Why a double dip recession is unlikely

Financial uncertainty and disappointing returns in the global markets have raised questions about a double dip recession, something Brenda Reed deems unlikely.

Recent economic data from the US has been disappointing, leading to increased debate about a possible double dip recession.

A renewed global downturn would mean that current corporate earnings expectations are too optimistic, necessitating a drop in valuations and prices.

Fear of this recently resulted in a surge in market volatility. While a return to recessionary conditions cannot be overruled, a number of considerations suggest that the markets may have become excessively pessimistic about the outlook.

There are several factors, which argue against a double dip recession.

The global banking system is more stable

Investors should take comfort in the fact that the global financial system is much more stable now. Globally, banks have moved on greatly from the worst of the crisis period.

In the US, loss rates on most types of loans seem to be peaking, while as a whole, bank capital ratios have also risen to new highs.

In Europe too, while the severity of the recent bank tests have been questioned, the result seems to indicate that most institutions are in relatively good shape.

Together, with generally good earnings news from most leading global financial institutions, improved banking health should be supportive of credit conditions.

Although actual evidence related to this is somewhat mixed, it seems reasonable to judge that credit conditions are at least not tightening any more, which is typically what might be expected during the start of recessionary periods.

US companies are cash rich

Past US recessions have tended to be associated with weak corporate cash flow positions, which in turn have tended to force companies to cut costs by retrenching heavily and reigning back investment activity.

However in the most recent example, the cash position of US corporations was comparatively good. According to the latest quarterly data from Bloomberg, Russell 3000 companies collectively have around $2.9 trillion in cash and short-term investments, 19 per cent more than a year earlier.

Companies have already taken significant cost reduction measures during the most recent recession and are now reaping some of the benefits of this in their cash flows. There should therefore be less pressure on them to make further cuts.

Self-correcting markets are helping

The recent global recession has had the effect of changing relative prices in a way that should be supportive of further growth. For example, the global oil price is currently still around a half of its peak level reached in July 2008. That is helping to keep costs under control in industrial (and consumer) sectors.

Similarly, sovereign debt worries in Europe have had the effect of weakening the euro; which should be supportive of regional exports, particularly German exports.

Although the level of exchange rate adjustment is clearly not sufficient for some of the more troubled peripheral countries such as Greece, in aggregate, Europe’s economies should benefit from currency effects.

Emerging markets are strong

The economic picture in key emerging market countries is significantly better than in most major developed markets.

Most emerging markets have been confident enough to push ahead with stimulus withdrawal (in marked contrast to their developed market counterparts).

For example, China, a key driver of the global recovery, has taken steps to cool its property markets as well as allowing greater flexibility in its exchange rate policy to moderate its export markets.

Despite its tightening steps, China’s real GDP still expanded by 10.3 per cent in the second quarter. Similarly, in late July, India raised policy rates for the fourth time since March.

Despite such actions, the International Monetary Fund (IMF) recently raised its 2010 real GDP forecasts for China and India to 10.5 per cent and 9.4 per cent, from 10.0 per cent and from 8.8 per cent, respectively.

Meanwhile, the IMF upgraded fellow BRIC member, Brazil’s growth forecast from 5.5 per cent to 7.1 per cent.

Further stimulus is possible

While many countries are moving towards a period of fairly intense fiscal entrenchment, this is not yet the case everywhere and many countries retain significant scope, at least on the monetary side, to take further stimulatory action in the event of growth slowing down more significantly.

In a recent testimony to Congress, US Federal Reserve chairman, Ben Bernanke, said that the Fed was continuing with its “prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation”, but in recognition of the “unusually uncertain” economic outlook, it was also ready to move the other way if it becomes necessary.

Policy options in this regard would include cutting the interest rate on bank reserves and further expanding the Fed’s balance sheet by further buying of treasury debt, federal agency debt, and mortgage-backed securities.

Conclusion: increased volatility is to be expected

Recent increased market volatility is reflective of investor concerns about the outlook for global economic growth.

While the economic outlook may be ‘unusually uncertain’ in some respects, the greater likelihood remains that the global economy is moving to a new phase of slower growth, rather than any kind of renewed downturn.

However, from a technical perspective, it is worth noting that heightened volatility at this stage of the recovery cycle is not so unusual.

Past crisis periods have quite often been followed by extended periods of choppy consolidation, which was seen in 2004.

Brenda Reed is portfolio manager of the Fidelity Global Equities Fund.