Why the Lopsided Recovery Remains Vulnerable

By Rom Badilla, CFA, Bondsquawk

The recession was official declared over in late 2009 and since that time the recovery has experienced modest growth. Though, the manner of this rebound is somewhat troubling according to Ethan Harris, Chief Economist at Bank of America Merrill Lynch.

In their latest U.S. Economic Weekly: Running on One Engine, he points out that growth in the past several years has been lopsided in favor of goods over services which he believes puts continued economic progress at risk.

“The nature of this recovery – with growth concentrated in goods rather than services – leaves the economy particularly vulnerable to an uncertainty shock. Unlike prior recoveries, the service side of the economy has remained disproportionately weak. The service sector shrank as a share of the economy over the past two years. That said, this was only a slight reversal from the multidecade trend away from goods toward services, which has left services as 70% of the economy.

The shift last year toward manufacturing and away from services was not due to an exceptional boom in manufacturing. The contribution to GDP growth from manufacturing was akin to prior cycles (Chart 3). The sector gained market share because of an exceptionally slow recovery in services (Chart 4). Unlike the typical post-war recovery, this was not led by a resilient consumer. Households have been in the process of deleveraging in the face of a massive negative wealth shock. The reduction in household formation and home values also significantly reduced spending on housing services.”

While markets have been resilient as of late, the fact is that risks remain for the U.S. as well as the global economy. The Fiscal Cliff and the European Debt Crisis are headwinds that add uncertainty to people’s spending as economies in Europe like Greece and Spain can demonstrate. Such events can lead to a slowdown in the goods side of the economy as Harris provides the following reasons:

  • The uncertainty shock will likely prompt corporations to postpone investment in capital and software. The long string of false dawns has undercut corporate confidence, making them more sensitive to uncertainty shocks.
  • Consumers typically reduce spending on durable goods in the face of a confidence shock. These are big-ticket items which can be postponed and require financing. For example, auto sales and housing.
  • The synchronized global slowdown, spurred by the crisis in Europe, restrains demand for US exports. The weakness has not been isolated to Europe; developing economies have started to slow. The strengthening US dollar further undercuts export growth.

Having said this, the research team admits that there are some mitigating factors that could come from sales in both autos and housing which as we all know can propel the economy. Since both of these factors are already at depressed levels and have shown some signs of rebounding, a sharp drop seems unlikely.

Given the weakness of the service side, the economy does not have much cushion to absorb shocks like the Fiscal Cliff and the debt crisis. These are headwinds that are on everybody’s radar but judging by recent market action, are currently being ignored. A lack of resolution, could put the economy at risk given its makeup, and a slowdown may be in the cards.

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BondSquawk is written by a team of bond market experts whose aim is to provide an unbiased view of one of the largest (but under reported asset classes in the world) – The world of bonds.

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