What Does A Recession Look Like?
It is just a recession. This will pass.
The Starbucks Index
First, I have one interesting observation and a request for help on a fun project. Last week, I was in Europe. I walked across the street from my hotel in Geneva and was delighted to see a Starbucks (SBUX). While I initially made fun of people who overpaid for a nickel cup of coffee (the price of my youth, which dates me), eventually I became hooked. I now have a venti decaf every morning on the way to work (venti being the Starbuck's code word for large). When I am feeling particularly adventurous I live on the edge and get a venti half-caf (half regular caffeinated coffee). The price in Dallas recently increased 5% to $1.95 or $2.11 after tax.
I ordered the same thing in Geneva and paid 6.7 Swiss francs which is like $6.43 or three times what I pay in Dallas. The fancy drinks were over $10. And the place was packed at 10 am in the morning. (Memo to returning Starbucks chairman and CEO Howard Schultz: the coffee was decidedly inferior.)
Then I traveled on to Barcelona. Father and son partners Antonio and Kai Torella of Interbrokers (and my new Spanish business associates) indulged me by walking to a Starbucks which was a nice hike away, but on a weather-perfect day. There that same venti decaf was roughly $5.70, depending on which exchange rate you use, as it is jumping all over the place. The coffee was better. And the place was busy.
The next day in London I went to the Starbucks right next to the office of London partners Absolute Return Partners. I again ordered my usual venti decaf late in the afternoon. It was a bargain at 2 pounds or roughly $3.96 (although the cost to exchange currency runs it to over $4). The large store was crowded. And the coffee was perfect, except after repeating three times that I wanted decaf and being assured that was what I was getting, it turns out I got the full dose of caffeine. I am quite sensitive to the drug (caffeine), and was soon really, really wired, as my associates will attest for the rest of the night. It made for an interesting business planning meeting, and more than a few jokes at my expense.
Now I am curious. Everyone knows about the Big Mac Index as a way of comparing purchasing power parity comparisons from country to country. I want to create a Starbucks Index for the 44 countries in which the company operates. I am curious as to what people pay for a totally self-indulgent product that is offered right next door nearly everywhere at much lower prices. So, I would like readers outside of the U.S. (I've got the U.S. covered) to drop into a local Starbuck's and find out what a venti (the largest size) cup of coffee is. No latte's or fancy drinks. Just the basic cup of coffee. I will have my assistant put it into a spreadsheet and will post it in a later letter. Thanks. It should be fun.
What Does a Recession Look Like?
I have had a few emails (and lots of questions) like the following from readers the last few months. How can I still think the economy is simply going to be Muddle Through?
"What are the differences between the current state of the economy from that of the 1930s that would allow us to have a 'muddle through' instead of a deflationary depression? There seem to be many technical and fundamental similarities. We westerners having been living above our means for a long time and something is going to have to give. If history repeats itself then the cure to our addiction requires us to go 'cold turkey' with a deflationary depression. Is there hope that perhaps we could have room-temp turkey instead?"
- Dr. John E.
Ok, John, let's see if I can get your heart rate down and make you feel better about the future.
I have long contended that a recession is a normal part of the business cycle, but it takes a major policy mistake by a government or central bank to create a depression. And while there is no doubt that there have been and will be mistakes, they are likely to be of a minor sort (as these things go) rather than something which would bring an out and repeat of the 1930's. And given the causes and problems attendant with the current slowdown, I think Muddle Through is a perfect description of the economy we will see over the next year or so. So, with that in mind, let's look at what a recession looks like.
First, I have already lived through 5five recessions. And every one was different in nature and cause. It is likely most of my readers, all except the youngest, have lived through at least two recessions, although the last two were rather mild, for reasons we will go into later. And this next recession, if we have one (and I think we are already in one) will be different than the past recessions.
But the operative words are "lived through." The U.S. economy will come through this recession and enter a new period of growth, just as we have in the past. As will, by the way, the European economy, which I also think will encounter a recession. Again, recessions are a normal part of the business cycle. Congress can't repeal them, and central banks can only fight them, but not prevent them entirely. Clearly, though, they can mitigate the immediate problem (although the Austrian school of economics, otherwise known as the take-your-medicine-now school, contends that any such actions simply postpone the Day of Reckoning).
Consumer Spending Slows Down
Recessions are generally accompanied by a slowdown in the growth of consumer spending, although the last recession of 2001-02 saw consumer spending continue to grow at a very healthy pace, making that recession one of the mildest (and strangest) recessions in history, not just in the U.S., but in the history or the world (to my knowledge).
Of course, we now know why consumer spending did not slow down in the last recession. Consumers leveraged their homes to continue their spending growth, as well as increased their credit card debt. However, in the current cyclical slowdown, it is going to be harder to use mortgage equity withdrawals to bolster consumer spending, as home values are dropping. The piggy bank of increasing home values is shrinking.
While long time readers have seen this chart on a few occasions, it bears review. Notice that mortgage equity withdrawals, or MEWs, accounted for 2-3% of the growth of overall GDP in 2001-6. Without MEWs we would have seen two solid years of recession (the red bars) rather than a few quarters, and a decidedly below trend economy. Such large MEWs were possible because of the bubble in housing prices and the availability of cheap and easy mortgages.
Click to enlarge image
Today we are watching a slow motion bursting of the housing bubble. In data released this week, we learn that home values are down almost 8% nationwide, with many areas in double digit declines. And it is likely to get worse. 1.3 million homeowners are in some state of foreclosure, or about 1% of homeowners nation wide, and the numbers grows each month. Predictions of 2,000,000 homes in foreclosure made in late 2006 in this letter no longer look ridiculous. No wonder that many (including your humble analyst) forecast a drop of 20% or more in home values.
Further, there are 2.18 million homes that were vacant and for sale in the 4th quarter. That's 2.8% of all homes. We are edging ever closer to a national average of 12 months supply of homes for sale this spring, with many more home owners who would like to sell simply not bothering to list their home. The good news is that if you want to buy a home, you are likely to find a very willing seller at a very good price.
Sidebar: my daughter is quite happy about the house she and her fiancé are buying and getting close to a 5.5% 30 year mortgage rate! My father bought a home in 1966 and I am pretty sure he got a 5% mortgage, paying the home off in 1996. Interestingly, my daughter now pays attention to the 10 year bond yield, cheering each time it drops as the closing date for her home gets closer. (There is a close correlation between the ten year bond and 30 year mortgages.)
But the point is that while MEWs will not go away, especially with low rates coming back, they are not going to be the consumer spending force they have been. So chalk this current recession into the slowing consumer spending category. One caveat. The Bush/congressional plan to air drop $150 billion into the economy should add about 1% of GDP into the economy over the last half of the year, and maybe even this spring if they can get it done fast enough, and that will be a boost to consumer spending.
(Quick aside: is it only me that sees the irony in that it is Congress that is dropping virtual $100 bills from the proverbial helicopter and not Bernanke?)
And all the recent data does indeed point to slower consumer spending. Foreclosures, increased credit card delinquencies and lower same store sales suggest that the consumer is getting closed to tapped out. Further, as housing values slide, I think it will slow even more. There was a positive wealth effect on the way up, and we will see the reverse on the way down.
Plus, the need to save more for retirement as homeowners realize that they cannot count on their homes to be their retirement plan. While saving more is a good thing for individuals, it means that for the economy as a whole there is less consumer spending. If we go simply back to trend it will mean that GDP will face at least a 1% drag over long term trend. Just one more reason why the next few years will be Muddle Through.
Rising Unemployment Starts to Show Up
Recessions are also associated with rising unemployment, and this one will prove to be no exception. We saw a large rise in unemployment applications this week to 371,000. Unemployment is at 4.9%, about 0.6% above the peak. That level of rise has always been associated with a recession in the post-WW2 period. It is likely unemployment will rise to over 6%, and 7% is certainly possible.
Now, I recognize that the old joke is still true: a recession is when your neighbor loses his job, and a depression is when you lose yours. But we have to keep in mind that 4% or so unemployment is "structural" or quite close to full employment. That is the normal level of people changing jobs, etc. This would suggest a rise of only 3% in unemployment, which is not a lot in the grand scheme of things, unless it is your job.
Why so low? Why won't we go back to the 9-10% unemployment of recessions in the 70's and 80's? Because we have shipped the cyclical manufacturing jobs offshore. In past recessions the U.S. had a much larger percentage of its job tied to manufacturing. Now manufacturing jobs account for just 20% of the economy. Even if in the unlikely event that 10% of manufacturing jobs were lost, that would mean just a 2% rise in unemployment. And I say unlikely, because many manufacturing companies with large export components to their sales are experiencing growth due to a weak dollar.
This is just not the economy your father grew up in. It is quite different, and trying to go back and look at past recessions to figure out precisely what is going to happen in this one is futile. One can only hope to get the general direction right.
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