Sharp but Short
Remember, this is a bowl-shaped recession.

Mr. Malpass is the Chief International Economist for Bear Stearns.
December 13, 2001, 8:00 a.m.

here is the sense that a strong near-term rebound is headed for the U.S., with positive spillover in non-Japan Asia. However, it may not have legs. Headwinds could weaken and shorten the U.S. rebound while foreign economies are still in the process of finding a bottom.

Rather than a synchronized global expansion, we're more likely experiencing somewhat of a ragged bottoming process - a bowl-shape trajectory with the bottom of the bowl extending into 2002. This has disappointing implications for 2002 corporate earnings and positive implications for bonds in the
U.S. and Europe. Just as the decline into recession was somewhat gradual, moving sector by sector, the recovery should also be gradual, with early strength in technology demand but only gradual follow-through into other sectors.

One can expect the Fed to be accommodative during this period and the European Central Bank to cut interest rates early in 2002. The sharp rise in bond yields in the U.S. and Europe in recent days adds to the headwinds by increasing the cost of capital for new borrowings, reducing mortgage refinancings, etc. Such high real-bond yields at this point in the recession spell trouble for the sustainability of a recovery. They are also likely to pressure equity-valuation models, which thrived on the lower bond yields of October and early November.

As with the oil price spike in 2000, some will misinterpret the higher bond yield as a sign of economic growth and inflation risk. Instead, the higher bond yields should be interpreted in a
straightforward way as a strong new drag on the recovery.

In 2000-2001, I argued that oil prices would fall one way or another - either through an early correction based on a market reassessment or later on through a global recession. The same logic holds for bond yields - either the market will lower the yields soon based on a proper
reassessment of the inflation and Greenspan rate risk, or the yields will fall later on based on a renewed economic downturn.

Several factors argue for near-term strength of the economy (a sharp rebound), softening the decline in fourth quarter GDP. Positive indicators include auto incentives; government purchases related to September 11 and the war on terrorism; and pent-up demand for inventory and investments after the November 12 progress in Afghanistan. This last factor began to reverse the intense global capitulation into liquid dollars in October and early November. That hoarding of liquidity came at the expense of inventory and deferrable investments, so when the spiral broke on November 12, there was a rush back into necessary business investments and inventory (pushing up the price of DRAMs and copper and down the price of a two-year Treasury note).

Yet, the reasons for the sharp rebound identified above are not, by themselves, sustainable engines for a recovery. The restocking will run its course. The auto incentives are too costly to sustain. And government purchases will probably stabilize once they've been ramped up.

To create a sustained recovery, we'd need to see sequential, multi-quarter growth in consumption,
housing, investment, exports, or inventory levels. Given the strong headwinds — high bond yields,
consumption and housing already relatively strong, heavy tax burdens, foreign recessions weighing on
exports, leftover deflation pressures from the dollar's 1996-2000 strength, and plentiful capacity - it's hard to see sustained growth.

One key driver for a normal recovery is consumption. It doesn't have much upside now, since it has stayed relatively strong during the recession. There was good reason to disagree with the negative wealth-effect arguments in early 2001, and don't expect a positive wealth-effect from the equity rebound for the following reasons. Consumption faces headwinds in the form of 1) weaker growth in personal income; 2) precautionary increases in savings in response to rising unemployment; and 3) fewer people working due to higher unemployment, a decline in the percentage of the population in the labor force (from the very high participation rates in the late 1990s), and fewer immigrant workers. While personal spending in the U.S. rose 2.9% in October, the growth in personal income has slowed to zero month-over-month in September and October.

We're in a bowl, America. Yes, we'll see (and are seeing) a nice spike in the economy, but we're gonna have to ride through a longer stretch before we reach a sustained recovery.