Morgan Stanley’s V-shaped recovery is my W-shaped double dip
Dick Berner, Chief North American Economist at Morgan Stanley, thinks we are in for a sizable uptick in GDP for Q3. I must be honest; I am sceptical about this, but Berner is a well-regarded economist whose views can’t be dismissed out of hand. He says:
Incoming data… confirm that the deepest and longest post-war recession is now ending. And it’s ending with a roar: A temporary surge in vehicle production is likely to pace a much stronger rebound from recession than we thought only a month ago, so GDP may rise 3-4% annualized in 3Q. The recession and recovery are starting to look more ‘V’-shaped: Revised data now show that the economy declined by 3.7% since the recession began in 4Q07, making it the deepest post-war downturn. But significant economic headwinds mean that the 3Q surge is unlikely to spill over into a stronger overall recovery. And with inflation declining, a tighter monetary policy is unlikely soon. We continue to think that the Fed will remain on hold until mid-2010.
Ingredients for a rebound. There’s no mistaking the ingredients for a sharp summer rebound, including a classic inventory snapback and modest improvements in some components of final demand. Aggressive vehicle production cuts (a 46%, seven-quarter plunge in motor vehicle output, with the first half down at a 36.3% annual rate) have brought motor vehicle inventories in line with sales. Indeed, the cuts in output overshot, pushing annualized US production 2-3 million units below the pace of domestic sales in the past three months. Just to catch up, vehicle production surged about 60% in July over June, and seems likely to rise further through the summer. As a result, motor vehicle output likely will add about 4 percentage points, or roughly double our estimate last month, to overall GDP.
A reduced pace of inventory liquidation elsewhere in the economy will probably also contribute to growth. Apart from motor vehicles, companies liquidated about US$100 billion in real inventories in 2Q, bringing the level of inventories in relation to sales down somewhat from its 4Q08 peak. And even if companies are still liquidating stocks, a slower pace of liquidation (which means that the change in the change in inventories is positive) will likely add more to growth in output than we expected last month. Indications of stronger orders and production in July’s ISM report suggest that manufacturing outside of motor vehicles is beginning to bottom.
Better-than-expected gains in housing and construction will probably add another half point to 3Q output. Despite the obvious headwinds that still face housing, imbalances are smaller, and activity is starting to improve by more than we thought previously. The vacancy rate in one-family housing, now 2.5%, has fallen 40bp from its 4Q08 peak. And modest improvements in sales and continued declines in inventories have brought inventories of new, one-family homes down to 8.8 months’ supply -from 12.4 months in January. The 2.4% June surge in one-family construction outlays signals that activity began to turn at the end of 2Q. With financial conditions gradually improving, despite lenders requiring higher downpayments, further gradual improvements in demand seem likely, and housing construction is also likely to improve further. Moreover, thanks to the funding from the American Recovery and Reinvestment Act (ARRA), it appears that state and local infrastructure outlays are starting to pick up a bit sooner than we expected a month ago.
Limited ‘payback’. This 3-4% 3Q surge in GDP growth is not sustainable, but neither a significant ‘payback’ nor a double dip is likely. Vehicle sales illustrate the point. The blowout response to the ‘cash-for-clunkers’ incentive program has been far stronger than we expected. With the initial US$1 billion in funding used up in a few days (even if some of the deals were booked at dealers in anticipation of the July 24 initiation date), this fiscal stimulus is getting a lot of bang for the buck. It is timely, targeted and temporary: The incentives have an immediate effect; combined with matching dealer incentives, consumers are getting a 30-40% discount off the sticker price, and consumers must use them or lose them. The deals will run out soon even if the Senate approves the US$2 billion in additional funding voted by the House before they recessed last week. If each billion in funding spurs an extra 250,000 vehicle sales, as seems possible, the annual selling rate in August may climb past the 12 million we expect for July. While the sales pace will slip back in the following months, manufacturers likely won’t have to trim inventories at all in 4Q. Beyond the spillover from the vehicle rebound, improving global growth, the growing impact of fiscal stimulus and looser financial conditions may also limit the slippage in 4Q, by sustaining exports, factory output, infrastructure and housing.
So, to recap, we have the Fed on hold at zero percent rates, a huge uptick in autos, government stimulus coming online, and a robust inventory cycle coming into place. This does sound very bullish regarding Q3. But, there are some major problems to contend with longer-term.
Four headwinds still indicate a moderate recovery, in our view. First, financial conditions are still restrictive, reflecting the gradual improvement in bank balance sheets and securitization markets. The combination of reduced access to credit and falling home prices will keep consumers cautious and promote further deleveraging and increased saving out of current income. Second, absent a sustained pick-up in vehicle sales, the inventory-related production bounce in motor vehicles won’t last. More broadly, inventories elsewhere in the economy aren’t yet lean in relation to sales. Third, despite the infrastructure pick-up, stressed state and local governments are cutting current services and furloughing workers. Fourth, ‘core’ consumer incomes (real, after-tax wages and salaries) are now falling again, following several one-time boosts to real after-tax income earlier this year (e.g., declines in energy prices, stepped-up tax refunds, a cut in withholding rates on April 1, and one-time checks to Social Security and SSI beneficiaries in May and June). Measured by the employment cost index, private industry wages and salaries rose just 1.5% in the year ended June, a record low. With continued pressure on wages and payrolls, and the bulk of the ARRA tax cuts likely to hit incomes only in spring 2010, real spendable income should be flat to down in 2H09.
Exactly right. Don’t forget the fact that jobs are still being cut and personal income is at 2007 levels as a result. Not exactly the stuff of sustainable recoveries. Berner goes on to suggest that declining inflation will keep the Fed on hold for some time to come and ends his analysis there.
I would add the comment that this sounds bullish over the short-term but not necessarily sustainable. Auto demand is being pulled forward artificially and the inventory cycle and government stimulus are both temporary. The only variable which is supportive of this V-shaped scenario over the longer-term is interest rates – and that is only because of the threat of deflation. I see this as further confirmation that a W-shaped recession is a very real possibility.
Roaring Out of Recession in 3Q – Richard Berner, Morgan Stanley