Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
July 12, 2010

Since last summer, when I wrote that I thought the recession was ending, we believed the most likely shape of the recovery would be a "square root." For those who don't remember what that looks like, it's a "V" followed by a flat line.

I'll concede that the end of the "V" part happened a little more abruptly than we'd anticipated—in large part, thanks to the European sovereign debt crisis and related plunge in business and consumer sentiment. But we remain committed to our view that we've entered a soft patch for the economy that won't ultimately be declared a second official recession. Today's report lays out that case—objectively, I hope.

Double dips are rare; double-dip fears are not
First, let's remember that double-dip recessions are rare, having only occurred once during the early 1980s, and that one was triggered by the unique legacy of Paul Volker, who smashed his venerable boot on the neck of inflation.

What's not rare is talk of double dips during the early stages of recovery. In 1991, US gross domestic product (GDP) slowed to 1.7% and 1.6% in the second and third quarters of recovery, respectively. Growth in the following year was 4.3%. In 2002, GDP slowed to 0.1% and 1.6% in the fourth and fifth quarters of recovery. Growth in the following year was 4.1%.

Remember too that because of how subject to revisions GDP data are, judging the pace of recovery early on is always difficult:

Quarter	Original GDP report	Post-revision GDP
Q1 1992	2.9%	4.5%
Q2 1992	1.5%	4.3%
Q3 1992	2.7%	4.2%

Source: ISI Group, as of June 21, 2010.

The case for the double dip rests on several legs:

• We're past the peak impact of both monetary and fiscal stimulus, while both are being pared back significantly.
• China, the world's second-largest economy, is taking proactive steps to cool lending, real estate speculation, and the economy overall.
• US debt-to-GDP has crossed the critical 90% threshold above which private-sector growth tends to suffer.
• Rampant uncertainty among business leaders continues to crimp hiring.
• Tax rates are likely headed higher in 2011, affecting sentiment today.
• Housing is faltering again post tax-credit expiration.
• The stock market corrected more than 15%.
• The Economic Cycle Research Institute (ECRI) weekly leading indicator gave a recession warning.

ECRI's recession warning signal
Let's start with the (ECRI) weekly leading indicator, since it's garnered the most attention. In fact, since it flashed its recession warning signal, searches related to "double dip" on Google have skyrocketed. (This in and of itself could be an interesting contrarian indicator, similar to how, historically, pessimistic covers on Time and Newsweek have been great contrarian indicators for the stock market.)

ECRI's recession warning

Click to enlarge
Source: Bloomberg, FactSet, as of June 26, 2010. Dotted line represents Sonders' assumption of June 2009 recession end date.

As you can see in the chart above, the ECRI Index has done a stellar job of forecasting recessions, but it's not infallible. A level of -3.5% is considered the recession warning level, and it's moved below that 11 times in history, including the recent signal. There were three instances out of the 10 prior signals (not including the latest, as we don't yet know the outcome) when a recession didn't occur until well into the future:

ECRI Index falls below -3.5%
Date	Months to recession
6/27/1969	5
9/21/1973	1
12/7/1979	1
10/9/1981	-3
11/13/1987	32
9/7/1990	-2
10/16/1998	29
11/3/2000	4
10/4/2002	63
12/7/2007	0
6/4/2010	NA

Source: Birinyi Associates, Inc., as of July 2, 2010.

It does appear as if the drop in the ECRI had a lot to do with the drop in the stock market, which has since rebounded a bit, so we'll have to keep an eye on subsequent readings. The only other period when the ECRI index was nearly this depressed and there wasn't a recession was just after the Crash of 1987.

Many suggest the stock market's decline itself was a warning of a double dip, but there has not been the kind of confirmation across other asset classes to suggest the correction was more than a relatively normal pull-back more than a year into a bull market that generated an 80% rally. With the credit market significantly outperforming the equity market, it's sending a no double-dip message.

And that's not the only factor pointing toward a slowdown, not meltdown. There are some more esoteric indicators worth observing, including Warren Buffet's favorite: rail car loadings. During the past two months, combined weekly traffic for new carloads and intermodal shipments is about 14% higher than a year ago.

A new tone out of DC?
In addition, and I think this one deserves more attention, Treasury Secretary Timothy Geithner talked down the notion of rising tax rates on dividends and capital gains during an interview with my friend Larry Kudlow on his CNBC show last week.

As rising tax rates on dividends and capital gains, which were assumed a done deal, had probably contributed to a tougher market in 2010, a change in those plans would be a welcome relief. A realization that capital, as well as labor, matters for growth is a good thing!

This comes alongside what appears to be a more business-friendly tone coming out of Washington very recently. This may be in reaction to the volume being turned up about the anti-business agenda by the likes of the US Chamber of Commerce and GE Chairman Jeff Immelt.

Bruce Josten of the former said the problem is "businesses face huge uncertainty … when businesses try to plan out what their tax liabilities will be next year, or game out credit availability or the investment climate, they just don't know what it will look like … uncertainty is just a real (jobs) killer."

Immelt, who's been an Obama supporter, recently voiced concern about the growing divide between the administration and business: "People are in a really bad mood. We are a pathetic exporter … we have to become an industrial powerhouse again but you don't do this when government and entrepreneurs are not in synch."

Any move to get back "in synch" would change perception about the trajectory of recovery in our opinion.

Global GDP forecasts remain positive
Part of what likely contributed to the stock market's recent rebound were new forecasts from Bloomberg and the International Monetary Fund (IMF) about US and global economic growth. Bloomberg's survey of 52 economists resulted in a consensus of 2.8% US GDP growth over the next year, while the IMF's forecasts are below:

International Monetary Fund real GDP forecasts
	2010	2011
United States	3.3%	2.9%
Euro-zone	1.0%	1.3%
Japan	2.4%	1.8%
United Kingdom	1.2%	2.1%
China	10.5%	9.6%

Source: International Monetary Fund (IMF), as of July 7, 2010

Further supporting no double dip, even in the euro-zone, European Central Bank President Jean Claude Trichet said at a June 8 press conference in Frankfurt: "There is a tendency from the outside to be excessively pessimistic" about Europe. He went on to note: "The figures don't confirm this pessimism."

Leading economic indicators say no double dip
I want to circle back to an indicator I've shown in several of my Market Snapshot video webcasts. As you can see below, the Organization for Economic Co-Operation and Development (OECD) Composite Leading Indicator for the United States increased again in May to the highest level since August 2007.

OECD LEI not rolling over

Click to enlarge
Source: FactSet, OECD, as of May 31, 2010. Dotted line represents Sonders' assumption of June 2009 recession end date.

It was the smallest gain in more than a year, but it remains on a 15-month winning streak, the longest since January 2000. The six-month rate of change did fall into the neutral zone, but that's consistent with slow but solid growth in the second half of the year.

Ned Davis Research keeps a recession probability model and it remains near 0%, indicating no imminent risk of a double dip. NDR also keeps a "Financial Stimulus Index" which also indicates little risk of recession before the end of this year and is at a level consistent with solid economic growth.

BCA Research also keeps a recession probability indicator, which is currently at 13%. It typically needs to rise above 50% before heralding a recession.

Philly Fed and ISM Composite say no double dip
According to the Philadelphia Fed Survey, economic activity advanced in 47 of the 50 states in May and during the past three months. The three-month state diffusion index has climbed to 94%, a zone where the economy has historically grown at a 4.5% annual rate.

And the national index is up the most since March 2000: It's risen 1.3% over the past three months, the most in six years—equivalent to a 5.3% annualized rate of real GDP growth.

Much has been made of the strong recovery in manufacturing, but even the overall Institute for Supply Management (ISM) Composite Purchasing Managers' Index (which includes both the manufacturing and services indices, seen below) remains at a level that corresponds with nearly 4% growth in the coincident index (a proxy for GDP growth).

ISM composite remains strong

Click to enlarge
Source: FactSet and ISM, as of June 30, 2010. Dotted line represents Sonders' assumption of June 2009 recession end date.

PMI	Coincident economic indicators
Above 48	3.9%
Between 43 and 48	0.2%
43 and below	-3.7%

Source: Ned Davis Research, Inc., January 1, 1948-May 31, 2010.


Slowdown, not meltdown
In sum, the list is long for double-dip risks, but it's longer for why we'll likely avoid one. In addition to the details noted so far in this report, the no-double-dip case is supported by several numbers:

• Unemployment claims have likely resumed their decline. (Even at their current level they suggest 2.5% real GDP in the third quarter.)
• The Business Roundtable CEO survey of employment plans is at its highest reading since 2006.
• Corporate profits are booming and corporate cash is at a record $1.8 trillion. 
• The rate of contraction of bank lending to commercial and industrial companies is slowing noticeably. 
• Durable good orders, though down in May, are in a strong rising trend and nearly 20% up from their recession low.
• Economic readings in emerging economies remain very healthy.
• The Fed is on hold for the foreseeable future and could reinstate quantitative easing were the recovery to falter further.

I've taken a lot of heat this year from the economic Armageddon believers, but we consistently try to be as objective as possible with our outlook. We remain in the camp that believes we're in a slowdown, not a meltdown. We will keep our readers updated if our views change.

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