Rececssion Ahoy!

On Friday, the ECRI publicized their call that the U.S. economy was headed for a recession (here). This firm has a respectable track record of forecasting turns in the business cycle, so this is a particularly noteworthy call.

Most of the financial commentary I have read so far has been forecasting a garden-variety recession (should one even occur), with corporate earnings falling 10-15%. While I have yet to be able to quantify the effect on corporate earnings, I take issue with comparisons to historical recessions for a number of reasons.

Starting with the C in Y = C + I + G + X, the consumer is still balance-sheet constrained. Historically, when consumer income fell, consumers would borrow money to smooth their consumption. With the American consumer leverage sitting as high as it is, it is likely that consumer spending will fall more than in historical recessions (higher flow through from falling consumer income).

Moving on to investment, while I am not expecting a total credit market freeze for highly-rated corporates,  the high-yield primary market has been effectively closed for nearly three months. Historically, high-yield names have not been a meaningful proportion of total corporate issuance, but in the last two years, we have seen $600B in high-yield issuance, which I suspect has significantly inflated business capital expenditures (admittedly some of this issuance was debt-for-loan swaps). With this group of firms locked out of the primary market (and higher-rated firms behaving in line with historical experience) I expect there to be a larger decline in business investment than has been seen in historical recessions.

Government. Given the hysterical obsession with cutting spending (and taxes) in the House, I cannot see the U.S. passing any marginal stimulus until after the 2012 elections. If this is the case, government expenditures will actually contract relative to 2011. This is in direct contrast to historical recessions, wherein the government traditionally inflates expenditure in an attempt to stimulate the economy.

I do not have any strong feelings on net exports and feel that it is probably a wash.

Throw in European and Chinese tail risks, and the risks to the consensus recession forecast are clearly overweighted on the downside.

I should clarify that I am not saying with 100% certainty that teh U.S. is headed for a recession (although I do believe that a recession is more probable than not), but rather detailing my thoughts on the nature of the recession, should it occur. I will flesh out these thoughts in upcoming posts.