By virtually any measure, this hasn’t been a typical recession, at least by recent standards. With the comparatively mild recessions of 2001 and 1990–1991 as the only reference points in more than a quarter century, many Americans were caught off guard by the severity of the most recent recession and financial crisis. Moreover, the recession wasn’t limited to the United States — in fact, far from it.

Although the depth and duration of the economic contraction here easily exceeded the previous two, the experience in many economies around the globe was meaningfully worse. This has truly been a global, synchronized recession, particularly in developed economies. Couple that with the worst banking crisis since the 1930s, and you have a powerful, negative combination to contend with: historically, recessions that are both global in nature and accompanied by a financial crisis tend to be much more severe than a typical cyclical recession. 

Peril and Promise

A year has passed since the fall of Lehman Brothers and the resulting chaotic conditions that erupted in the capital markets. In recent months, signs that the economy appears to be turning have become increasingly apparent. Perhaps the most conclusive statistic is the gross domestic product result itself for the second quarter. The economy contracted, but at a relatively tame -0.7 percent annualized rate — much better than the nearly -6.0 percent annualized pace of the preceding two quarters.

Although the unemployment rate is still rising, the pace of job loss is slowing. Industrial production was positive in July and August, marking the first consecutive months of growth since the end of 2007. Retail sales, which virtually went off a cliff last year, are also showing signs of stabilization. Although the strong headline result in August was the beneficiary of additional juice from the “Cash for Clunkers” program, the result excluding auto sales was still positive. These factors are suggestive of a turn in the economy, a fact that was not lost on Federal Reserve Chairman Ben Bernanke when he stated in his comments on September 15 that the recession appears to have ended. 

The Paradox of Thrift

That being said, the specific timing of the end of the recession and return to growth is not our primary focus. This recession will end just as every previous one has — no matter how grim — and the economy will grow again. A sharp pickup early in the recovery is possible, as the inventory restocking cycle further sweetens the growth driven by increased consumer demand. At the heart of uncertainty about the outlook, however, lies skepticism about the sustainability of the recovery. Consumers still face a mountain of debt, a weak labor market, and little expectation for meaningful income growth in the near term. The rebuilding of individual balance sheets will take some time; the question is whether or not the newfound austerity and renewed emphasis on savings will prove fleeting as consumer confidence improves. If consumers revert to recent form, there may be room for better-than-expected growth for some period, although that may only serve to delay the inevitable. The bottom line is that consumers cannot borrow to spend indefinitely. The “paradox of thrift” recognizes that increased savings to repair personal balance sheets can have a negative effect on the broad economy. Tighter credit conditions will likely take the choice between spending and debt reduction out of the hands of many potential borrowers that cannot access credit to the same degree as in the past.

For many households, that added discipline is necessary, even if it restrains growth in the short term. Over the long term, a concerted effort to reduce household debt to more manageable levels should position the economy for a renewal of stronger consumption down the road. In the near term, reduced spending could be a significant headwind contributing to sub-par growth after the impact of the massive stimulus efforts ebbs.

What does this portend for the capital markets? Slower economic growth would appear likely to restrain equity market returns after conditions stabilize. It would also appear to give the Fed room to keep interest rates low for some time, as the risk of inflation should remain subdued. As such, investors should be prepared for the potential that returns could be lower than average over the next several years. Nonetheless, patient investors in risk assets should continue to be rewarded with superior results compared to those available in cash or Treasuries. Moreover, such an environment may also make other risk assets (beyond stocks) appealing, particularly on a risk-adjusted basis. We encourage investors to remain flexible in implementation and look beyond traditional stocks and bonds, while not losing sight of their long-term asset allocation and investment strategy.