Going by the euphoria witnessed in global financial markets since March, it seems that US Federal Reserve chairman Ben Bernanke has finally succeeded in sowing the seeds of “green shoots of recovery” with his hard monetarist policies. US stock indices such as the Dow Jones Industrial Average (DJIA) and the Standard and Poor’s (S&P’s) 500 have gone up 31% and 37%, respectively, in May from their March lows. Prices of commodities such as crude oil and gold have also moved up sharply from their respective lows. The 10-year US bond yields that had fallen to 2.5% have also moved above the 3% mark—indicating a considerable reduction in risk aversion. Risk-taking behaviour is also evident in the currency markets, where the dollar has taken a beating against most major currencies owing to investors moving out from the safe-haven greenback in favour of riskier currencies and asset classes offering higher yields.
It is worth noting that the recent rally in financial markets has taken place despite the economic fundamentals remaining extremely weak. True, there has been some marginal bounce back in certain monthly economic data points but does it really justify such a strong rally in stock markets worldwide? The supporters of the “green shoot” hypothesis argue that financial markets are always forward-looking and, hence, the current rally only indicates that the economic scenario is expected to improve considerably in the next few months.
Illustration: Jayachandran / Mint
Frankly, I find it difficult to share this sense of optimism for the following reasons.
First, if stock markets are good at predicting economic fundamentals, how did they continue to rally till late 2007, when the credit crisis in the subprime mortgages was already in full swing? Should not the stock markets have predicted—and, therefore, corrected in advance—that the subprime crisis would spread to other parts of the credit market and finally push the real economy into a nasty recession?
But then Bernanke and former US treasury secretary Henry Paulson were busy reassuring market participants at that time that the subprime problem was under control, thus helping support the equity market’s rally. In March 2007, Bernanke declared: “At this juncture, the impact on the broader economy and financial markets, of the problems in the subprime market, seems likely to be contained.” Echoing Bernanke’s sentiments, Paulson reiterated in July 2007: “I don’t think the subprime mess poses any threat to the overall economy.” If Bernanke and the global equity markets got it so wrong about the impending recession risks in 2007, how can one trust them now?
Even if stock markets are right in predicting the end of the recession by 2009, history shows that unemployment continues to rise even after recession comes to an end. According to the National Bureau of Economic Research— the official record keeper of US recessions—the last economic downturn in the US ended in November 2001. The unemployment rate at that time was around 5.5%. But unemployment kept on rising even after the recession ended, and peaked at 6.3% in June 2003 (19 months later), finally coming down to below 6% in November 2003.
How did the DJIA index fare in this period? This equity index, which was at 9,852 when the recession was declared over in November 2001, fell to 8,985 in June 2003, when unemployment peaked. The index finally clawed back to 9,782 when unemployment fell below 6% in November 2003, two years after the official end of the recession. It was almost the same experience when the US went into recession in 1990-91.
This time around, the US unemployment rate is definitely going to peak at a double-digit level; it is already at 8.9%. Private business investment fell at a record 37.9% annual rate in the first quarter of 2009, thus pulling the US growth in that quarter to -6.1%; this segment of investment will continue to remain weak and lead to rising unemployment in the US economy, despite various stimulus packages.
The Federal Reserve recently used an estimate of 10.3% peak unemployment rate (“severe but plausible scenario”, according to the Fed) while conducting its stress tests on the banking system. According to the Fed, the peak unemployment rate is likely to be reached sometime in 2010. This estimate seems a bit optimistic. Given the severity of the global recession, the US unemployment rate is more likely to peak at a higher rate than 10.3% and at a later date than 2010—probably sometime in 2011. This means that the current recession will continue at least till the first half of 2010, with unemployment expected to increase persistently. This can hardly be good news for the equity markets.
As past experiences have shown, the soaring unemployment rate will lead equity markets to realize slowly that the “green shoot” hypothesis is bogus, then leading to a correction of the current bear market rally. The truth of the matter is that both this global recession and weak stock markets are likely to stay with us for quite some time. The sooner markets embrace this inevitable reality, the faster we would see green shoots turning into what they always should have been seen as: yellow weeds.
Kaushik Das is an economist with Kotak Mahindra Bank. These are his personal views. Comment at email@example.com