combine that with the fact that regarding their incomes, the pessimists still outnumber the optimists--it doesn't suggest that there's going to be any significant pickup in spending in the near term," says Franco. To complicate matters, the stock market's recent plunge may put a further strain on spending. "It might affect people's psychological views, particularly for people in a position of influence in business as to whether they want to expand--or whether consumers spend," says Tjornehoj.

European debt crisis. For the time being, the European Union faces the most imminent sovereign debt threat. Spain, Portugal, and Greece have all seen their debt downgraded in recent months. Greek debt is now valued at "junk" status. To calm fears throughout the world that Greece could potentially default on its debt, members of the European Union have set up a $1 trillion bailout fund. Still, this fund doesn't guarantee that countries like Greece will be able to fix their budget woes, and that has implications for the state of the U.S. economy. "It weighs a lot on the financial system because what we're really talking about is the health of European banks, and our banks are going to have a lot of exposure to them," Tjornehoj says