February 20, 2008 / 12:33 PM / in 11 years

Angst grows over double-dipping "W" recovery

LONDON (Reuters) - Investors who have written off 2008 as a year of an economic slowdown and depressing stock market returns, are already gearing up to face a cocktail of new problems next year.

A trader works on the floor of the New York Stock Exchange February 5, 2008. Investors who have written off 2008 as a year of an economic slowdown and depressing stock market returns, are already gearing up to face a cocktail of new problems next year. REUTERS/Brendan McDermid

If you imagine a chart of the global economy’s future growth — and hence the stock market’s path — you get to the heart of the investors’ big debate right now. Will that chart look like a sharp “V” shaped recovery, a double-dipping “W” or a long “L”-shaped funk?

Six months after the turmoil began, the credit crunch has forced 2-1/4 percentage points of U.S. interest rate cuts and the first joint action by the world’s top central banks since September 2001 to calm money markets.

Yet, as the world economy slows, some stock indexes have fallen 20 percent from their peaks, dipping into technical definitions of a bear market; many loan and bond markets remain closed; and insurance premia on credit defaults have soared to record highs.

The crisis, which originated from a crash in the U.S. subprime mortgage market, has to date cost the global banking sector well in excess of $100 billion in debt writedowns — around a third of the estimated total loss of $300-400 billion.

Financial markets have already built much of this fallout into current prices and, some say, are already positioned for a cyclical upturn in the second half of this year that would resemble a “V”-shaped recovery.

Consensus assumptions are the U.S. economy experiences its low point for growth — perhaps recession — in the first half of 2008. The optimism about a sharp bounce stems from expectations that by September another percentage point will be lopped off U.S. interest rates to 2 percent and Washington’s $150-billion fiscal stimulus will feed through the economy.

But what if that best-case scenario does not materialize?

“It’s very probable we get a cyclical rebound in the second half of this year but after a short snap back we might get a double dip... if consumption doesn’t pick up,” said Jan Poser, chief economist at Swiss wealth manager Sarasin.

“There is a risk of a W-shape recovery,” he said, adding the U.S. policy response may soften the consumer downturn this year but it would be a temporary fix to a likely recurring problem.

For financial markets, it means that stock markets would develop a false sense of a bottoming out before falling back and yields would come down further.

“Usually the cyclical recovery dominates stock markets, which will raise stock indices around the world. Then of course if there is a double dip developing, stock markets may be going down further in the second leg of the downturn,” Poser said.

The likely shape of a profit cycle also points to a prolonged period of falling corporate profits, if a profit recession were to materialize.


Merrill Lynch reckons that in the past two 10-year profit cycles, it took around 100 months for profits to hit a peak and earnings fell 35 percent on average from peak to trough.

The current cycle shows profits hit peak levels last year twice as quickly — in about 50 months — and markets are currently discounting a 28 percent fall in profits peak-to-trough.

The upshot is that markets may not have discounted the full picture yet.

“We are in the early stages of a profit recession,” David Rosenberg, Merrill’s North American economist said in a note.

“Those in the V-shaped recovery camp are going to look back on this whole post-bubble deleveraging period, surprised to see that... what looked like a V time and again was really just part of a string of 26 W’s in a row.”

“The transition to the next economic cycle and bull market is going to be long and arduous,” wrote Rosenberg.

U.S. rate cuts and Washington’s fiscal package might help a recovery, but this is also threatening to push inflation higher at a time commodity and energy prices are hitting record highs. This is further complicating the 2009 horizon.

Such concerns are reflected in recent moves in the U.S. yield curve — the gap between short and long-term interest rates. The curve has steepened in recent months, with the difference between 2-year and 10-year rates hitting 1.85 percentage points from one percentage point early this year.

“The U.S. yield curve is telling you there is an aggressive loose policy mix implemented by the Fed and the government. But this stimulus is fuelling concerns about long-term stability when it comes to inflation,” said Cyril Beuzit, global head of interest rate strategy at BNP Paribas.

“Central banks are forced to cut rates aggressively, certainly in the case of the Fed. The UK and euro zone will join the club.”

A steeper yield curve typically occurs when investors expect a faster economic expansion — and hence higher inflation risks — in future.


Credit Suisse also sees resumption of sluggish growth later this year and early next year after a small recovery this year.

Basing its assumptions on the Taylor Rule, a formula developed by economist John Taylor to calculate the appropriate level of central bank interest rates, the bank estimates average G3 (U.S., euro zone and Japanese) short-term rates might fall below 2002 lows of 1.35 percent if a recession occurred.

“Our ‘slower for longer’ scenario suggests central banks might have to keep cutting well into 2009. And should a more classic recession scenario unfold, there is reason to expect new lows in G3 short rates,” the bank said in a note to clients.

“The banks are likely to be conserving their capital for more than just the next several months, which means that the credit multiplier is likely to be contracting,” it added.

“These are not the circumstances in which to count on a quick recovery in G3 final demand and a return to the global boom of the last five years.”

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