What's scary about this recession

5 steps down

That global circus of leverage and the unwinding of that leverage -- what we call the global financial crisis -- has had five big impacts on the shape of the recession we now face:

It means this recession started in the corporate sector. Most recessions start with a decline in consumer demand that leads to cutbacks in production -- and then in hiring, capital budgets and in day-to-day spending on everything from travel to staples -- by companies across the economy.

But the credit crunch caused by the global financial crisis led companies to make spending cuts even before consumer demand fell significantly. Companies began cutting spending on new plants and production, on hiring, on travel, on office supplies, on benefits and more in an effort to save cash because it was difficult or impossible to raise cash in the public debt markets.

It means that when the recession finally did reach the consumer sector, the drop-off in consumer buying was steep. Take a look at the auto industry. U.S. auto sales hit a record 17.4 million units in 2000 and then stayed above 17.1 million units in 2001. What's extraordinary is how little sales fell over the next five years: In 2005 sales were still at 16.9 million units, and in 2006 they dipped just a bit, to 16.6 million. Even in 2007, when the financial crisis and the mortgage meltdown started to hit, sales just fell to 16.1 million units.

Why did sales stay so close to record levels so long? Cheap money. When consumer demand gave any hint of flagging, car companies borrowed at low interest rates to offer car buyers 0% financing and cash rebates in the thousands of dollars. At the same time, they used cheap money to finance the shift of millions of car buyers from car loans to car leases, which reduced the monthly payments on buying a new car. Stretching out car loans from three years to four and then to five also reduced the monthly payments.

When the financial crisis finally forced the automakers to cut back on these incentives, auto sales dropped off a cliff. Sales in September ran at an annual rate of 12.5 million. That's a drop of 22% from the 2007 rate.

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Going forward, I suspect it will take extra time to get auto sales in the U.S. back up to the 2007 or 2006 levels because some percentage of sales during those years were essentially borrowed from 2008 and beyond. Cheap money in the form of cash rebates, leases and low loan rates moved some percentage of sales forward as people who might have "naturally" bought in 2008 were persuaded to buy in 2007.

I think we can expect the same effect in the housing, computer, cell phone and other industries in which cheap financing kept demand from falling by borrowing from future sales.

It means consumer demand will show a protracted, two-stage decline. I'd call what I described in No. 2 above the first stage of consumer decline. It's a version of the typical drop in consumer demand we see in a recession, although its arrival was delayed by the global abundance of cheap money. It finally arrived when the deleveraging of the global financial system reduced or, in some cases, eliminated the supply of cheap money that companies could use to keep consumers buying.

But the credit crunch has a direct effect on consumer buying, too. In this stage, the drying up of consumers' access to credit creates a second drop-off in consumer buying. This consumer credit crunch is about to kick in now that credit card companies are reducing the amount of credit they offer their customers and making that credit more expensive. American Express (AXP, news, msgs), for example, has said it will increase interest rates by 2 or 3 percentage points for some of its cardholders and reduce credit limits on some of its business and personal cards. Another big card issuer, Capital One Financial (COF, news, msgs), has reduced customer credit lines, on average, by 4.5% in the second quarter.

The moves by the card companies aren't surprising; the companies wrote off $21 billion in bad credit card debt in the first half of 2008. Losses in the first half of the year came to 5.5% of credit card debt outstanding and could climb to as much as 7.9% before this recession is over. And while it's not surprising that credit card companies are tightening the debt spigot, it's sure bad news for a U.S. consumer economy that runs on debt.

It will mean we're likely to see a second drop in corporate spending in response to the delayed decline in consumer spending. That will stretch out the recession. Once consumers slow their spending, companies will launch a second round of cuts of the sort typical in normal recessions.

At this point companies will take the same steps to reduce production that they take in any recession. These cutbacks are just now becoming visible in the economy.

It will mean ending this recession will be tougher than usual. The standard medicine for a recession is more government spending on infrastructure (roads and bridges), an extension of unemployment benefits to prop up demand (and relieve suffering), grants to cities and states so they can keep spending and not add to the recession with their own set of cutbacks, and interest-rate cuts.

Those fiscal moves are exactly the package of fixes that the Democrats in Congress have proposed for a second stimulus package. I think that kind of plan would indeed be good news for infrastructure companies and local governments, and could well reduce how far the economy will fall in this recession.

However, the amount of money Congress is talking about -- and the amount in the first stimulus package (remember those checks that some of us got?) -- is small compared with the amount that the credit crunch has taken out of consumer buying power. Add to that the flip side of the wealth effect -- people spend less when their houses and stock portfolios are worth less -- and you can see why this recession is a lot more likely to look like the long recessions of 1973-75 and 1980-82 than the blink-and-they're-over recessions of 1990-91 and 2001.

As for interest-rate cuts, the Federal Reserve has already cut the federal funds rate to 1%. However, with the financial markets recovering but still ruled by fear, low rates from the Fed are largely irrelevant.

What should investors do about a protracted U.S. recession? I've got three suggestions. I'll mention them briefly here and then spell them out in more length in future columns.

3 steps forward

First, if everybody and his uncle are going to spend on infrastructure to fix this crisis, go long infrastructure.

China is going to spend $300 billion on its railroads as one way to get its economy at full speed again. Even if this kind of infrastructure spending in China, the U.S. and elsewhere isn't going to work well as a recession fix, it still should benefit the income statements of the infrastructure companies involved.

Second, go overseas. Especially go overseas to emerging markets. Emerging economies were growing faster than the mature economies of the U.S., Europe and Japan before this crisis, and they'll grow faster than the developed world after this crisis is over.

JPMorgan Chase (JPM, news, msgs) now expects the U.S. economy to shrink 4% and the euro economies to shrink 2% in the fourth quarter of 2008. In 2009, it forecasts 0.4% global economic growth, with developed economies shrinking 0.5% and emerging economies growing 4.2%. It stands to reason that the consumers most optimistic about being out of a recession in 12 months live in China, Vietnam and Russia, according to recent surveys.

Third, if the U.S. recession is going to be a long one, value investors looking for bargains in the U.S. stock market should look for bargains that pay dividends. That way they'll get paid while they wait for the market to catch up with their valuations on these shares.

Warren Buffett has done exactly that in recent deals to buy shares of General Electric (GE, news, msgs) and Goldman Sachs Group (GS, news, msgs). Those have come with 10% dividends. You can't do quite as well as Buffett, but there are value stock bargains out there paying 4% or 5%. Not bad when a 5-year U.S. Treasury note was yielding just 2.71% as of Oct. 29.

In my next column, I'm going to take a look at China's efforts to end its recession -- if you can call the possibility of 7% growth in 2009 a recession -- before it starts. I'll get to the other topics, I promise.

Continued: Developments on past columns

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