Wednesday, August 5, 2009

Risks Going Forward

As the free fall in GDP has ebbed, a certain level of optimism appears to have returned to the market. Corporate earnings in Q2 have also exceeded expectations, further fueling the market's buoyant tendency of late. But going forward, risks to this economy remain. One risk in particular that may be underestimated in the financial media is the unemployment rate.

The rising unemployment rate (US unemployment currently sits at 9.5% and continues to rise) is often dismissed by the media as a "lagging" indicator of the economy and therefore not relevant to deciphering the current economic picture. Historically, businesses have held off shedding workers until after they have been hit by recessions, and they have been reluctant to add employees even as GDP growth has returned, hence the "lag". But an examination of specific factors relevant to this particular recession may reveal some important differences between this recession and the ones of the recent past.

When members of the labour force have lost their jobs in the past, they have been able to draw equity from their homes or borrow in order to maintain spending. While recessions usually have several causes, among the major causes of this recession was a credit crunch and a bursting housing bubble. As such, lending institutions have tightened their standards, and a larger than normal deleveraging has taken place, which suggests the unemployed will act as more of a drag in this recession than in those of the recent past.

Furthermore, while second quarter corporate earnings did come in better than expected, this was primarily due to cost-cutting: while 82% of companies beat the earnings expectations, only 50% of companies beat the revenue expectations. But the cost cuts of one company are the revenue cuts of another. The magnitude and speed of the job cuts in this recession have been particularly harsh. As a result, the rising unemployment rate will act as a drag against the fiscal and monetary stimulus being provided by the government.

Will this drag be enough to cause a double-dip recession? In the near term, it is not clear whether high unemployment will help cause such a dip in the GDP. However, investors should be aware that the risks of this taking place are indeed present, and should therefore avoid getting too carried away with the market's recent runup.

1 comment:

Ninad Kunder said...

Hi Karsan

You have echoed what has been a concern area for me in the current rally. Globally I think corporates have delivered better quarter earnings largely driven by bottomline improvements and not topline growth.

Also a significant chunk of the bottomline improvement has been driven by lower commodity prices and reduction in employee costs.

Unless we see some turnaround on the topline front, I dont think there is too much bottomline improvement that u can push for.

There is a lot of liquidity in global markets driven by the stimulus packages rolled out by various central governements. If the stimulus packages fail to kickstart growth, we risk building liquidity driven inflation in the system and the subsequent tightening.