My Firm LPL Financial just released its Outlook for 2009. Here is one of the inserts that addresses the likelihood of another Great Depression. A bit technical, but good information.
The Great Depression came about because of serious economic and monetary policy errors which compounded what was already in serious recession. Actually, according to the National Bureau of Economy Research, the NBER, the official date setter of US recessions, there were two major back to back recessions in the late 1930s with a significant recovery in the middle. The economy and regulatory environment of the 1930s are a far cry from today’s, but can great a great depression occur again? We believe we cannot, but it is important to understand why the 30s Great Depression unfolded as it did, and the lessons that the experience offers today.
There are several key elements of recessions.
There was a recovery that started in 1933 but was aborted in 1937. During the recovery, U.S. industrial production rose 121% before nose diving a second time in 1937 and 1938. Additionally, the unemployment rate followed a similar up, down, and then back up pattern.
The main problem throughout the Great Depression was, in our opinion, highly ineffective monetary policy on the part of the Federal Reserve. As the first recession was underway in mid-1929, the Fed did nothing; actually worse than nothing, it allowed the money supply to contract and did nothing to support the banking system. The Fed is supposed to be the “lender of last resort”, but back then it did not accept that role. Its policy was to lend reserves to banks only if those loans were collateralized by investment grade corporate debt. It would not even accept government securities as collateral.
The Deepening Recession
As the recession deepened, more and more corporate debt on banks’ balance sheets dropped below investment grade. When depositors started withdrawing money from the banks, the Fed refused to give banks enough borrowed reserves to meet the deposit runs, and a wave of bank failures recovery started underway. However, between 1936 and 1937 the Fed doubled the bank reserve requirements. The demand by the Fed for higher reserves triggered a second wave of bank failures, and another deep recession took hold. Industrial production plunged again, real GDP fell again, and the GDP price index, which had already fallen about 25% in the first recession, fell again in the second.
Take a Look at The Monetary Policy
So, although there were a number of serious blunders in fiscal, regulatory, and trade policies, we view the main cause of the depression to be very counterproductive monetary policy by the Fed. Today, we view monetary policy as strongly headed in the exact opposite direction—the right direction. Over the last three months, the Fed has expanded bank reserves from their normal level of about $45 billion to more than $650 billion, accepting just about any assets the banks have as collateral for loans. The Fed is also in the process of generating a major expansion in the money supply, with the monetary base nearly doubling during the last three months. M1 has increased 9% during the last three months. Given these actions, coupled with much improved fiscal, regulatory, and trade policies, we consider the probability of a return to the “Great Depression of the 1930s” to be highly unlikely. Not Repeating the 1930s For the United States to enter into a depression like the one in the 1930s, huge policy mistakes would have to be made, and made quickly. We do not think these mistakes will be made, but want to outline what they might be and how they would impact the economy and markets.
Policy mistakes would include:
- The Fed reversing course and increasing rates over the course of 2009.
- The Fed raising bank reserve requirements.
- The Fed abruptly discontinuing the reflation program that it has already begun.
- A wave of global protectionism.
- The elimination of the TARP and related housing and bank rescue measures.
- Consequences of those policy mistakes for the economy and markets would include:
- Real GDP falls by an annualized 7% per quarter for all of 2009.
- The unemployment rate soars past 25%.
- Deflation grips all assets prices.
- Oil approaches $5 a barrel.
- Massive corporate and personal defaults—greater than 20%-25%
- Social unrest increases in the United States, along with a continued increase in social disorder overseas.
- The US dollar rises due to a flight to quality.
- The Eurozone breaks apart.
- Gold soars.
Equity markets: Under another great depression, we believe the S&P 500 index would fall to a level of 360, driven by an 8 price-to-earnings ratio (P/E) on the next 12-months expected earnings per share (EPS) of about $45 in 2010 and a dividend yield of 5% to 7%. For context, this would be an additional 60% decline from current levels and would erase 12 years of earnings growth. The index would likely be mired there for the next few years. If this scenario of “completely eroded confidence with no end in sight” unfolds, investors would focus on only the most defensive of earnings streams, and relative performance among equity asset classes would be immaterial to the magnitude of the losses across all asset classes.
Fixed income markets: We would expect T-bill yields to turn negative and expect the 10-year Treasury Bill to trade below 1% and move close to 0%. Investors would be seeking any and every safe haven—and government issued and guaranteed debt would be the place to go. With yields at 0% or negative, investors would be paying the government to hold their money.
However, investors acknowledge that knowing their assets are safe is worth the price.